Thursday, August 16, 2007

Moody's, S&P Lose Credibility

From Bloomberg today:

Moody's, S&P Lose Credibility

Moody's Investors Service and Standard & Poor's, the arbiters of creditworthiness, are losing their credibility in the fastest growing part of the bond market.

The New York-based ratings firms last month gave a new breed of credit derivatives triple-A ratings, indicating they were as safe as U.S. Treasuries. Now, investors are being offered as little as 70 cents on the dollar for the constant proportion debt obligations, securities that use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.

``The rating doesn't tell me anything,'' said Bas Kragten, who helps manage the equivalent of about $380 billion as head of asset-backed securities at ING Investment Management in The Hague. ``The chance that a CPDO won't be triple-A tomorrow is a lot greater than it is for the government of Germany.''

The legacy built by John Moody and Henry Varnum Poor a century or more ago is being tarnished by losses on securities linked to everything from subprime mortgages that the firms failed to downgrade before it was too late to high-yield, high- risk loans. Bonds backed by mortgages to people with poor credit fell by more than 50 cents on the dollar in June before the companies started to slash their ratings.

Moody's Corp. shares have fallen 28 percent this year, while McGraw-Hill Cos., the parent of S&P, has declined 24 percent. The firms say they determine the risk of default rather than prices.

Highest Ratings

Ratings are ``a measure of risk on a buy-and-hold basis and say nothing about the pricing volatility of an investment,'' said Gareth Levington, a senior analyst at Moody's in London. ``The market level isn't hugely relevant for the rating.''

S&P's rankings ``are appropriate for existing CPDO structures,'' S&P spokeswoman Felicity Albert in London said.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

The rating firms help borrowers structure debt securities in a way that will get the highest possible credit rankings while allowing managers of the securities the most profit, according to Charles Calomiris, the Henry Kaufman professor of financial institutions at New York's Columbia University.

Moody's earned $884 million last year, or 43 percent of total revenue, from rating so-called structured notes, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That's more than triple the $274 million generated in 2001.

`Crossed the Line'

Ratings firms ``used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,'' said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. ``But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.''

CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc. HSBC Holdings Plc in London and Dresdner Kleinwort in Frankfurt also sold CPDOs.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money- market rates -- a ``holy grail'' for investors, Bear Stearns Cos. strategist Victor Consoli said in a November conference call.

Selling Insurance

CPDOs sell credit-default swaps, contracts that would pay a buyer face value for bonds if the company that issued the debt can't meet interest payments or otherwise defaults. CPDOs provide insurance on a basket of 250 companies, borrowing up to 15 times their initial capital, boosting their investments to as much as $60 billion.

Moody's and S&P assign their top credit ratings to the securities because of rules designed to ensure they never have to pay a claim. CPDOs only hold swaps on companies with investment-grade ratings.

The first CPDO, ABN Amro's 100 million euros ($136 million) of AAA 10-year ``Surf'' notes, paid about 5.3 percent in annual interest when they were sold a year ago, or about 1.50 percentage points more than floating-rate notes sold by German state lender KfW Group with the same ratings.

Now, investors are finding just how risky CPDOs can be as the cost of protection against default rises, causing existing contracts held by the securities to become less valuable. The iTraxx Europe Index of swaps on 125 companies increased to as much as 70 basis points in July from below 20 basis points in June as corporate credit markets slumped, data compiled by Bloomberg show. A basis point is 0.01 percentage point.

Prices Tumble

CPDO prices probably dropped between 19 percent and 33 percent, Banc of America Securities LLC credit strategist Jeffrey Rosenberg said in a July 30 report.

``Something that's triple-A clearly shouldn't be this volatile,'' David Watts, an analyst at bond research firm CreditSights Inc. in London, said.

ABN Amro's Surf CPDOs fell to as little as 70.2 cents from almost 104 cents on June 6, and were quoted at 76.73 cents yesterday, prices on Bloomberg show. An equivalent price decline on government notes would push the yield as high as 11.7 percent.

The increase in credit-default swap indexes means investors can expect to earn a higher premium for providing debt insurance as soon as new indexes are created in September. To make up for losses, CPDOs would typically increase their borrowing.

ABN Amro's CPDOs are ``behaving well in difficult market conditions,'' said Steve Lobb, global head of structured credit at ABN Amro in London.

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