Commentaries

German covered bonds under scrutiny

Fitch Ratings seems to be getting nervous about the amount of commercial real estate loans included in German banks’ covered bond pools.

The agency today affirmed 17 covered bond programs as part of a review, but kept nine German banks programs `under analysis.’ The rating firm now wants more information from the banks on the kind of real estate debt they use as collateral for their covered bonds.

Covered bonds are a kind of secured debt issued by banks in which bondholders have recourse against both the issuer and a segregated pool of assets, such as mortgage or public sector loans.  German banks include large amounts of commercial real estate debt in the covered bond pools, alongside more granular and lower risk residential and public sector loans. Investors were happy to keep funding the banks and rating agencies gave the debt AAA ratings because the loans included in cover pools were required by law to be backed by a minimum amount of collateral, giving the loan a cushion in case the borrower defaulted.

The rules state that loans can only be included in covered bond pools if the principal is no more than 60 percent of the value of the property. However, given the sharp fall in commercial property values in recent years, Fitch is no longer comfortable relying on just this rule.

Fitch said today in a report:

“Whereas so far, Fitch considered that the mortgage lending value threshold set at 60% by the German Pfandbrief Act provided adequate protection against expected losses evening higher stress scenarios, the agency recognises commercial real estate risks in German cover pools need to be assessed more precisely’’

The rating firm has given banks three months to gather all the necessary data it needs to analyse the loans. There’s no mention of downgrades in Fitch’s report., though if the firm does decide the bonds aren’t adequately covered by the current cover pool, it could mean banks will have to stump up more collateral to support the deals’ ratings.

Is the Fed having trust issues with rating agencies?

The Fed published changes to its TALF facility that provides financing to investors buying eligible asset-backed securities. One, the Fed is looking to expand the number of rating agencies issuers could use to evaluate the AAA-worthiness of their debt offerings.

The second one looks more interesting though.

Starting with the November subscription, in addition to continuing to require that collateral for TALF loans receive two triple-A ratings from TALF-eligible NRSROs, the Federal Reserve Bank of New York will conduct a formal risk assessment of all proposed collateral–ABS in addition to CMBS, which are already subject to a formal risk assessment. The change to the collateral review process will enhance the Federal Reserve’s ability to ensure that TALF collateral complies with its existing high standards for credit quality, transparency, and simplicity of structure.

To facilitate the risk assessment, each issuer wishing to bring a TALF-eligible ABS transaction to market will be required to provide, at least three weeks prior to the subscription date, information including, but not limited to, all data on the transaction the issuer has provided to any NRSRO.

This additional red tap is likely to be off putting to some investors, but it’s not like the program has been going gangbusters either. Investors only applied for $2.5 billion in loans in the latest round of TALF financing.

What did rating agencies know about AIG?

It’s time to start asking the big credit rating agencies just when they realized that American International Group might pose a systemic risk to the global financial system.

And what, if anything, did the rating agencies do to warn financial regulators of the global crisis that might ensue, if AIG’s debt ratings were suddenly slashed.

There’s been a lot of attention paid to the role the credit agencies played in the build-up to the financial crisis by slapping triple A ratings on complex securities built from mortgages to subprime borrowers.

But there’s not been enough scrutiny into the behind-the-scenes work the credit rating agencies did last summer as Lehman Brothers lurched toward bankruptcy and AIG’s cash crunch grew increasingly grave.

By virtue of their status as Nationally Recognized Statistical Rating Organizations, the major credit agencies are charged with making sure companies that sell bonds are able to make good on their obligations. Some 30 years ago, securities regulators effectively deputized Moody’s Investors Service, Standard & Poor’s and Fitch Ratings as gatekeepers for the financial system.

And with that lofty and privileged status, there should come a responsibility to help regulators keep an eye out for systemic financial risk.

“We rely on our gatekeepers to help insure that financial markets are safe and information is accurate,” says law professor Frank Partnoy.

Forecasting takedown

It’s a wonder that anyone has any faith in forecasting anymore. The failure of ratings agencies to see the storm brewing in subprime and economists to fully grasp the vulnerability of the financial system should be making cynics out of all of us. Paul Krugman devoted 8 page screens over at the New York Times explaining what went wrong with economists. I must admit, I stopped reading after this line:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.

Bank of America Merrill Lynch analysts devoted a portion of their research to a glitch they see in forecasting corporate default rates. For high-yield bond and loan investors, default rates are a key component in trying to figure out whether it’s time to snap up that incredibly risky CCC debt or exit quickly. If they’re looking at S&P and Moody’s forecasts it could be both.

Moody’s forecasts defaults to peak at 12.6% in November 2009, and then improve rapidly over the next 9 months, reaching 4.3% by next year, a level which is below historical average of 4.8%. This puts the two major rating agencies on the opposite ends of default forecasting spectrum. S&P is forecasting a 13.9% default rate in a year from now.

That differential highlights the critical role of liquidity – the ability to refinance maturing debt – in forecasting defaults. In our assessment, Moody’s historically had ignored such a variable and as a result during the credit bubble years consistently overstated default forecasts. Partially as a result of such errors, in August 2007 they switched their modeling methodology to incorporate implicitly a liquidity factor. Incorporating liquidity factors into default models is very difficult as no precise measure of liquidity exists. Unfortunately from a modeling perspective, Moody’s chose to use credit spreads.

While the inclusion of spreads lends to better explanation of defaults in sample, such an inclusion raises logical flaws when the output of the default forecast is to be used to forecast spreads. That is because a forecast of spreads is required to forecast the Moody’s default rate. In the above forecast of 4.3%, Moody’s forecasts spreads at 578 (vs. roughly 900 currently).

Circular thinking at its best.

Banks face commercial real estate stress tests

One of the big uncertainties left at this stage of the credit crisis is the amount of losses banks will have to take from foreclosing on defaulted commercial real estate loans. The question is both how bad those losses will be and when they materialize, and how much money banks can make in the interim to absorb them.

Fitch Ratings is obviously sufficiently worried about the issue to launch a new review, looking at banks’  loans books and underwriting critieria,  and conducting its own stress tests.  

 So far banks haven’t had to take too much pain from forced sales, Fitch notes. But it expects losses to pick up as rentals decline and property companies breach covenants.

Banks’ “flexibility to absorb significant additional problems may be constrained by a weak earnings outlook and capital bases that have yet to recover from the current turmoil,’’ the agency said in a report today.

Of course the agency already has an idea of banks’ exposures and likely future losses and factors that into its ratings. But Fitch notes that “current indicators point to heightened potential for continued deterioration.’’  The agency doesn’t say anything about downgrades — yet.