Debtor's Prison

Greetings fellow inmates:

You are well aware that we place a great deal of blame on the credit rating agencies for the severity and inevitability of the Great Credit Catastrophe (GCC). Their utterly inadequate rating models and skewed incentives to positively bias ratings created such an illusory perception of credit quality that has since single handedly caused trillions of dollars of losses worldwide. Their initial models and incentives were so inept that there have since been downgrades on trillions of dollars of securities. Much of the initial carnage happened in securitization, forcing investors to take mark-to-market losses on the securities and forced banks to bring some of these assets back onto the balance sheets, allegedly. The credit rating malaise then spread to other types of debt. Rating downgrades have been so frequent and ubiquitous for the past two years or so that it’s hard to keep up with such a dizzying bombardment of cases and we even stop paying attention to it at times. In this post our purpose is to touch briefly on some historical points for context and current ones for some insight into any potential trends.

Two Harvard economists, Efrain Benmelech and Jennifer Dlugosz, have written a great paper on the trillions of dollars of downgrades in the securitization market from mid-2007 to the end of 2008. They go really in depth into the ABS CDO sector, of which we are so fond. We highly recommend the reading, but we’ll give you a brief paraphrase here.

For starters, it’s important remember some definitions. There are two main types of securitization, pass-throughs and tranched. In both there is an underlying pool of assets, such as mortgages or home equity loans, that may or may not be diversified. In pass-throughs, which Fannie and Freddie have been issuing since the 1970s, all investors participate proportionally in the same underlying basket. In a tranched security, different investors have different levels of risk and thus different underlying yields. For example, investors in the top tranche get a lower yield, but they get the credit protection of lower tranches which are obligated to take credit losses first before the senior tranches get impaired. For that reason, different tranches have different credit ratings and they are reviewed independently even though they form part of the same underlying pool of assets (which have their own credit ratings).

By December 2008, structured securities accounted for $11tr, or about 35% of the total US bond market. More than half of these securities were rated AAA by Moody’s. Can you imagine that, such a huge proportion of the securitized market - which was made up of complexly engineered products backed by risky debt - was rated AAA, the same as the US sovereign credit rating. In 2007 and 2008, 36,346 tranches were downgraded by Moody’s, nearly a third of which were AAA securities. Truly amazing numbers. Through the end of 2008, ABS CDOs accounted for 42% of total write-downs of financial institutions around the world. An important point to remember at this point is that some investors are restricted to invest only in AAA securities. So while normally, they could not invest in a basket of corporate loans rated B for example, tranched securitization allowed these investors to gain exposure to this asset class through the senior AAA-rate tranches. Once the ratings on these tranches were downgraded, many investors were forced to sell them at distressed prices since they were unable to hold them any longer. Banks were allegedly able to hold these securities in off-balance sheet vehicles, thus “hiding” them, as long as they were rated AAA. To be perfectly frank, we are somewhat mystified by the numbers because we are uncertain to what degree banks have brought all the off-balance sheet special investment vehicles (SIVs) onto the balance sheet. Looking at the balance sheet of the US banking system, it doesn’t seem like a big portion of these securities have been brought back onto the balance sheet, leading one to the logical deduction that a lot of these losses remain off-balance sheet for some reason (even though such a huge proportion of the AAA-rated ones were downgraded) and banks are in fact insolvent, stress tests notwithstanding. Money market funds are required to have AAA, AA+ or AA securities, so they have also taken a big portion of the downgrade losses.

Below is a chart in dollar amounts of the total amount of notional value of downgraded mortgage backed securities. Notice the tremendous spike upwards from Q3 08 to Q4 08. To be honest, comparatively little coverage was given to the rating downgrade onslaught that brought about such massive write-downs across the world. This might be explained by the fact that the peak of the GCC was happening at the time and attention was focused on the myriad of problems, bank failures, bailouts and the like. The fact of the matter is that ratings downgrades were largely to blame for all the losses. This would not have been the case had their skewed incentives not led to models that grossly inflated ratings in the first place. So, while downgrades were reported, we believe that their central role in mark-to-market losses and systemic failures has been greatly downplayed. Credit rating agencies have not been properly derided and punished for their role in this, and in fact they are even getting rewarded as many of Uncle Benny’s liquidity facilities require assets to be rated by the big three agencies, the same culprits that led to this hemorrhaging of credit “quality”.

Below is a chart of downgrades versus upgrades for all securitized products. Notice that even though the chart is a little dated (beginning of 2008), it shows in dramatic fashion the upward spike in downgrades. If the rest of 2008 is taken into account, the spike is even larger.

This is a chart of downgrades versus upgrades for corporate bonds. Thought this chart is similarly dated, we now know that for all of 2008, $900bln of US corporate bonds were downgraded, or nearly 24%. This approaches the highs of 2002. Since then, in 2009, more corporate debt have been downgraded. This is an example of the rating downgrade malaise spreading. As the recession hit, a large number of corporations and businesses found themselves harder pressed to meet debt payments and their ratings got cut. We expect that corporate downgrades will continue to outpace upgrades by a wide margin for the foreseeable future. This is partly due to our belief that the economy will not recover as fast as smokers of green shoots seem to believe and that the wave of corporate bankruptcies is far from over.

This brings us to the current pace and nature of the downgrades. Corporate downgrades continue, especially at troubled economies, as evidenced by recent downgrade of 30 Spanish banks by Moody’s. UBS was recently put on negative watch. Even colleges have been on a downward credit slide, with 20 downgraded so far this year. US states have also run into some trouble with their own debt. Ohio’s debt was recently downgraded by Moodys from Aa1 to Aa2 due to their economic underperformance. The budgetary crisis in California finally prompted S&P to put California’s debt on negative watch. We expect municipal credit rating downgrades to continue at a fast clip as the ongoing recession reduces tax bases and budgetary deficits plague the nation.

Perhaps even more interestingly for us, sovereign credit ratings have also been on an ongoing downward spiral. We are well aware of the multitude of downgrades of sovereign debt of nations with large imbalances and external debt ratios, such as the Baltics. What’s notable is that this has spread even to the most highly-rated nations. Recently, Ireland was downgraded by SP to AA from AA+ and still put under negative watch. This follows a massive bailout package to the banking sector that served to transfer private credit risk to the sovereign. Also, quite recently Britain’s credit rating was put on negative watch by S&P. This sent quite a reverberation through the markets since Britain is a AAA-rated nation and one of the reserve currencies. Also, it’s important to keep in mind that a negative outlook almost always results in an eventual downgrade. This also prompted speculation that the US might also one day lose its AAA-rated debt.

We strongly believe that the US will in fact lose its AAA-rating, which will be an event of enormous importance for everyone. All of a sudden, the plethora of institutions that are forced to hold AAA-rated debt will have to unload their Treasuries. To be quite frank, the implications are so staggering that we don’t really have a good handle on what could happen if this scenario actually comes about. There are a variety of reasons why we believe the US will lose is AAA-rating. Amongst them, we believe the case of Britain is a canary call, clearly showing that even a reserve currency can be dethroned due to the heavy burden of an over-leveraged nation. As a planet, our approach to solving the GCC, a debt problem, has been to issue enormous amounts of new debt. Similarly to home refinancings, in a large fraction of cases, this roll-over of debt only forestalls the eventual default. Globally, we are replacing toxic debt with newly minted sovereign debt and absorbing a large proportion of the world’s debts onto central bank balance sheets. Nowhere is this more prevalent than in the US. Of course, the pressure to maintain the US’s credit rating might be enough to prevent a downgrade. However, we believe that eventually the debt overhang, which is shifting to the sovereign class, will be large enough to make it nearly impossible to justify the US’s rating, especially after a precedent has been set with Britain.

We have no idea when this event might take place. Nor, as we said, do we really have our heads wrapped around the magnitude of the eventual ramifications of a US downgrade. All we know is that it would be gargantuan. What’s disgusting is that in all likelihood credit rating agencies will remain at the center of the credit crisis all the way to the bitter end, completely untouchable.

May your capital be safe and your investments prosperous,

MAAA