Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

CPDOs: Where the Creators and Ratings Agencies Went Wrong

By

Or, free speech aside, you can't yell, "Fire!" in a crowded movie theater.

PrintPRINT
MINYANVILLE ORIGINAL

Ratings and Rating Agencies

Before going into the details of how a CPDO (Constant Proportion Debt Obligation) works, it is worth talking about what rating agencies are, and what they do. The "big three" are Standard & Poor's, a division of McGraw-Hill (NYSE:MHP)' Moody's Investor Service (NYSE:MCO); and Fitch Ratings, a joint subsidary of FIMALAC (PINK:FMLCF) and privately-owned Hearst Corporation.

I think in most cases rating agencies do a good job, yet I would never rely on them. I think their "single name" issuer ratings have had a pretty decent history. This is the part of the business where they tend to get access to management and information that isn't always generally available. They have missed some fraud (but they aren't alone in that). They have some quirks where they tend to be reluctant (in my opinion) to have companies cross from Investment Grade to High Yield. The fact that being investment grade, or high yield, or even AAA is so important, is something we need to revisit.

Before moving on to the structured side of the business, it is worth spending a couple more minutes on the corporate side. What is the rating of a holding company versus an operating company? What is the difference in rating between senior secured and unsecured debt? Such simple questions have no simple answer.

All of the rating agencies attempt to rate "probability of default" rather than "probability of loss" for their corporate issues. They can argue that holding companies are more likely to default than operating companies, or that secured debt is less likely to be defaulted on. Many investors like the secured debt of junk bond issuers (leveraged loans) because they feel the rating precludes a lot of other investors from buying, but that the rating overstates the risk if the collateral is good. I'm not sure there is a right answer here, but the distinction of what they are rating becomes apparent as soon as you move into the structured world.

In the structured ratings world, most ratings are tied to probability of loss. Various scenarios are run including expected loss and stress loss, and those calculations are mapped to a rating. It is very methodical, generally conservative, process. However, loss severity plays a key role in the rating of structured debt versus its corporate counterpart. It's worth noting because it highlights the general differences between structured ratings – mechanical based on no specific additional knowledge, and corporate ratings – personal and subjective with additional company-specific knowledge.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE