Good morning, Your Honor. May I approach the bench, to do a sort of defense of Standard and Poor’s, pro bono?

There are many reports which indicate that the US department of justice is expected to file a civil lawsuit against Standard & Poor’s for the issuing of overly rosy credit ratings with respect of some collateralized debt obligations. 

If I was allowed to defend S&P, pro bono, without of course implying that any outright illegalities committed by it should not be punished, I would state the following: 

Your honor: Credit rating agencies have been around for a long time issuance opinions which are certainly quite often very wrong, by being very rosy or by painting a too dark picture. Doing the first investors and lenders might lose out in favor of borrowers, doing the latter borrowers might lose out in favor of investors or lenders. C’est la vie. 

But one thing I am absolutely sure of is that, had the bank regulators not assigned so much importance and so much credibility to some human fallible rating agencies, like by allowing banks to hold AAA to AA rated securities against only 1.6 percent in capital, and which translates into a mindboggling approved leverage of bank capital of 62.5 to 1 times, we would not be standing here. 

There would have not been the kind of pressures exerted on credit rating agencies to produce these AAA to AA ratings, and if produced there would not have been the same outrageous demand for these securities, and the consequences would not have been something to write home about. 

And so, if you ask me, the credit rating agencies broke the window, but the bank regulators, placed the stone in their hands. 

Your honor, in evidence of what I am saying I introduce here a letter I wrote in January 2003, and which was published by the Financial Times. It states: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds” 

Also, in April 2003, in a formal written statement delivered as an Executive Director of the World Bank I held: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on a limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.” 

And in May 2003 in an Op-Ed I also wrote “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators we find it so strange that the Basel Committee delegate, without any protest, so much responsibility in the hand of so very few and so very fallible credit rating agencies” 

Your honor, unfortunately the bank regulators did not want to listen, just as they still do not want to do. If you find Standard and Poor’s guilty of misdoings, something which you might do, I beg of you not to ignore those who unwittingly, but with extreme arrogance, set us up to all this disaster.

A wicked question to credit rating agencies, about risks and sovereign ratings

I suppose you are all professional with solid academic degrees and a lot of knowledge and experience rating the creditworthiness of borrowers. If not, excuse me and ignore the following question. 

You must be aware of course that bank regulators allow the banks to hold much less capital when investing in an asset that has been deemed to you as belonging to the privileged group of “The Infallible” than when holding an exposure to something less well rated or unrated. 

And you must be aware of course that this allows banks to expect to earn much higher much higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

And of course you must understand that this means than banks will invest more and more in assets considered to be part of “The Infallible” and less and less to assets considered “The Risky”, like small businesses and entrepreneurs. 

And so here is my question to you: With banks that are given special regulatory subsidies to invest, almost exclusively, in “The Infallible” and abandon, almost totally, the lending to “The Risky”, in a competitive world, can any country keep a healthy economy that allows it to service its long term debt at current levels of public debt? Is not a very important degree of risk-taking by banks a must to keep economies rolling? 

Would you, as risk analysts and practitioners, in normal circumstances, ever think of giving your personal investment managers similar risk-adverse orders? 

I know what the extreme importance given by the regulators to your credit ratings has done to your business… but, come on, frankly, is that just not something too risky for the world you want to hand over to your children and grandchildren? 

Sincerely, 

Per 

A friend, not out to shoot the messengers

The lover’s spat between Goldman Sachs, Paulson and “sophisticated investors” is not the real problem!

The beauty of the action of the SEC against Goldman Sachs is that it allows us to understand with a real and public example a lot of what happened all over the market. Let us see it here from the perspective of IKB the German Bank who invested $150 million in ABACUS 2007-AC1.

In paragraph 58 we read that IKB bought $50 million of the A1 tranche paying Libor plus 85 basis points, and $100 million of the A-2 tranche paying Libor plus 110 basis points. The average return comes to about 102 basis points.

Since these $150 million were rated Aaa by Moody’s and AAA by S&P when purchased, that meant that IKB’s investment, for bank capital requirement purposes, would be weighted at only 20% signifying only $30 million for which 8% capital requirements had to be held. IKB would therefore need $2.4 million of their own capital to back the operation, a leverage of 62.5 to 1.

$150 million at 102 basis points and $ 2.4 million in capital signifies then an expected gross return of 63.75% on IKB’s capital.

In order for IKB to make a comparable return when lending to their traditional client base of small and medium sized businesses, most certainly unrated, and who therefore are risk weighted at 100%, IKB would have to lend them the funds at Libor plus 510 basis points.

And here we have it, the way the current capital requirements for banks are based on the risks perceived by the credit rating agencies, provide huge incentives for the banks to enter into the virtual world and invest in these “synthetic” operations, instead of lending to the real world... and, that problem is so much larger than a simple lover’s spat between Goldman Sachs, Paulson and “sophisticated investors”.

Do you understand why I beg of you to keep your eyes on the ball? Do you understand why I am upset nothing of this is even discussed in the current proposals for financial regulatory reform?

Goldman’s ABACUS 2007-AC1: The whole truth and nothing but the inconvenient truth!

But the whole truth and nothing but the truth would in the case of ABACUS 2007-AC1 have to include the following facts, no matter how politically or agenda inconvenient they might be:

IKB, a commercial bank headquartered in Germany did not use $150 million to lend to small and medium sized German companies, as they historically had done, but instead invested and lost “$50 million in Class A-1 notes at face value” and “$100 million in Class A-2 Notes at face value” in ABACUS 2007-AC1, exclusively because of the following two reasons:

First both tranches, the A1 paying Libor plus 85 basis points, and the A-2 paying Libor plus 110 basis, points were rated Aaa by Moody’s and AAA by S&P when purchased by IKB.

Second, in order to invest $150 million in these securities which because of their ratings were risk-weighted by Basel II at only 20%, IKB needed only to have $2.4 million of capital, 1.6%, compared to the $12 million it would be required to have if lending that amount to unrated small and medium sized German companies.

If IKB had known that Paulson had had his hand in the picking, and known fully about his motives, then they might have asked for a slightly higher interest rate, maybe 10 basis points more, and still have bought the securities.

If the securities did not have the splendid credit ratings assigned to them by the credit rating agencies then they would probably not have bought them even if Mother Teresa had done the picking.

If the regulators had placed the same type of capital requirements on all assets then IKB would have stayed home, lending to their traditional clients, instead of going to California to dig prime rated subprime gold.


And so while naturally we should lend all our support to efforts to eliminate wrong-doings like those described in the SEC action against Goldman that should not signify we take our eyes of the unfortunate truth of having been saddled with grossly inept regulations, creating grossly bad regulations.

Now all of this does of course not imply that the Goldman Sachs, the Tourres, the Paulsons or the ACAs of this world are angels… it is just about putting it all in the right perspective.