global bond and currency
markets continue to totter three years after the U.S. subprime mortgage market collapsed. And although the source of the pain is different now than it was three years ago — European bonds today vs derivatives then — the core issue is the same: why didn't the credit-rating agencies spot the seeds of the problems long before they bloomed? More to the point: what lessons have credit raters learned from the 2008 debacle?
It is no coincidence that the problems of 2008 and 2011 are much the same. Three years ago, it was structured finance in the form of instruments such as credit-default swaps and collateralized debt obligations produced by investment banks. Now, it is sovereign debt issued by governments and carried by banks, both as capital and as assets. The question, then and now, is: what is all that paper really worth?
The debacle of 2008 has taught the "buy" side and financial advisors to ask, "What's behind these bond ratings?"
In turn, the credit-rating agencies' letter ratings are no longer taken at face value. As a result, the agencies have moved to make their work more transparent and to limit their dependence on implied promises of government backup of very large bond issuers.
Says Chris Kresic, co-head of fixed-income and a partner with Jarislowsky Fraser Ltd. in Toronto: "The credit-rating agencies are now more cautious and more hawkish." Translation: the agencies no longer give as much weight to the political idea that a bank or any other financial services institution can be too big to fail.
In the financial services arena, credit-rating agencies are backing away from their old habit of giving AAA ratings to large, systemically important banks, says Joe Morin, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont. The new caution on the buy side stands on two feet, he explains: one is in less trust in government; the other is in demand for transparency.
"The agencies have explained that they are changing their rating methodology," he says. "They are unwinding the trust they had placed in what national governments would cover for their nationally important banks."
In truth, there are now too many technically insolvent banks to rescue. So, not only is government support for the "too big to fail" firms no longer taken for granted, but even the covered bonds backed by specific assets and payment guarantees by governments, such as Germany's provincial landesbanks, are now losing buy-side support. Once the best-of-breed corporate debts, so-called "covered" bonds now are being looked at closely by buyers.
"Covered bond issuers used to be able to package and sell debt with the promise that the issuer would stand behind them," Morin says. "But now, the market wants to know what's in these bonds."
In other words, even though covered bonds, which are new to Canada but common and even characteristic of the investment-grade bond market in Europe, have pedigreed issuers and AAA stamps on their wrappers, buy-side investors want to know what they are getting. Thus, the credit-rating agencies are now doing what they should've been doing all along: looking inside structured products and covered bonds to determine the likelihood that the assets will be available to cover what's due in case of default.
In essence, bond investors want more transparency, Morin notes: "Goldman Sachs [Group Inc.] and J.P. Morgan Chase [& Co.] say they have US$2 trillion in exposure [combined] on credit-default swaps, but they report only their net exposure. We don't know the gross exposure. There is pressure from investors and from the credit-rating agencies pushing for more openness. And there should be, for if they have $1 billion in exposure to Italy and they offset that with a $1-billion [credit-default swap] from a hedge fund, then, if the hedge fund defaults, the big investment house may be holding the bag."
Transparency on derivatives trading has improved, Morin adds. Case in point: J.P. Morgan now issues a 200-page, quarterly statement with 50 more pages of supplemental data. That is enhanced transparency, Morin says, but it can also be drowning people in so much data that they don't know what is going on.
In one sense, the credit-rating problem has been made easier by the contraction of markets that have collapsed. For instance, Canada's asset-backed commercial paper market is now just $25 billion, a fifth of its pre-scandal size, says Jerry Marriott, managing director of Canadian structured finance with Toronto-based credit-rating agency DBRS Ltd.
As a result, retail investors no longer participate in Canada's ABCP market; the buy side now is just institutions that can do their own homework — and the agencies are quicker to report changes in status in what they are rating. But, Marriott cautions, "There is a need for investors to understand what they are buying."
This comment — that inves-tors must do their own homework — can be taken as either simple truth or an abdication of responsibility. Still, the credit-rating agencies are not going to disappear or morph into something else, as many institutions have mandates that require investment-grade ratings from at least two credit-rating agencies for everything they buy and hold.
That means even bonds from the top levels of the capital structure of the biggest and best-capitalized banks need an investment-grade rating from the agencies. Yet, despite the stamp of approval from the agencies, there is a very different view.
"We are not becoming more skeptical," says Vivek Verma, vice president with Canso. "We have always done our own homework. Today, the agencies want to de-link sovereign risk from bank bonds. They may change the rating methodology tomorrow. We want consistency, but we do not get it."
The challenge for the buy side is to recognize who is holding the bag of risk. As Warren Buffett once quipped, "In a deal, if you don't know who the sucker is, it's you."
That's why financial advisors and all buy-side investors have to assess the assessors. IE