Today’s Fin runs a letter from Standard & Poors responding to my column from last week, reprinted here. Unfortunately the letter is paywalled (if anyone would like to email me the text, I’ll make fair use of it), so you’ll just have to take my word that it contains some interesting semantics. For example, the writer takes umbrage at the suggestion that S&P “threatens” governments with the loss of AAA credit ratings, but does not deny that the agency explains to government that certain policies will lead to the preservation of the rating while others will not. (“Nice little state you’ve got here …”)
I’m most interested though, in a claim that, since 1978, the default rate on AAA-rated structured finance offerings has been only 0.5 per cent. Obviously, a statistic like this can mean just about anything, but the claim is surprising to me. AFAIK, the biggest single category of structured finance offerings rated AAA by the agencies were collateralised debt obligations (CDOs) and the vast bulk of these were issued in the last few years. According to Alan Kohler in today’s Business Spectator (I think the ultimate source for this is Gillian Tett in the FT).
Between 2005 and 2007, about $US450 billion of CDOs of asset backed securities were issued. Of those, $US305 billion are in a formal state of default, with those underwritten by Merrill Lynch accounting for the largest proportion, followed by UBS and Citigroup.
The real problem is what has happened after the default. JPMorgan estimates that $US102 billion of the CDOs have been liquidated; the average recovery rate for the super senior tranches – rated AAA – has been 32 per cent. For the ‘mezzanine’ tranches – created from mortgage-backed bonds – the recovery rate is just 5 per cent.
Up to a 95 per cent real loss rate on AAA debt CDOs …
(Note that, although the text is ambiguous, the top mezzanine tranches were typically AAA-rated – the super-senior stuff was supposed to be better than plain old AAA).
The default rate here is over 60 per cent, which is a bit higher than 0.5 per cent, and it’s safe to bet there are more defaults to come. Even assuming that older issues pull the average down, can there really have been anywhere near $60 trillion ($300 billion/0.005) of them issued, as you would need to get the S&P average default rate? Or is this the kind of average that conceals more than it reveals?
Update A kind reader has supplied me with the text, and I’ve selected the relevant bits for reference (OTF). If anyone is still interested, and keen to do an Intertubes meme mashup, we could do a crowdsourced fisking.
In “Risky business needs rethink” (Opinion, February 26) John Quiggin evaluates Standard & Poor’s February 20 downgrade of the state of Queensland to AA+ and in the process misstates the role of a credit rating agency and how credit ratings should be used.
Standard & Poor’s does not “threaten” states or other rated issuers with downgrades or make demands to “implement whatever economically irrational policies”. Nor do we act as an “advisor to bondholders” or “ensure that bondholders get paid in full and on time”.
Our sole role is to provide the market with an independent opinion on the creditworthiness of issuers and their debt. A Standard & Poor’s rating does not speak to the market value of a security, or the volatility of its price. Ratings are not recommendations to buy, sell or hold a particular security. Nor do they replace the need for investors to do their own risk analysis or to seek professional advice.
Like many others in the market, we did not anticipate the speed or extent of deterioration in the US housing market. However, our track record remains strong. Since 1978, only 0.5 per cent of AAA structured finance ratings have ever defaulted, which is broadly similar to corporate ratings performance.
For many decades, Standard & Poor’s has in effect served the global capital markets with high quality, independent, and transparent credit ratings. We have listened to what the market is saying, and reflected long and hard on the recent, unprecedented market events. We are working with market participants and policymakers worldwide to do our part to restore confidence in global financial markets.