Veryan Allen has another
rant up at his Hedge Fund blog, reprising his refrain that anybody who loses
most of their investors’ money is likely not to be a hedge fund at all, 2-and-20
pay rates notwithstanding. Most of the rant is annoyingly unspecific, naming
no names and not even hinting at the identities of the few good fund managers
Allen claims to admire. But every so often he drifts out of his normal hand-waving
mode and gets specific, as in this riff on triple-A ratings:
It was absurd to assign a measure originally designed for rock solid government
and corporate debt to the untested (till now!) financial alchemy of CDOs,
CLOs and CPDOs. It is applying a fundamental metric to model-based credit
structuring using wildly optimistic assumptions of default and recovery rates
and correlations of different borrowers. Collateral is "sound" only
if someone else will buy it at prices you "assume". If product structurers
want to rate shop for a sellable classification that is their freedom but
investors should ignore them. The only things "investment grade"
are those assets whose rewards outweigh the risks. How shortsighted to gain
a few hundred basis points for a while but end up losing 100%.
There’s some truth here, but also a lot of disingenuousness. Two rhetorical
tricks are worth calling out in particular.
Firstly, it’s true that CDOs, CLOs and CPDOs, in their present form, are untested
– that’s because all three are relatively new products, and any
new product is, by definition, untested. On the other hand, it’s absurd to say
that all new products are, by definition, unsafe. And Allen’s implication is
actually broader still: that asset-backed securities in general are
untested, and that triple-A credit ratings should be assigned only to rock-solid
unsecured debt.
In truth, there’s no reason to believe that asset-backed triple-A securities
are more likely to default than unsecured triple-A securities. Given a long
enough time horizon, all assets tend to zero, and history is littered with stories
of cities, countries and companies which once had great wealth and power but
which collapsed with astonishing rapidity. At the same time, asset-backed bonds
in general have a long history which can compare reasonably favorably to unsecured
bonds. Both have suffered defaults, of course, but the default rate on asset-backeds
is not appreciably higher than the default rate on similarly-rated unsecured
debt. (Is it true, at least, that asset-backed bonds are more likely to default
during a general economic downturn than unsecured bonds are? I don’t know. Maybe.)
And to check on whether the ratings agencies were "wildly optimistic,"
you have to look at their work in toto. Obviously, in hindsight, any
instrument which defaults is likely to have suffered from overly optimistic
assumptions. But there will always be instruments which default, so this kind
of ex post criticism is generally unhelpful. What would be much more
useful would be if Allen could point us to other, non mortgage-backed securities
which he thinks are based on wildly optimistic assumptions: that sort of ex
ante analysis can save people a lot of money and pain.
Secondly, "investment grade" does not mean "worth investing
in" – as Allen knows full well. It’s possible to make a lot of money
investing in non-investment-grade ("junk") debt, especially if you
pick credits which are likely to get upgraded to investment-grade status in
the coming years. Similarly, a credit which starts off with a AA rating and
slowly gets downgraded all the way to BBB is going to lose a lot of value, even
though it’s investment-grade the whole time.
And in any event, almost no one has ever ended up "losing 100%" of
their money by investing in investment-grade debt, unless they employed leverage
or they invested in the unsecured debt of a major fraud such as Enron. Even
WorldCom bondholders made out pretty well in the end, considering.
The ratings agencies are not – and nor do they purport to be –
a service telling investors which securities are going to turn out to be profitable
investments. They rate only the probability of a default, not the probability
of a drop in price. In 1998, credit spreads gapped out sharply across the board,
and a lot of investors lost a lot of money. That’s market risk, and it’s not
something the ratings agencies can or should be concerned about. In fact, over
the past decades, it’s very hard to find areas where the ratings agencies have
been spectacularly wrong.
Eventually, of course, one such area will emerge, and it looks very much as
though subprime is that area. I do think that the ratings agencies did get subprime
wrong, although we’re still a long way from finding out just how high up the
ratings scale there are likely to be defaults. But I don’t think that it’s worth
dismissing everything that the agencies do as worthless just on the basis of
a bad outcome in subprime.