Market Outlook

The market didn’t have to look very far for clues about the Fed’s “tapering” intentions after all. Chairman Bernanke tackled the subject head-on yesterday at a Congressional briefing and gave the markets (both stocks and bonds) a dose of reality check. Mr. Bernanke did try his best to hedge himself: “tapering” efforts may start as soon as this summer, depending on continuing economic growth and restrained inflation, but a premature tightening would choke off the incipient recovery. That sounded reasonable enough and market participants took it in stride, until the minutes of the last FOMC were released and showed a much more hawkish stance from many Fed officials. This mixed message did not sit well with traders and both bonds and stocks went into a nose dive. Ten-year and 30-year Treasury yields spiked to 2.03% and 3.21%, respectively. Overseas markets also sold off significantly overnight.

So far, tax-exempt yields have not backed up nearly as much as Treasury rates (only about 3 basis points or so) but that may be due to lethargy ahead of the long weekend as much as anything else. Next week might tell a different story.

… one can make the case that, as an asset class, [municipal bonds] have been systematically under-rated as opposed to over-rated.

At the end of the day, none of this would matter unless the economy continues to gain strength over the next few months, so the next couple of monthly employment reports will take on enormous importance. This morning’s big drop in jobless claims to a level not seen since March of 2008 does not bode well for any significant retracement of yesterday’s losses, however.

The SEC keeps talking … and talking and talking about rating agency reform

As we reported last week, the SEC held another Roundtable on Credit Ratings on May 14th, ostensibly to gather input on how it may best fulfill its mandate under Dodd-Frank. The 2010 financial reform law requires the Committee to either create a board to assign a rating firm to evaluate structured-finance deals (per the so-called Franken Amendment) or come up with another option to eliminate the conflicts that could arise from the “issuer pay” model.

Senator Al Franken, the rating industry’s self-appointed nemesis, opened the meeting with an impassioned plea for his proposed solution to the problem: through the so-called Franken-Wicker Amendment, Senator Franken advocates the creation of “an independent, self-regulatory board to administer a system in which issuers are assigned a credit rating agency to provide an initial rating. NRSROs could opt-in in to this system, and apply to become a qualified NRSRO (QNRSRO), which would allow them to participate in the assignment process. The process would not be “random.” The board could consider things like institutional capacity, expertise, and track record in developing its assignment system."

It’s fair to say that Senator Franken’s proposal was met with only a lukewarm reception from the audience, although, in all fairness, it’s only meant to apply to structured finance issues.

A rating should be viewed only as a snapshot of the credit at a particular moment in time.

The Roundtable then proceeded with three separate panels of experts. The first one, which re-hashed generally known problems with the issuer pay model, failed to give us any new information.

Next, SEC Rule 17g-5 was discussed at length by the second panel, again without any clear conclusion. As you may recall, SEC Rule 17g-5 requires NRSROs that are hired by issuers, underwriters or sponsors (collectively referred to as the “Arrangers”) to provide credit ratings for ABS transactions. Furthermore, the rule requires the “Arranger” to post information provided to hired NRSROs on a password-protected website and make it available to non-hired NRSROs. The intent is to encourage non-hired NRSROs to publish unsolicited ratings through a kind of peer review process, particularly if they strongly disagree with the assigned ratings.

Listening to this panel, we couldn’t help thinking: what incentive would a rating service have to risk incurring the wrath of potential clients without even getting paid for it? At best, it just gives bond raters a way to take cheap shots at the competition every once in a while, but that’s just about it.

Of the three panels, “Alternative Compensation Models" was the one that really captured our interest. The Commission did a great job in putting together a group of experts from a wide variety of backgrounds, from established institutions such as SIFMA and Freddie Mac, to independent thinkers such as Marc Joffe from Public Sector Credit Solutions. We also heard the views from foreign players such as Felix Flinterman, Head of Credit Rating Agency Unit at the European Securities and Markets Authority (ESMA), and Alberto Ramos, CEO of HR Ratings de México. Of course, the current legacy rating agencies were also represented, this time by Farisa Zarin from Moody’s.

These experts brought to the table a surprisingly broad range of alternative solutions to the “issuer pay” rating model. They included: (1) an independent supervisory board which would assign and rotate work among credit rating agencies (proposed by Senator Franken); (2) a certification and registration process for credit rating agencies (already implemented by ESMA in Europe); (3) a ratings supervisory board managed by the largest institutional investors (as proposed by private consultant Neil Baron); (4) a publicly available credit default model sponsored by a non-profit organization (as proposed by Annette Heuser from the Bertelsmann Foundation); (5) a purely software-driven approach with no qualitative input (as proposed by James Gellert of Rapid Ratings International Inc.); and last, but not least, (6) a free open-source credit rating model available to the general public (as proposed by Marc Joffe).

Needless to say, many of these alternative solutions potentially raise more issues than they resolve, and most are not mutually exclusive. As well-meaning as these proposals may be, they all seem to miss a couple of major problems, in our view.

First, let’s recognize that most of the rating abuses that indirectly led to the financial meltdown of 2008 occurred in the structured financing area, where hordes of Wall Street quants dreamed up whole new financial instruments and derivatives based on theoretical mathematical models. Since most of these instruments had with very little grounding in the real world, their “creditworthiness” was also based on theoretical assumptions. Thus, it must have been easy for rating agency analysts to be steamrolled by investment bankers armed with their supposedly sophisticated financial models.

Such a problem may be unique to structured finance. Elsewhere in the fixed-income markets, in sectors such as corporate and yes, even municipal bonds, the potential for egregious rating errors, even under an issuer pay model, may not be very significant, in our view. Over the years, bond market participants have come to some general understanding of what constitutes a AAA credit or a below investment grade, based on actual empirical evidence. So, there’s always some degree of market discipline that should prevent blatant attempts at rating shopping.

Because of its historically low default rate, the municipal market is one of those sectors where rating scales may also be more theoretical than derived from any actual default records. However, one can make the case that, as an asset class, munis have been systematically under-rated as opposed to over-rated. To the extent that rating agencies have traditionally erred on the conservative side, this may not be perceived by regulators as a problem that needs to be fixed to protect investors. Bond issuers, however, should care, to the extent that they perceive their interest costs to be unfairly high as a result of overly conservative rating practices. No wonder many of the current alternative credit scoring schemes are being underwritten by muni issuers, rather than by the buy side. The rating services themselves have recognized this, although their last attempt at re-aligning the muni rating scales turned out to be atrociously timed, coming as it did right before the latest recession.

James Gellert from Rapid Ratings (love that name!) also pointed out that too much focus has been put on the new issue rating process. In fact, new issue ratings are not the problem: with their unfettered access to all relevant information during the initial underwriting process, the rating agencies by-and-large have done a decent job on new issue ratings (with the obvious exception of structured finance, for all the reasons mentioned above). It is their credit surveillance process that has been shown to be lacking. While investors implicitly assume that all outstanding ratings are monitored on an ongoing basis, it is virtually impossible for any rating agency to keep up with the thousands of ratings they’ve issued at all times. Thus, we believe “stale” ratings in the secondary market are the real problem here, and most regulators seem impervious to it.

This brings us to what we’ve always believed is the “correct” way to use an agency rating. A rating should be viewed only as a snapshot of the credit at a particular moment in time. Because the underlying obligor is not a static entity, investors should always assume the credit information contained in a rating will get out-of-date very quickly.

A rating is also just one institution’s opinion. It may or not match with your own perception of the credit. It is this potential mismatch that will give rise to relative value opportunities. In case you’re a novice investor, the process of determining relative value usually consists of two steps: first, one must decide whether or not one agrees with the current rating (a recent development may have occurred that rendered the rating “stale,” or the original rating was “wrong” in the first place); and secondly, whether the market is pricing the bonds “correctly” – i.e., in accordance with your perception of the credit. If the answer to both questions is “no”, then a relative value opportunity has arisen that could be profitably exploited. A bond could be trading at too cheap a price in relation to its perceived credit quality and thus should be purchased, all other things the same, and vice versa.

Note that a “relative value” opportunity exists only in the eyes of the beholder, at least initially. Obviously, the market must ultimately agree with your credit assessment and re-price the bonds accordingly for the trade to be profitable.

This is not to say there aren’t problems with the current use of credit ratings. We do believe the current oligopolistic nature of the ratings industry is not healthy for the market. More competition should be fostered to provide a much-needed diversity of credit opinions and enhance rating methodology discipline. Also, the “hard-coding” of the Big Three rating requirements into institutional fiduciary standards, as one panelist put it, is another huge barrier-to-entry for any rating upstart and should be abolished as soon as possible. Under Dodd-Frank, this process has already begun in the banking sector, where regulators have ordered financial institutions to stop relying solely on agency ratings and obtain independent credit opinions, either from internal or third-party sources, to justify their bond purchases.

It’s likely the rating establishment will come out of this process chastened but not drastically altered. Then perhaps, just like Stuart Smiley, Al Franken’s old character from Saturday Night Live, they can finally tell themselves: “I’m good enough, I’m smart enough, and, doggonit, people like me!”

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