This post invokes both teen country/pop music star Taylor Swift and one of the richest men in the United States. On a long plane ride, my rich friend once told me, "There are only three ways to make money any more: tax arbitrage, regulatory arbitrage, and ratings arbitrage." "Which are you going to do next?" I asked. "Ratings arbitrage," he said, "I'm going to create a new structure that gets rated AAA even though it won't really be a AAA credit." My friend did as he promised, and things worked out fine for him and badly for the rating agencies. Looking forward, not backward, we ask this question: is issuing ratings on new issues of structured products likely to be a profitable business? Or, as Taylor Swift sings, is it true that "I'm not a princess, this ain't a fairy tale...this isn't Hollywood, this is a small town." We look ahead at rating structure
My rich friend was very blunt in describing his mission, and one of the surprises in the tons of commentary on the role of the rating agencies in the current crisis is that no one has raised the Taylor Swift issue--was the whole business model just a fairy tale? Or was there really a chance that one could provide accurate ratings for a decent fee from either the structurers (with a conflict of interest) or the investors (with no conflict). We argue in this post that making money rating exotic structured products like CDOs is an oxymoron. We distinguish between structures which have an economic rationale, like mortgage-backed securities where the tranching is by maturity, and structures where there is complexity for zero or near-zero economic purpose, like CDOs and knock-in knock-out foreign exchange options to name two. We focus on the latter form of exotic derivative in our comments.
We argue that standing ready to rate any structure, no matter how complex and no matter how little economic rationale, is suicidal unless the rating agencies do two things:
A. collude with the structurers, and
B. hide the collusion from the investors, so they will still believe in this fairy tale.
Consider the opposite case, where the rating agencies are paid by investors for ratings of issues that are launched and not paid for issues that are analyzed but not launched. Let's go through a brutal assessment of the structured product production process.
Step 1: Find a structure that is very complicated and likely to result in valuation errors that lead investors to overpay, generating profits for the structurer
Step 2: Enhance the overpayment by applying for a rating, paid for by N institutional investors, in the hopes that the rating will be too good, as my friend outlined in the introduction to this post.
Step 3a: Assume the rating agency is brilliant analytically and correctly values the structure, shows that it is overpriced, and correctly assesses the risk. The investors won't buy it. The structure is not issued, the rating agency does not get paid, and the structurers make no money. The structurers return to Step 1 and repeat until Step 3b is reached.
Step 3b: The rating agency makes a mistake. It tells investors the deal is fairly priced, and the risk is less than it actually is. The investors will buy the structured product, it gets issued, and the structurers make tons of money. They go back to Step 1 and repeat.
The trouble with this process is "this ain't a fairy tale." Investors, as they have recently, are mercilessly candid in pointing out rating agency mistakes. In the current environment, these mistakes are being blamed on the conflict of interest of being paid by the structurers. In this post, however, we are solely looking forward. The rating agencies are in a lose-lose game of "gotcha." They are wearing a big red t-shirt that says "Fool me." Investment banks keep coming back over and over again with weirder and weirder structures, forcing the agencies to analyze deal after deal. As long as the agencies keep correctly assessing value and risk, the deals don't get issued because there's no arbitrage or structuring profit there. There's no money for nothing. It's only when a rating mistake is made that a rating gets applied and the deal gets issued. 100% of the deals that get issued will be mistakes.
That's why this game of "gotcha" is doomed as a business. That's why the volume of CDOs is down 90% or more. In the end, there is a cheaper way to insure that investors don't buy weird structured deals that are mispriced--by putting in place an investment policy that (a) recognizes that complexity is introduced to make the investor a victim, not a victor, and (b) requires independent valuation before purchase by the investor's risk management staff, not the deal makers. This investment policy is free, and it's superior to paying for a rating. More on a realistic investment policy in a future post.
Turning back the clock ten years, one could have made the same assessment of the business of rating CDOs.
Donald R. van Deventer
Kamakura Corporation
Honolulu, May 1, 2009