June 12, 2008
Shocking, Just Shocking: Performance Measurement at the Rating Agencies
The SEC has just release for comment (within an aggressive 30 day period), their proposal for improving the process at credit rating agencies (NRSROs).
One suggested change is:
Require credit rating agencies to publish performance statistics for 1, 3 and 10 years within each rating category, in a way that faciliates comparison with their competitors in the industry.
Shockingly, this adds a hint of competition to an industry that is an oligopoly. It is a slow move towards the word most hated and feared by Moody's, S&P and Fitch - COMPETITION. In a capitalist economy, lack of competition can lead to inefficient and ineffective markets....something that is still endemic in the NRSRO industry today.
We firmly believe this disclosure is a step in the right direction. It might even get investors to realize how truly imperfect credit ratings are, and how important independent credit research is. It should also be a stark reminder to investors that ALL portfolios with credit risk are subject to losses which can indeed be anticipated and analyzed in advance.
Unsurprisingly, we are called upon to provide such quantitative analyses for our client portfolios. Each portfolio exhibits a different expected loss distribution, but all portfolios' credit loss distributions tend not to be 'normal' and are subject to severe negative spikes in losses in certain 'unusual' cases.
Given the current and expected state of the economy, perhaps it is time for analysis of expected loss distributions in your company's portfolio?
Posted by cogert at 12:25 PM
| Comments (0)
June 11, 2008
The Rising Tide of Credit Risk
Last December, in a blog entry entitled, "Credit Risk: Prepare for What Will Come Next" we warned of focusing on the 'headlines' of sub prime problems without considering "good old fashhioned credit risk". We noted:
"What's the next shoe to fall in the credit risk arena?" may not be the correct question. Perhaps "What and how many shoes?" is a better question.
Now, Moody's has confirmed our thoughts with a recent report, as noted by Reuters:
A record $772 billion of U.S. corporate debt may be put on review for downgrade this quarter as financial firms stumble and rising commodity prices take a toll on industrial companies, according to Moody's Investors Service.
The previous record for downgrade reviews was $543 billion in the third quarter of 2001, a year of massive bankruptcies as accounting scandals and recession toppled corporate giants. Downgrade reviews for this quarter are on pace to top the $593 billion reported for all of last year, according to a report released late on Wednesday.
We've been in recent meetings with some investment managers who see value in the investment grade corporate market because spreads are predicting defaults in excess of those seen back in 2001. Alas, these managers may be too sanguine if Moody's predictions, which are pointing to worse credit conditions than 2001, come to pass.
The report goes on to say:
"Three clear trends have stood out among U.S. issuers subject to recent downgrade reviews: financial firms hurt by holdings of toxic structured financial products, industrial firms squeezed by rising commodity prices, and firms with direct exposure to the discretionary spending of the U.S. consumer," according to Moody's statistical economist Benjamin Garber.
In the case of financial firms, the reliance on leverage is endemic; and for firms with direct exposure to discretionary consumer spending, leverage has been a strong contributing reason for revenue gains.
The rising tide of credit risk will make your investment managers' tasks more difficult. However, it is incumbent upon insurers to carefully question, understand and monitor the process or credit risk management at those investment management firms.
And, as noted in our earlier blog:
Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve. We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.
There are many different ways to perform such an analysis. However, using credit rating transition matrices, credit default swap spreads, long term credit default performance as well as stress testing that performance is a good start.
It is much better to be prepared now than surprised later.
Posted by cogert at 10:52 AM
| Comments (0)
June 06, 2008
Mark to Market is Just An Implementation Problem
That's not our quote, but it was Bob Herz, FASB head who noted this at the recent CFA Institute Annual Conference in Vancouver, B.C, as he laid out a plan for convergence of FASB and IFRS (international accounting) standards. There are several areas that need to be addressed before this occurs, and mark to market (now required by IFRS) is one of these areas.
We're all for mark to market of assets AND liabilities...when it makes good sense.
Please remember that accounting is basically sociology...what we group of humans think is the best way to report financial results of enterprises, etc...and these are always subject to change.
And, as we tell all of our clients, when it comes to their investment process, everything starts with what you are trying to accomplish (your company's key goals and objectives, key performance indicators, etc.). And, the same holds for accounting...it still comes down to what you are trying to accomplish.
If the goal is to provide a snapshot of balance sheet market values without regard to why those assets and liabilities are on the balance sheet, it's full speed ahead on MTM -- and any problems are indeed implementation problems, per the esteemed Mr. Herz. However, if the goal is to accurately convey the financial condition of a firm within its unique goals and objectives, MTM only applies where those assets and liabilities are subject to conversion at those values.
For example, insurers typically purchase equities for long term capital appreciation. When preparing a balance sheet as of a certain date, there is good reason to mark these assets to market, because we all want to know how far along that capital appreciation path those investments are hopefully on.
However, if an insurer puchases a bond to hold for a long period of time (whether for maturity or not) in order to provide investment income (assuming no credit risk), it makes little sense to mark the bond to market, since the bond is being held to support the business/income statement of the company and not to produce outsized total returns. Conversely, if an insurer actively trades those same bonds, with a philosophy of looking for total return advantages through relative value decisions, etc., than the insurer should indeed mark those bonds to market, because they are less interested in providing income to support the business and more interested in that long term capital appreciation, similar to the investment in equities noted earlier. It all comes down to something similar to the 'cash flow statement' required of companies -- trying to determine what the sources and uses of cash flows are.
Of course, market illiquidity has caused getting good market values to be problemmatical, but if one is actively trading, one should know those values or else how could one trade effectively...and if one could not trade effectively, it brings up much more serious issues than what is shown on a financial statement.
Meanwhile, our friends at the CFA Institute, without considering all of their consituencies such as insurance company investment professionals, continue down the path of blindly supporting MTM:
“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”
Market value disclosures are always a good idea...the more transparency the better is a generally good rule to follow. However, forcing MTM on investors that use investment grade bonds as a source of income, not total return, is completely missing why those investments are being held. Alas, MTM is not just an 'implementation problem' when you look at insurers.
Posted by cogert at 09:39 AM
| Comments (0)
