When is a AAA not a AAA?I've recently been looking into the reliability and stability of ratings for an ABS fund. (This is of course based on the fact that some ABS is ludicrously underpriced-but we have to avoid the dogs!). Fitch has produced some useful research in the last couple of months.
There are interesting conclusions regarding 2008.
-98% of all RMBS downgrades were in the US; but we're not looking there
-99.8% of European prime RMBS AAAs remained AAA.0.2% was downgraded to AA. No downgrades below this
-Only 50.9% of US Alt-A AAAs remained AAA. A massive 36.4% went to sub-investment grade
In European CMBS, 98.9% of AAAs remained AAA, 1.1% went down only to AA.
Remember, these were all AAA 12 months earlier. The obvious conclusions are
-Not all AAAs are going to stay that way
-Some sectors look pretty solid and, subject to some professional credit, modelling and monitoring work, there are good profits to be made.
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There was talk of the market turning at the recent IMN conference. We have to draw a distinction here between a move from ludicrous to merely silly levels of undervaluation on the one hand; and a return to the "good old days" of originating, parcelling up then flogging off the lot, including the equity piece, on the other.
It's only 18 months since I attended a conference where the head of securitisation of one of the big US investment banks (RIP) stated quite seriously in public that retaining or selling on equity pieces was of no consequence. Authorities in both Europe and the US are now insisting on risk retention, so that one has been put to bed.
When we see the likes of Barclays and Rabobank offering to buy back their ABS (Barclays tendering 70% for perfectly well-performing assets), it's a clear sign that there's real value there. There is a clear difference between European and US paper, with the latter coming in much tighter. Mind you, we don't have a TALF in Europe. Yet.
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The ECB is now pushing for more disclosure (also known as "transparency") regarding the underlying assets of securitisations. What's that all about?
It seems to be based on the assumption that data and information are the same thing. They are not. Just as you have to mine many tons of rock to get at a small quantity of gold or diamonds, masses of data are only useful when presented in a digestible form. I've seen cases where passing on reams of data is a means of obfuscation: "I've passed it all on, so nothing to do with me if it goes wrong".
The proposal from the ECB is that all of this stuff be passed on to ratings agencies. Yes, ratings agencies, those Aunt Sallies pilloried by various EU parties from McCreevy downwards. But raters have always had the right to ask for whatever information they want, so nothing really new there.
Then there's the suggestion (in the FT) that "analysts say the ECB should also push for full public disclosure of the loans that back these securities – as in the US – and not just to the ratings agencies." Would that be the highly liquid and successful US market we are all familiar with? Phew, the answer at last, just disclose a load of data and everything will be fine!
Hector Sants of the FSA said in a speech this week that investors should not buy investments they don't understand. That probably limits us all to Gilts.
A friend recently invested in a bond from the West Bromwich, which now appears to be in some difficulty. She did not engage in a rigorous balance sheet analysis, nor compare various ratios on an international basis. She would certainly not have been in a position to do a loan-by-loan analysis of several thousand borrowers-which is after all the real risk of a building society, whether in balance sheet or securitised form. She lacked both the skills and the time to understand all of this complicated stuff; but did understand that there is a government guarantee on deposits up to £50k.
There's nothing wrong with disclosure, but it should be in the form of information, not data.
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The International Financing Review reports this week that "Triple A CLO prices are below liquid loan prices, which makes little sense given the subordination, excess spread, and event of default control rights afforded to the AAA noteholder". In other words, you can buy AAA bonds based on much lower rated loans at a more attractive price, and on better terms, than the loans themselves.
What is driving this? One bank suggests that "The relative sensitivity to ratings and downgrade risk for Triple A CLO investors may be weighing more heavily on CLO prices than rating issues at the loan level". That means that two sets of investors are taking quite different views of risk. Which is the pre-requisite for arbitrage. Some see arbitrage as the bad guy in the black hat, but the positive aspect is that it brings disconnected markets back into line.
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That was a headline in a recent edition of the New York Times. The article is about very clever scientists who thought they could reduce markets to formulae, and beat the markets as a result. There were, of course, more things in heaven and earth than were dreamed of in their philosophy. I gave some views on how the Gaussian copula (bell curve) is a fundamentally flawed analysis in "The Cracked Bell Curve" http://www.robinhoodfinance.com/docs/Th ... _Curve.pdf
a year or so ago.
The most recent edition of International Financing Review has an article entitled "The Copula That Killed" which describes the work of one David Li of JP Morgan, who produced an explanation of correlation which was clear, simple... and fundamentally flawed. Mr Li must empathise with Thomas Midgley, a well-meaning scientist in the early 20th century who developed two clever solutions to industrial problems-lead tetraethyl in petrol (poisoned lots of people); and chlorofluorocarbons for refrigeration and aerosols (made big holes in the ozone layer). Wikipedia says of Midgley "While lauded at the time for his discoveries, today his legacy is seen as far more mixed considering the serious negative environmental impacts of these innovations."
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