Friday, August 28, 2009

Rating agency shopping from the inside

Here is a great BNN interview with Ed Grebeck discussing bank capitalization and the rating agencies. Of particular interest is the discussion on rating agencies' methodologies and the resulting ratings that vary across the various departments within a single agency. Here are some highlights:

1. Basle-II convention treats a company (such as GE) debt "AAA" and a structured credit "AAA" (such as a CDO) in the same manner, allowing banks to hold minimal capital against both. Thus by pooling risky assets and selling the junior tranches of these pools, banks retained (and still sometimes do) the senior most tranches (which have much higher notionals than the junior tranches) with minimal capital requirements. That allowed banks to run excessive leverage, getting to 30:1.

2. "AAA" tranches used to trade with such tight spreads that the yields and the implied levels of risk were approaching treasuries. And a number of institutions were buying paper based entirely on agency rating. Many have learned their lessons.

3. Mr. Grebeck discusses the issue of rating agency "shopping". In addition to banks' ability to "shop" the various agencies for the best rating, an even bigger ratings arbitrage exists among the various departments within a single agency. Rating agencies' internal departments covering various products or in different geographic locations operate in silos from one another.

A bank familiar with the agencies' internal workings can pick them off to obtain a reduced capital charge - depending on how they structure a security and which department/location does the rating. In effect to get a desired rating a bank can find a department within an agency that would require the least amount of subordination, thus increasing permitted leverage.

Hat tip Ed!