Rating structured bonds is impossible

By Felix Salmon
December 16, 2010
regulatory arbitrage with negative economic value -- you take a bunch of bonds , and then spend lots of money on bankers and lawyers and ratings agencies in order to transform them into other bonds.

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Re-remics are a regulatory arbitrage with negative economic value — you take a bunch of bonds , and then spend lots of money on bankers and lawyers and ratings agencies in order to transform them into other bonds. The financial-services industry gets lots of lovely fee income, which ultimately comes out of the pockets of the beneficial owners of those bonds. And no one makes out more handsomely than the ratings agencies, without whom none of this would be possible: it’s their precious triple-A ratings which make the arbitrage attractive in the first place.

The problem is that the ratings agencies, as we saw in the crisis, have no idea how to rate structured debt. And they also have no idea how to learn their lesson: the first big re-remic downgrades happened almost immediately, and then they just kept on trickling out — there were 224 in September, and another 129 have just arrived.

S&P is the big villain in this story, both rating and downgrading many more re-remics than anybody else. They emailed their press release to the FT, where Tracy Alloway reprints large chunks of it, but if you Google the headline on the release, the only way you can find it is by paying $100 to Alacra. Just because you’re releasing something to the press doesn’t mean you want it to be public, I guess, and neither does it mean that you want to talk about it:

“Our written statements are what we are providing,” Ed Sweeney, a spokesman for S&P, said in an e-mail. He declined to comment further and didn’t answer an e-mailed question about the principal balances of the securities under review.

The business of structured-finance ratings broke so badly during the financial crisis that it cannot easily be put back together again. The ratings agencies have no business rating structured bonds: they’ve proved that many, many times, and there’s zero indication that they’re any better at it now than they were before the crisis. Indeed, it might well be something which is impossible to do — these things are just too complex to be able to assign a risk-free rating to. Somebody should stop the ratings agencies from even trying.


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I agree completely. Structured credit rating methodologies are not fit for purpose, and the Re-Remic scams are a case in point. However, it’s too bad it has to take these kinds of events to throw some light on this issue. It’s too bad, because there have been plenty of official sector warnings about this problem. I’ve been involved with at least three of them. There’s the 2004 “CDO Rating Methodology: Some Thoughts on Model Risk and its Implications” BIS working paper, the “When is a AAA not a AAA?” in the IMF Global Financial Stability Report (Boxes 2.2 – 2.4), and “Re-Remics and the Revival or Resecuritization” in the October 2009 IMF GFSR (Box 2.3). The point is that the problems with these models are really fundamental, and aren’t fixed by tweaking a few parameters or inputs.

Posted by Kiffmeister | Report as abusive

structured finance is the equivalent of 3 card monty without even the pretense of using a folding cardboard table for the show.

Posted by Nick_Gogerty | Report as abusive

I have a dream that one day certain myths will cease to be believed:

Credit-risk free=risk-free. All AAA is meant to mean is that there is a high probability that the obligation you have bought will pay out as per the contract assuming you hold to maturity. If you buy a US 30 year bond then AAA means if you hold it for 30 years you will collect all the coupons and get the principal back. It most certainly does not mean it is “safe” or “risk-free”. If you think it is then I suggest you have a look at the volatility on Treasury bonds over the last couple of months. The very simplest AAA instrument is one where you give me 100USD and I promise to pay you 0USD in return. There is zero probability of me defaulting on that contract and you are 100% guaranteed to receive that in 6 months time.

They are “too complex” to value. Hands up anyone who thinks it is harder to come up with a model that gives an accurate future price for Citigroup as opposed to one of their structured notes? Equities fundamentally are the most complex products to value objectively, the reason we know the price is because we can see it on an exchange and know if we hit yes we are more or less going to get that price. Liquidity difference not complexity.

Also there is no reason why credit risk should be static. No one expects other risks to be. Answer to all this nonsense is to stop privileging credit risk over other risks. Stop mandating that investors can palm off their responsibilities for analysing the risk – not just credit risk – and returns to the rating agencies and stop using discrete bands with a line below which all the sheep have to mechanically ditch the bonds.

PS Is this the same FT Alphaville that thinks deposits at banks are assets? Or that the ECB has a new rule allowing banks to post their **liabilities** as collateral for loans? I wonder if S&P will be linking to that article. At least Mr Salmon is honest enough to show any original errors along with the corrections!

Posted by Danny_Black | Report as abusive

Nick_Gogerty, and investing in dot.coms and emerging markets is what exactly?

Posted by Danny_Black | Report as abusive

Why are AAA ratings still so “precious”? Are there investors with old prospectuses that they hold a certain amount of their capital in AAA securities, or is this largely a problem created by regulators at this point?

Posted by dWj | Report as abusive

If I understand it properly, AAA securities can be held at par value while lower-rated securities must be marked to market.

Posted by TFF | Report as abusive

So it’s a problem created by banking regulators and accounting regulators?

Posted by dWj | Report as abusive

dWj, can put it more simply than that…

We desire security in an uncertain world, so we invent a host of strategies (diversification, hedging, collateralization, structured bonds) that pretend to construct a risk-free portfolio out of securities that are anything but. None of these strategies are perfect, unfortunately, so we make ourselves feel better by tacitly agreeing to ignore their flaws.

If people were to stop paying a premium price for annuities and insurance products, and embrace the risk/return gamble, then there would be less demand for AAA rated securities and less motivation to manufacture them. But that flies in the face of our nature.

Posted by TFF | Report as abusive

TFF, I can put it even simpler than that – “everyone wants a free lunch”. There is no such thing as risk-free. There are relative levels of risk and there are different types. For historical reasons, credit risk has got this privileged role – mainly because once upon a time people were buy and hold and there were less interest and FX fluctuations – but it is just one risk.

The demand for AAA is down to the continued misrepresentation of “no credit risk= no risk” and regulations that reinforce that view.

Posted by Danny_Black | Report as abusive

Very true, Danny_Black.

And when bond yields were falling, there was an incentive to construct higher-yielding “risk-free” securities. Didn’t work very well. :)

Posted by TFF | Report as abusive

The ratings agencies really should be limited to corporate ratings and traditional debt they issue. That is their core competency, such as it is and they are out of their depth in other arenas. Not just structured – look at ratings on banks, insurance and other FIs. It is almost a binary situation, because of the confidence necessary to operate those businesses. Lehman had an A+ S&P rating the day it filed. Bear was still investment grade (same as Enron) the day it filed. They can’t get their arms around trading and derivatives – you can’t imagine how behind the curve they are in these arenas.

Next shoe to drop? Public finance. Muni, sovereign and state ratings are a backwater in the agencies. The slowest of the slow and dimmest of the dim are sent to these pastures and the amount of analysis that goes into the munis is close to zero. Every state in the country is investment grade and all but one are in the A category or above – yet many states sit on the precipice of default. Ireland was in the double-A category as recently as last month. Just as with the intricacies of complicated CDOs and the like, the agencies don’t know how to handle debtlike obligations such as pensions – the very things that are dragging cities and whole states under.

Posted by Debt_Whisperer | Report as abusive