Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

China and Russia to Cooperate in Joint Credit Rating Agency

Since the 2008 financial crisis, the credit rating agencies have not undertaken needed reforms. In February 2007, I recommended the SEC revoke the credit rating agencies’ designation as Nationally Recognized Statistical Rating Organizations (NRSRO) for structured products. Of course that didn’t happen, so in July 2011, in a symbolic move, I revoked the NRSRO designation for Moody’s, Standard & Poor’s and Fitch and gave recommendations for what would be required to restore the designation.

The global financial community is disappointed with absence of an appropriate U.S. response to the financial crisis, and today there is prudent distrust of our methods. Russia and China announced an independent move to form a joint credit rating agency. They will also engage in talks about joint management of gold and foreign currency reserves.

Russia and China Should Change the Model

What possible objection could we in the U.S. make without inspiring laughter? Given the low bar we’ve set, there’s a strong likelihood they’ll do a better job. Anton Siluanov, Russia’s Acting Finance Minister, said the new rating agency would be modeled on existing rating agencies. I hope he reconsiders and instead heeds recommended fixes.

Moreover, among financial professionals, there is a strong view that the credit rating agencies are politicized, and the new credit rating agency is meant to be apolitical. It will be a hat trick to pull it off, but it’s a worthy goal.

It’s key to remember that the rating agencies didn’t merely fail to anticipate the financial crisis, they were complicit contributors to it. The rating agencies didn’t demand evidence that appropriate due diligence had been done on new loans with drastically different risk profiles and novel structures that posed cash flow risks that swamped credit effects and amplified losses. Moreover, they actively ignored evidence of risk. Congressional investigations were clear on these points.

Heedless of any reasonable standard of sound analysis, rating agencies issued ratings as issuance of corrupt collateralized debt obligations accelerated, and the worst cohorts of loans were originated in 2006 and 2007.

Rating Agencies Cooperated In a Cover-up

The rating agencies’ malfeasance materially contributed to systemic risk and had a role in damaging multiple markets. The rating agencies contributed to the suicidal deals struck by monoline insurance companies. You’ll recall monoline insurance companies Ambac and MBIA provided credit wraps for municipal bonds, among other things. When it became clear they strayed into risky waters and were headed into credit troubles of their own, everyone scrambled to assess the implications and to do damage control.

Prior to the September 2008 financial crisis, rating agencies cooperated in a cover-up with investment banks and bond insurers to deny the gravity of systemic losses due to fraud-riddled collateralized debt obligations combined with leverage.

On January 3, 2008, I wrote a commentary explaining the monoline bond insurers would lose their “AAA” ratings and were wildly overrated. The Fed, investment banks, banks, and credit rating agencies continued to stonewall.  On January 18, 2008, Fitch downgraded Ambac from AAA to AA after Ambac couldn’t raise $2 billion in capital, and Moody’s and S&P affirmed Ambac’s rating.

On February 18, 2008 I wrote the following commentary. By June 2009, MBIA had a junk rating, and in November 2010, Ambac filed for bankruptcy and re-emerged from bankruptcy in May 2013:

Ambac and MBIA: Structured Finance Underwriting Standards – February 18, 2008

Ambac and MBIA claim they can maintain their “Triple-A” ratings. MBIA recently complained to Congress calling short sellers’ tactics “unscrupulous” and “dangerous.” Presumably MBIA was complaining about Pershing Square’s allegations of, well…MBIA’s opaque disclosures and seeming lack of sensible structured finance underwriting standards.

We are, after all, talking about insurance companies, and one does not want to start a public panic. It is important to be responsible.

Mr. Ackman put out some high numbers for the amount of capital MBIA and Ambac would require [about $12 billion each]. Mr. Ackman showed his assumptions, but the open source model is too complex for most people to opine on his figures. Besides, he has incomplete information, and there was some guesswork involved. To Mr. Ackman’s credit, he tried to lay it all out in the open, and anyone is free to second-guess his assumptions. The monolines, on the other hand, protest that his numbers are much too high without providing sufficient transparency to prove it.

Sean Egan of Egan-Jones, a competitor rating agency (to Moody’s, S&P, and Fitch), claimed that the monolines would need $200 billion in additional capital to merit a Triple-A rating. His number seemed arbitrarily (and sensationally) high, just as those of the other rating agencies seemed arbitrarily low, but he is entitled to his opinion.

In early January, I gave my opinion of additional capital requirements relative to the S&P model’s calculations. Instead of showing a complex model, I simply pointed out that based on my view of defaults and recoveries relative to S&P’s view, the capital required would have to be significantly higher. I was not suggesting S&P captured all the structural risk I see in prospectuses. Subsequently, S&P raised its base case loss forecasts to almost match mine.

Perhaps this is still too complicated, so allow me to make it even easier to follow. Let us use the rating agency performance attributes instead of numbers.

Ambac’s Mr. Callen: Salvage Value?

In a February 14, 2008 Wall Street Journal interview, Ambac’s Mr. Callen suggested that cumulative loss rates may be lower than expected, since Congress may overreact. Presumably he meant Congress would engineer a bail out of bad mortgage loans, thus mitigating his ultimate losses. Perhaps he is correct, but if so, he is guessing future events will be favorable to his portfolio.

Besides, it may already be too late. Looking at Ambac’s deals in 2006 and 2007, seven out of twenty CDOs linked to the mortgage market already experienced an event of default (EOD), according to the rating agencies. I do not have enough details to know if an eighth deal called Lancer is the first or second of that series, but either way, it does not look good: Lancer I is in downgrade mode, and Lancer II is in liquidation (See attached). Given the deterioration in these deals, Ambac may experience substantial principal losses, and capital suppliers may view the portfolio as financial guarantees on non-investment grade products.

Mr. Callen’s position may be unsalvageable.

MBIA: Apocalypse Now

MBIA’s Gary Dunton famously claims to underwrite to a “zero loss [impossible] standard,” and claims MBIA’s portfolio is in better shape than Ambac’s.

Attached is a summary of MBIA’s positions along with the original deal closing amounts to compare with insured amounts. Notice that of 22 deals done in 2006 and 2007, four are in acceleration and one is experiencing an event of default.

Mr. Dunton may have thought he was better off, because in recent deals, particularly deals done with Merrill Lynch, MBIA raised the attachment points, thus increasing subordination. In public interviews, Mr. Dunton declined to name the deals he agreed to do after Merrill made its famous Apocalypse Now helicopter ride to MBIA’s offices in August 2007.

Allow me to guess. Due to the high attachment points, I believe the deals were Bernoulli II, Silver Marlin I, Forge ABS High Grade CDO, West Trade III, Tazlina II, Robeco High Grade I, and Biltmore 2007-1.

Why do I guess those deals? If I were the type of person (I am not) who wanted to lull a lazy financial guarantor into a false sense of security, I would helicopter to its office, raise the attachment point, and perhaps offer a few more basis points. One of the deals, Forge ABS High Grade CDO, is already experiencing an event of default. Despite the “high grade” label, it is probable that even with seventy percent subordination, MBIA may experience principal loss. A higher attachment point is better than a lower one, but MBIA’s underwriting standards still appear woefully inadequate.

Three deals currently in acceleration have much lower attachment points and present a high probability of substantial principal losses.


CDOs guaranteed by Ambac prior to the financial crisis


CDOs guaranteed by MBIA prior to the financial crisis

See also:

Goldman’s Undisclosed Role in AIG’s Distress

China’s New Silk Road and USD Reserve Currency Status

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