[A-List] The coming savage downturn

[Michael Keaney]

Confidence in CDO rating system showing signs of strain
By Gillian Tett
Financial Times: June 15 2007

Are some investors getting more cynical about the reliability of credit
ratings?

That is a question that a number of financiers have raised with me in
recent weeks, following the US subprime mortgage debacle.

However, now an intriguing hint has emerged in the capital markets that
some of this unease might be turning into trading decisions.

Until recently, it was generally presumed that debt, which carried
similar ratings from the agencies, should trade at roughly the same
price, given that these instruments carry similar credit risks - at
least if the ratings are correct.

However, Arturo Cifuentes, a New York banker who manages and advises on
collateralised debt obligations (and a former rating agency analyst
himself), has noticed that this pattern has started to break down in the
US in recent weeks - or since the subprime mortgage debacle.

In particular, the spreads on tranches of CDOs (or pools of debt
portfolios) that carry the same BBB rating (or equivalent) have started
to move within a range of 140bp to 1,000bp. Meanwhile, at the single A
and BB level, a similar discrepancy has appeared - with the gap
sometimes reaching 400bp (meaning, in effect, that investors receive
different returns for holding instruments with the same ratings).

This divergence is not universal and such swings may reflect factors
that are peculiar to these CDOs and not captured by the ratings process.
After all, credit ratings only cover default risk - as the ratings
agencies themselves keep loudly pointing out - and the price of
instruments can also be influenced by items such a liquidity risk. It is
thus possible that the divergence also reflects new liquidity concerns,
given the recent market jitters.

However, Mr Cifuentes, for his part, blames another factor: a recent
"breakdown" in the level of market confidence in the ratings of CDOs.
"The market does not believe the ratings," he declares. And while this
may overstate the case, I have heard many similar sentiments being
muttered (less publicly) in recent weeks by other financiers.

Part of this cynicism stems from a perception that the ratings industry
business model has become excessively entwined with the structured
credit universe in recent years, in a manner that could undermine their
independence. But arguably the most important issue is that the
structured credit universe is developing so fast, there is a perception
that ratings models sometimes struggle to keep up.

Mr Cifuentes, for example, points out that Moody's own research shows
there has been remarkably little difference in historical performance,
in loss terms, of the BBB and BB rated tranches of CDOs. That might
sound like a minor technical detail - but not when you remember that
many investors are banned from buying anything below BBB, because
instruments ranked as BB are supposed to be riskier.*

Similarly, a fascinating and important paper presented to a financial
conference last month in Dallas by Michael Gibson, a senior official at
the US Federal Reserve, shows that the way that rating agencies assign
the AAA label for CDO tranches is rife with what might be dubbed
"anomalies".

The research backing this argument is complex, based around relative
risk weighting; but the implication is clear: investors should view the
AAA tag - or even the A label - with a degree of wariness.**

Many sophisticated investors already know this and routinely ignore
ratings. Many also relish the arbitrage opportunities. But there is also
a large pool of investment money in the world that does depend on
ratings, since these grades define the universe of assets that can be
purchased. And let no one forget that these ratings are due to be given
more, not less, weight in the financial world by the new Basel II
capital adequacy regime.

Let us all hope that the rating agencies and regulators can find ways to
make us all true believers again - and the sooner, the better.

*CDOs and their ratings by Arturo Cifuentes and Georgios Katsaros at
www.totalsecuritization.com

**Credit Derivatives and Risk Management; Michael Gibson

http://www.frbatlanta


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