How To Get To AAA

When a debt security carries a high credit rating, like AA or AAA, what makes

it secure? Sometimes it’s just the fact that the issuing entity has a lot of

financial strength: think UPS,

for instance. But the number of companies with that kind of financial strength

is decreasing rapidly, as mangement succumbs to shareholder pressure for more

leverage. Yves Smith of Naked

Capitalism notes in an email to me that

in the stone ages of finance, there was a fair bit of AAA paper (most money

center banks, many utilities, AT&T when it was Ma Bell, most sovereign

credits) but now there are very few native AAA credits. So there has been

an imbalance in that slice of the market.

That imbalance is driving demand for more artificial AAA bonds, from investors

who can’t find the native stuff any more.

Meanwhile, Tanta at Calculated Risk is quoting

John Mauldin on how the ratings agencies rate mortgage-backed

securities:

The rating process was not the same as the ratings that were used in the

corporate world. But the problem is that the ratings used the same designations.

Instead of creating a whole new type of rating standard (say, using numbers

like "CDO rank 1-10"), they used the same designations that bond

investors were used to.

I think it is disingenuous for a rating agency to explain the difference in

paragraphs 457-503 in 7-point type and dense legalese in their disclosure

document. Investors had (and should have) a certain level of expectation when

the designation "AAA" is used. GE and Exxon types of expectations.

The main difference between a native AAA and an asset-backed AAA is in mark-to-market

volatility. A credit rating does not mean that an investor is unlikely

to lose money if he marks his investments to market. It means only that an investor

is unlikely to lose money if he holds his security to maturity. The problem

is that if you’re buying native AAA bonds, you’re getting safety on both counts,

whereas if you’re buying asset-backed AAA bonds, you’re getting safety only

on the latter count. But investors knew that perfectly well: it’s not the ratings

agencies’ fault that they chose to ignore it.

How does a bunch of subprime nuclear waste become a AAA bond? That’s the question

I hinted

at yesterday, when I said that diversification was key. In response, I got

a number of comments, both on the blog and by email, telling me, quite rightly,

that I’d ignored the other key way of boosting credit ratings: overcollateralization.

But in the CDO market, I’m not convinced that overcollateralization always

works particularly well. Consider three different CDOs:

  1. A $100 million CDO backed by $200 million in mezzanine tranches of subprime-backed

    mortgage-backed securities.

  2. A $100 million CDO backed by $100 million in AA tranches of subprime-backed

    mortgage-backed securities.

  3. A $100 million CDO backed by $100 million in a mixture of residential MBS,

    commercial MBS, and corporate syndicated loans.

All three of these CDOs can and would be tranched, and one of those tranches

would end up carrying a AAA rating. But I think I would feel safer with the

triple-A tranche of CDO3 than of CDO2, and I would feel safer with the triple-A

tranche of CDO2 than of CDO1.

How can CDO1 be the least safe of the lot, when it’s backed by twice as much

collateral? Because in the event of a serious subprime meltdown, mezzanine tranches

of subprime bonds could be wiped out. And twice zero is still zero. Once the

mezzanine tranches are wiped out, the higher-rated tranches start taking losses

as well. But at least they retain some cashflow, which means that the

AAA parts of CDO2 – the parts which get paid first – would probably

be fine.

Meanwhile, the owners of the AAA parts of CDO3 are really quite sanguine about

subprime losses. Those losses are absorbed entirely by the equity portion of

the CDO, and the AAA parts can be paid entirely with cashflow from commercial

mortgages and corporate syndicated loans.

In other words, the most diversified CDO is the safest, while the most overcollateralized

CDO is the weakest. Now of course this is an artificially-constructed thought

experiment, and I’m sure there are lots of overcollateralized CDOs which are

perfectly safe even if they don’t have much diversification. But as a general

rule I think a CDO buyer should be looking first at diversification, and then

to other sorts of credit enhancement, such as guarantees or wraps from insurance

companies who specialize in such things.

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