Sub-prime defaults – the smoking gun?

How about this explanation?

GS Khoo

Racquel Welch (alias NR), The Subprime Mess & A New Order –
A Tongue-in-Cheek View of the Subprime Mess
By GS Khoo

Fantastic Ratings!, a re-make of the 1966 movie, Fantastic Voyage was shot in the summer of 2007 and won an “Oscar” for its surprising effects – an Oscar which I believe was well deserved. Although the effects have dated in the sense that they appear to be in a very 1960s psychedelic style, they are still impressive.

The storyline has a medical ratings team reduced to the size of microbes, who are given the task of being injected into a CDO’s body to cure him of an incurable blood clot on the brain – the subprime region. They have to navigate their way around the CDO structure and layers of artificial tranches, previously rated as healthy, in a green-powered submarine which has also been miniaturized. There are lots of action in the film – witness the volatility and liquidity crunch in the voyage – and the presence of Racquel Welch alias NR in any film makes it more than watchable! Other cast members include the “nursing” members of the CityBears’ team, the ML (“mortgage lenders”, etc.) team and other luminaries on WS.

The premise of the re-make was based on the fact that prior to miniaturization, the health of the CDO was mistakenly rated and diagnosed based on its bodily (portfolio) measures like BP, BMI, etc., which tended to be very static in the “corporate body” framework, rather than on the dynamic unhealthy delinquency rates of the underlying “retail loan organs”. Investors depended heavily on these ratings/measures as the underlying parts of most CDOs, especially those that were retail-based and asset-backed, were very opaque.

Intermediaries, financial health structurers and insurers like CityBears and the other WS firms, typically also received the health information at the portfolio body level, rather than at the granular “loan” organ level. As the affliction grew from the subprime region and spread to the rest of the body (housing market), encompassing even the so-called healthier HB (home buyers) organs, the deteriorating prices rapidly impacted on those “ARM1 and HEL2 drug treatments” re-setting to higher thresholds, further exacerbating the crisis!

While part of the blame lie at the doors of the aggressive sales brokers, who reaped huge commissions by selling these exotic ARM treatments, one fundamental flaw as depicted in the re-make, Fantastic Ratings!, is the whole process of structuring and treating the CDO bodies, where the medical ratings team used an approach more suitable to a fairly static environment of a corporate body framework, rather than a more dynamic rating on the granular retail organs, where health delinquency rates may change more quickly. While the health ratings of bodies like CityBears tend to remain pristine, in spite of the widening spreads, at the microbial “consumer” organ level, if the individual cells lose their functions (jobs), their credit-worthiness would simply deteriorate.

In the real world, a company like Merrill or Citi, etc., would hardly have its ratings downgraded, even in a crisis. Typically, the manifestation would appear as a credit spread widening rather than an actual downgrade – this is because the corporate ratings of such companies are benchmarked to default rates over a span of 5 to 20 years as default incidences are actually scarce in the corporate world. Hence, the ratings of highly rated companies (those with AAA or AA ratings) tend to remain pristine or static.

In comparison, asset-backed securities like the CDOs based on the subprime and other residential mortgage payments were also assigned AAA ratings, partly because of the equivalent ratings of the bond insurers like MBIA and partly because they were rated based on the “portfolio” loss rate (default) information. Here, the payments to the investors have their origins in the consumer credit mortgage payments.

If one of these borrowers works for Merrill or Citi and loses his job as a result of the crisis, e.g., in a cost-cutting exercise, his FICO (or credit score) or individual credit rating would be downgraded as his credit-worthiness would simply deteriorate. Hence, consumer credit risk rating is a different animal from corporate credit risk rating as it tends to be more dynamic and susceptible to the “boom and bust” economic cycles. Moreover, the ratings agencies would not be able to capture this information on credit deterioration at the account or granular level as their model is usually based on information obtained at the portfolio level.

As a start, one possible solution is to revamp the whole process of structuring financial products. Firstly, there is a need for some form of entity, with a fiduciary duty to protect the interests of certain groups of investors, esp. the pension funds and as a counter-check to the ratings agencies, to demand some form of accountability in terms of having access to the information on or tracking the underlying behavioral scores/ratings of the underlying pools of consumer credit loan payments that constitute the tranches in the CDOs, that were rated by the ratings agencies. Secondly, the current modeling process of rating these structured financial products would need to be modified in a holistic manner to take into account the nature of the underlying ratings (consumer vs. corporate), the asset-liability or liquidity risk environment (witness the drying up of the liquidity in the ABCP3 space), the dimensions or impact of the other players like the bond insurers and their own ratings. Thirdly, like what Yul Bryner said in the movie, “The King & I” – quote, “et cetera, et cetera, et cetera, ……”!

Here then, lies the nub of the subprime mess! Thank you.

1 ARM refers to adjustable-rate mortgages
2 HEL refers to home equity loans
3 ABCP refers to asset-backed commercial paper