Thursday, February 28, 2008

What does a AAA mean anyway?

S&P has affirmed MBIA's insurance sub's rating at AAA, and has removed it from negative watch. MBIA does remain on negative outlook. In credit ratings parlance, no longer being on watch means a downgrade is not imminent. The negative outlook reflects the simple fact that MBIA may well fail to regain a AAA-level reputation, regardless of the AAA rating. If they fail to regain their reputation, their business will not ultimately recover. But for financial institutions with exposure to MBIA, chief among which was Merrill Lynch, this is unequivocally good news.

S&P wasn't done doling out the good news. They also affirmed Ambac's AAA rating, although Ambac remains on negative watch. Normally negative watch indicates that a downgrade is imminent. In this case, however, S&P indicated that Ambac was about $400 million short of the capital level needed for a stable AAA rating. Therefore if Ambac is able to complete the capital infusion plan reportedly in the works, which will supposedly raise $3 billion, they should be able to retain their rating. Several reports indicated that the only thing holding up the negotiations between Ambac and the banks is a sign-off by the ratings agencies, and I'd say today's report from S&P tells us that at least one agency would indeed sign-off.

The market continues to be highly skeptical of these ratings. CDS on both MBIA and Ambac's AAA-rated insurance subs are still well over 300, roughly in line with BBB+ rated Washington Mutual, wider than A rated Bear Stearns.

Now we can quibble about S&P's methodology of estimating "stressed losses" on mortgage-related securities. For 2007 vintage tranched RMBS rated A or lower, S&P assumed at least a 84%+ loss rates on Alt-A and closed-end second mortgages, and home equity lines of credit. On first-lien sub-prime loans the loss rates are slightly better, no doubt owing to somewhat better recovery. The 2006 vintage loss estimates are similar, with some product worse and other product better.

On ABS CDOs, S&P assumed loss rates of around 60% on higher-rated collateral and 80% on lower-rated collateral for the '06 and '07 vintages. Given that the monolines generally only insured the most senior tranches of ABS CDOs, that probably puts the eventual monoline losses on these products in the 40% area.

So like I said, we can quibble about whether or not that represents a "stressed" scenario or not. The reality is, it doesn't matter what we think. If S&P says that Ambac and MBIA have enough capital to be called AAA, then they are AAA. Banks will now use AAA ratings when calculating their capital ratios. Money market funds can keep holding insured paper.

It especially doesn't matter what we think because neither Ambac nor MBIA is in any real danger of running out of cash in the near term. Ambac and MBIA reported over $18 and $35 billion in marketable securities respectively as of 4Q 2007. Plenty to pay any losses they are likely to incur over the next several quarters. So if the monolines aren't going to actually run out of cash, if they aren't actually going to go bankrupt, who is to say they aren't AAA?

And that's what bothers me. When you come down to it, the debate over whether the monolines should or should not be rated AAA is entirely subjective. We all agree that a AAA-rated bond should have a remote chance of taking losses, but how remote is remote? We all agree that a AAA-rated insurer should be able to withstand a 6-sigma event, but what constitutes a 6-sigma event? There is no single answer to these questions. Its subjective.

That would be OK, except that credit ratings are so ingrained in our financial system. Everything from banking and insurance regulations, mutual funds, money markets, pension funds, debt service reserve accounts, etc. all depend on a ratings system to guide them. Try sometime sitting down and reading the SEC 2A-7 rule, which governs money market investments. The rules all but encourage managers to buy whatever they want as long as the instrument has the right rating and right maturity. And yet if 2007 taught us anything, its that credit ratings are just opinions. No matter how sophisticated the modeling and financial analysis, those opinions can be just plain wrong.

On Monday, the Dow rallied nearly 200 points, and credit spreads almost universally tightened. Why? Because a AAA rating for MBIA and Ambac means that banks won't have to pledge more capital against downgraded ABS. This gives them more capital to lend into the economy. No matter what you think of S&P's analysis, that's the reality. If that reality bothers you, perhaps your derision should not be aimed at S&P or MBIA, but at the banking regulations that are so heavily reliant on ratings.


Unsympathetic said...

All that's needed for the ratings hoo-hah to end is for Congress to mandate that ratings agencies can only receive income from investors.

This nonsense of being paid by Bear Stearns to rate Bear Stearns needs to stop - yesterday. Yeah, no conflict of interest there. None.

What does AAA mean? A company rated AAA can repay any and all of its debts on time regardless of what happens - unless we get nuclear winter. Berkshire, GE, and the US government are the only AAA I can think of right now. One could argue that China is AAA right now as well, except for their nasty habit of squicking all non-Chinese companies doing business within their borders.

"AAA relative to the companies playing in that specific sandbox" is 110% inane. Either the market does the right thing here or we will continue to slide sideways at best. Opacity is not a good thing - do we need another 1930's style depression to remind folk of that?

Anonymous said...

What alternately amuses and annoys me is all the noise from people who barely knew what a credit rating was at this time last year, but now how very definite and strongly expressed feelings about the subject.

Anonymous said...

If I told you the odds your flight to Chicago would land in Lake Michigan were 1 in a 100 would you get on the plane?

One in a hundred.

No. You wouldn't.

We now discover that an AAA rating is a lot less secure than commercial air travel.

And people are all up in arms about it. Well, I guess that's not entirely accurate. They're not quite up in arms about it.

PNL4LYFE said...

The current rating agency model (issuer pays) is unlikely to change as a result of this. How could they keep ratings from being obtained by investors that didn't pay for them? The internet virtually guarantees that ratings will be widely available at no cost. And Egan-Jones doesn't work as a counterargument. The reason no one makes an effort to 'steal' Egan-Jones ratings now is that you can still look at the other three.

It bothers me that there are people out there who pretend they were completely blindsided by AAA rated securities that are now in question. Most of the CDO and other structured products traded with higher yields than "real" AAA from the very beginning. In fact, that's why people bought them! The only way to interpret the wider spread is that the market knew all along that they were riskier. Clearly, it didn't know quite how much...

Anonymous said...


Very, very good comment. Feel the greed.

Anonymous said...

What are the odds that the social structure of the US will break down?

We've been being told that Government is evil for a long, long time.

Suppose people felt that they had been betrayed and that their livelihoods were in danger.

Off topic? I don't think so. "AAA" ratings were supposed to be solid gold.

Chrisfs said...

even AAA ratings represent a small chance of default. Would you rate giant heavily defended space station with a single unshielded exhaust vent, as an AAA risk, but there's always a chance something can happen.

If memory serves, I read an article that the ratings companies were effectively gamed. A bank would call and ask "what is required to get an AAA rating" and fashioned the tranche or pool to match those requirements.

BackOfficeMonkey said...

One argument that I heard is that while many different securities are rated AAA they all do not have the same definitive risk structure. For example I received an "A" in my intro to macroeconomic class while my friend also received and "A" however my grade point average was a 93 but my friend's average was a 98. There is a pretty large difference between our grades while we got grouped together in the same grade category. Same thing w/AAA rated securities.

Anonymous said...

What was AAA at a higher yield? The monoline or the CDO?
I think there is a big distinction here - to my understanding the insurer AAA of Ambac (and insuring senior tranches) vs the AAA of a CDO is comparing apples to oranges.
I wouldn't argue with you about the validity of a CDO's AAA, but I would disagree with a monoline's AAA. Or at least, some of the monolines.
Please correct me if I am missing your point...

Anonymous said...

From 2005-2007, every news paper and magazine was running stories about the housing bubble. No offense to any journalist that reads this comment, but these people are english majors-- they don't have an economics background or an MBA/CFA.

Somehow, Wall Street was caught completely off guard when the bubble collapsed.

People who have economic backgrounds and are paid six or more figures a year didn't see anything coming. Greenspan, Bernanke and a Federal Reserve full of PhDs apparently saw nothing wrong. Greenspan even told Americans to switch into ARMs. Meanwhile, a bunch of english majors saw right through the AAA rating nonsense.

So now, every news station, paper and magazine is talking about inflation. Members of Congress (usually the last group to figure anything out) are asking about it; today a **democrat** Congressman questioned Bernanke if inflation would limit his ability to lower rates.

Oil, corn, sugar, soybeans, CRB index are all at highs. The dollar keeps hitting lows. M2 is growing 6% year over year. The clues are all there-- the english majors and Congress are seeing them anyway.

Wall Street has every single US Treasury out past the 10yr note trading BELOW the recent CPI reading.

So if history holds, Wall Street will act all surprised in a year, year and a half, when inflation "suddenly" appears.

All this discussion of supposedly AAA ratings is making people realize the folks on Wall St don't really know what is going on

Anonymous said...

Wall Street doesn't know?

Would that it were true.

Alan Greenspan knew precisely what he was doing: financing the Iraq war.

THE Iraq war has cost the US 50-60 times more than the Bush administration predicted and was a central cause of the sub-prime banking crisis threatening the world economy, according to Nobel Prize-winning economist Joseph Stiglitz.

The former World Bank vice-president yesterday said the war had, so far, cost the US something like $US3trillion ($3.3 trillion) compared with the $US50-$US60-billion predicted in 2003.


Professor Stiglitz told the Chatham House think tank in London that the Bush White House was currently estimating the cost of the war at about $US500 billion, but that figure massively understated things such as the medical and welfare costs of US military servicemen.

The war was now the second-most expensive in US history after World War II and the second-longest after Vietnam, he said.

The spending on Iraq was a hidden cause of the current credit crunch because the US central bank responded to the massive financial drain of the war by flooding the American economy with cheap credit.

"The regulators were looking the other way and money was being lent to anybody this side of a life-support system," he said.

That led to a housing bubble and a consumption boom, and the fallout was plunging the US economy into recession and saddling the next US president with the biggest budget deficit in history, he said.

Christopher Wheeler said...

S & P says MBIA is AAA. The market says MBIA is B. Because S & P's is the opinion that counts, the biggest prop to the muni market is not kicked out, and banks have access to more capital to ease the onging credit crunch.

It looks to me like the fix was in, and if MBIA has enough assets to weather this storm, than thank God the fix was in. Aside from Ackman, does anyone really WANT to go through the fallout if the monolines get downgraded?

Now, if MBIA management gets through this period, dodges the bullet, and then runs back out into the line of fire by insuring more toxic waste, that would be amazing.

Similarly, if S & P doesn't start tightening up their rating assumptions, now that everyone knows how risky these CDO's really were...well, that would be criminal.

Anonymous said...

Another blog recently compared the financials of Pfizer and MBIA. S&P recently downgraded Pfizer to AA but did not downgrade MBIA. The differences in the two financial statements is stunning. It goes a long way to show the unevenness of their ratings.

Anonymous said...

Let's not ignore where a huge grey area exists. Big underwriters sold these CDO's to their customers and when the CDO's turned sour, the big dealers fired their CDO traders and stopped making markets in any of the CDO's.

So we have no idea if the market value even remotely resembles the NPV of any recovery. Nonetheless, banks are being held accountable for the market value of those securities when a market barely exists.

The icing on the cake is that the next time the big dealer who sold the customer the CDO calls with his next great product, the customer will take his call rather than slamming the phone on him.

If you sell it, you need to maintain some kind of market for it.


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