What a roller coaster for Fannie and Freddie

Well, if you haven't heard about the roller coaster ride taken by Fannie Mae and Freddie Mac in the markets this week, then try this on for size. How about loosing 50% in its market cap in a matter of hours and then recovering to a loss of about 5% by the end of the same trading day. Then, of course, you must has what triggered all that volatility. The answer, unfortunately, doesn't exactly inspire a lot of confidence in the financial markets.

It comes down to your definition and interpretation of the government's guarantee of both Fannie and Freddie and, more simply, rumours and speculation. Rumours, probably more than anything, caused the massive swings. Rumours about both the institutions' abilities to raise capital as well as about what the government would do, exactly, to help protect investors. Secondly, there is now even more speculation about what any government support would mean for the U.S. government as a whole and how that could even more broadly affect America's financial markets and the continuing credit crisis.

With the Fed's credit window now opened to both Freddie and Fannie, many of the concerns have been calmed. As I write this post, actually, Freddie and Fannie are reallying - up almost double digits today. Nothing has changed, of course, from yesterday so your guess as to the cause of this rally is as good as anyone else's. That's the real problem; there's so much uncertainty that investors, and the markets as a whole, are too eager to grab on to any positive news and trade the hell out of it. If you've ever studied finance, then you'll remember reading about the efficiency of markets; the activity in Freddie and Fannie over the past month will no doubt go down in textbook history as an example of how inefficient the markets can be. 

Fannie Mae's Debt Issue & Credit Yield Spreads

Amid speculation that Fannie Mae doesn't have enough capital to weather the continuing credit crisis, it has gone ahead and issued $3 billion in new debt. What's interesting about this, however, is the yield (cost) at which it was issued. The new debt will yield 3.25% - a full 74 basis points above the equivalent U.S. Treasuries. Given that Fannie Mae, theoretically, has the backing of the U.S. government and, consequently, should benefit from essentially risk-free cost of capital, this suggests the investing community feels otherwise about its credit worthiness.

With all the talk about the ratings agencies and the validity of those ratings, I suppose it's not all that surprising to see investors making their own determinations about the credit risk associated with a particular issue. Moreover, when you think about it, shouldn't the market as a whole be better qualified to determine the risk associated with a particular security than a single ratings agency?

The capital markets serve as a pricing mechanism. The collective buying and selling of millions of investors every day works to determine the value that we, on average, associate to a particular security. Why, then, should we not use the power of the same distributed intelligence to ascertain the credit risk associated with a debt issue? To be fair, the markets already do this - using the ratings agencies as a sort of starting-point for their evaluation. My question, I suppose, is whether or not we actually need that starting-point.

Blame Everyone. Accept No Blame.

I find this almost funny at this point; comical, really. Moody's, who suggested that their triple-A ratings collateralized-debt obligations (CDOs) may have been incorrectly assigned due to a computer error is now ousting some employees along with an announcement that some may have violated internal policies to award unwarranted investment-grade ratings on constant-proportion debt obligations (CPDOs). Moody's has suffered a substantial hit to its credibility, to be sure, but do such tactics really work to reverse public opinion?

The media holds a very influential position in that it is often able to sway opinions in the general public. In this case, however, you're talking about a very specialized group with an intimate understanding of the companies involved and the business of credit ratings. Does media rhetoric really affect the opinions of investors who understand enough to question Moody's credibility in the first place?

More Information Is Always Better

There's a lot of talk about the SEC and its persisting investigation of the ratings agencies. The good news is that, at least it appears at this point, investors will be winners now matter what the outcome.

I wrote earlier about the SEC's consideration of a plan to require the ratings agencies to make their research material available to others. This, of course, would allow others (hopefully individual investors as well) will be able to assess risk-and-reward profile for a given investment - just as the credit ratings agencies do. The advantage is that investors could become less reliant on the AAA-ratings and could review the actual data that goes into such a rating. With the agencies being blamed for having rated mortgage-backed securities as tripple-A (the highest investment-grade rating) that subsequently defaulted and resulted in hundreds of billions of dollars in losses and write-downs.

Now, there's news that the SEC will offer the ratings agencies a choice between two possible outcomes. The first, will be a disclosure of the underlying information as I described above; the second will introduce a new rating scale that would help identify mortgage-backed securities and distinguish them from corporate bonds. While certainly not providing as much information, this too would work to make investors more aware of where they were placing their money and that's never a bad thing. So, no matter what happens, at least its comforting to know that we, lowly investors, will ultimately win.

Ratings Agencies Screw-Up & Get Paid Anyway

With all the economic trouble that has resulted from the sub-prime debacle, a great deal of attention was paid to the ratings agencies that awarded high ratings to the debt instruments that later collapsed. In its investigation of the factors that led to this collapse, the New York Attorney General, Andrew Cuomo, also began an investigation into the credit ratings agencies themselves and a settlement in that investigation was just reached between the state and both Moody's and Standard & Poor's. That settlement, however, may leave some investors scratching their heads.

As usual, of course, no one admitted any wrongdoing. You may recall that I previously wrote that Moody's was quick to suggest that a computer bug had caused the ratings to be inflated in certain situations and it never assumed any of the blame otherwise. What is interesting about the settlement, however, is that it may mean greater revenues for these ratings agencies going-forward - yes, more money! The reason, however, actually makes sense.

It all comes down to incentives. Just as the top CEO's have a large part of their total compensation packages tied-up in stock options that align their interests with the performance of the company's earnings (that, of course, is a whole other story), the ratings agencies will be paid for initial analyses and assessments performed on new sub-prime issues. Currently, prior to the new rules, the ratings agencies were paid only if they were ultimately selected by the issuer as the final, official, ratings agency. This approach, of course, incentivized the agencies to give better ratings than they might have otherwise in order to win the business. Being able to earn some cash regardless of their ratings, therefore, should make them more willing to speak the truth ...of course, I'm not saying that they haven't been doing so in the past... you understand, right?

Is the downgrade of the financials warranted?

In short, no. The downgrade of the investment banks just doesn't make sense. Why? Simple. With access to the Federal Reserve's credit facilities, the same facilities made available to the commercial banks, these investment banks have access to plentiful, and cheap, capital whenever they need. A credit rating downgrade, by definition, presumes that the ability of the entity being downgraded to satisfy its debt obligations has somehow worsened. The fact that these banks now have access to more, not less, capital directly contradicts this action by the ratings agencies.

So, then, why did they do it? Good question - I'm not sure I know the answer. The consensus, however, seems to be that the ratings agencies are late to the game and are now reacting to popular fears that have all but disappeared since the first fall-out from the collateralized debt obligation defaults and, more recently, swap defaults and associated insurance scandals. Furthermore, the spotlight that was placed on ratings agencies following the aforementioned collapse when they did has placed the integrity of their models and practices into question. It could very well be that they are now simply trying to follow the herd rather than lead.

Credit Spreads As Economic Indicator

Remember the yield curve? Well, to freshen your memory, the yield curve is just the graphical depiction of the relationship between yields (required rates of return) and maturities. So, for example, the curve would tell you the kind of return demanded for their investment dollars when committed for a specific period of time (to maturity) - all else equal. While it might sound like a boring subject, it's actually quite interesting in what it can foretell about expectations for our economy.

Before we get to the credit spreads, you have to also remember that there's not just one yield curve, but many - one for each level of risk determined by investors (and generally based on the ratings issued by the big ratings agencies). The credit spread, therefore, is the vertical distance between two curves - i.e., the difference between the required rate of return demanded by investors in securities of equal maturity, but different levels of risk. Why is this interesting? Well, this difference, referred to as the credit spread, is an indicator of what investor's believe is the relative risk associated with lower-grade investments.

Imagine, for example, that investors believe that we're heading into, or are already in, a recession (I know, I know, how could anyone think that!). If you were such an investor, then  you would likely believe that the lower-grade issuers of these securities were likely to see a slowing in their sales, cash flows and, ultimately, a weakening in their ability to satisfy their obligations to the investors in the securities they issued - yeah, that's you and me. Well, to accept that added risk, you would demand a higher rate of return and this would begin to shift-up the yield curve for securities of similar risk. As that yield curve shifts-up, the spread between it and the safer (investment grade) securities grows.

Ok, so now that you understand the mechanics at work, I'm sure that you can put one-and-one together and see how you can use the yield curve to evaluate what the economy is thinking. If you were to look at the yield curve today, however, you probably wouldn't find what you were expecting. While most people would agree that we're either in, or heading into, a recession, the yield curve doesn't reflect it. With a spread of only 46 basis points, down for a high of almost four times that just a few months ago, we're not seeing the affects of higher commodity costs, rising unemployment and record high foreclosures and bankruptcies. Does this mean that something in the mechanism is broken?

Well, possibly, but there's a silver lining to any dark cloud. Today's yield curve tells us that the average investor hasn't adjusted their expectations to what most others believe is our economic reality. As an investor, this information is golden. As an investor, you should always be looking for information about what will be, but hasn't yet been accounted for by your fellow investors. Doesn't this sound like what we're seeing today? So, the question is, then, what will you do about it? How will you position your portfolio to take advantage of what appears to be an arbitrage opportunity?

It Wasn't Us; It Was The Computers!

That's what Moody's appears to be saying, or at least laying the groundwork to say, in light of the many law suits that are waiting in the wings spurred by the collapse of so-called Aaa-rated securities. One of the biggest head-scratchers with the financial crisis has been how such high credit ratings could have been issued on securities that were so susceptible to default; with news that Moody's is now investigating a possible computer bug that caused the mismatched ratings, it certainly does look as though it's covering its proverbial ass.

Both Moody's and S&P only began to strip-away their previously issued triple-A ratings after some of the constant proportion debt obligations (CPDOs) defaulted. Are we to think, then, that S&P's rating system was inflicted by the same virus?

CPDOs are portfolios of index-based credit default swaps (CDSs) that include both risky and safer trenches that have, somehow, made them candidates for the highest investment grade ratings. These CPDOs represent the latest innovation in one of the largest markets - credit default swaps - allowing investors to collect even higher returns as a result of even higher leverage. From this short description alone, does it sound to you as though this would qualify as deserving a Aaa rating? When will investors learn that there's no free lunch; higher rates of return do necessarily mean higher assumed risk. Period.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money-market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.

There's no holy grail; if there were, every investor, their brother, their sister and their cousin's nephew would be buying and the price of such assets would rise and thereby reduce its yield. It's a classic arbitrage opportunity that just can't exist for any extended period of time. If a broker or advisor is telling you differently, then they themselves probably don't understand the securities.

Here's a bit of a primer on CPDO's and credit default swaps from this bloomberg article:

CPDOs sell contracts on credit-default swap indexes and use the premiums to pay investors. If the perception of credit quality deteriorates, the cost of insuring the debt increases and CPDOs lose money. To make up for losses, the funds would typically increase their borrowing.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Rating a CPDO involves making assumptions about the way the indexes of credit-default swaps will move, based on a limited history of the benchmarks. The U.S. index referenced by CPDOs was created in 2003; its European counterpart started in 2004.

Earnings & Credit Ratings

In reading this article about GE on Bloomberg, I felt the need to write about the distinction between earnings reports and concerns over credit ratings. The two are separate and one does not directly depend on the other.

Credit ratings are simply that: relative evaluations of a company's creditworthiness or its ability to repay its loans. The difficulty arises from the fact that we tend to try and relate the stories we read to our own experiences. We know, for example, that the loss of a job will directly impact our credit rating and consequently the cost of borrowing to buy a home or car - as it should. Although this is accurate, it's not wholly relevant when discussing a company such as GE.

A lower earnings report is not the same as the loss of a job; it's more akin to rising expenses. Your personal credit rating may rise if you suddenly have mounting medical bills to pay, but it's probably not going to change as a result of the higher cost of oil. The important thing to note is the magnitude of the change relative to our overall wealth. In the case of GE, that wealth is significant. When GE reports lower earnings for the quarter, its rating is certainly not going to change. The reason is that this is likely both insignificant in light of its overall market capitalization as well as likely to be a temporary glitch in its continued profitability. Should GE show similarly weak earnings on an ongoing basis, however, then there may be cause for concern as this would tend to indicate signs of trouble within the company and not necessarily as a result of general market or economic conditions.

To make a long story short, it's easy to be swayed by an article that presents the facts in a way that is designed to stir discussion and either increase page views or newspaper sales. As with any information, consider the facts in light of the other information available to you.