Wednesday, March 18, 2009

Outlaw Ratings Downgrade Triggers

One of the biggest contributors to the financial crisis has been ratings downgrade triggers, sometimes known as ratings-based collateral calls. These are provisions in financial instruments (especially derivatives) that automatically trigger collateral calls when a counterparty has its credit rating downgraded. AIG failed because ratings downgrade triggers in its credit default swap (CDS) contracts forced it to post $15 billion in collateral when Moody's and S&P downgraded its credit rating immediately after Lehman failed. AIG couldn't come up with that much cash on short notice, especially with markets essentially frozen due to the Lehman bankruptcy. Enter the U.S. taxpayers. Similarly, the monolines (e.g., MBIA, Ambac) teetered on the edge of failure in January 2008 because the rating agencies were threatening to downgrade their credit ratings (then AAA), which would have forced them to post billions in collateral that they simply didn't have. All the various rescue plans that were floated that month were aimed at staving off a rating downgrade. Ratings downgrade triggers force a company that is already struggling (hence the downgrade) to then post billions in extra collateral. In other words, the company is being forced to post billions in collateral at precisely the time it's least able to raise that much cash without seriously damaging the health of the company. This creates a downward spiral where the company is forced to liquidate assets at firesale prices in order to post the required collateral, leading to another rating downgrade, which triggers further collateral calls, and another round of forced liquidations, and so on. This could very easily cause a company to go directly from AAA-rated to bankruptcy (which completely distorts the idea of "credit ratings" in the first place). In fact, this almost happened with MBIA and Ambac—had they been downgraded from AAA in January 2008, they would almost certainly have been forced to file for bankruptcy. The justification for including ratings downgrade triggers in derivatives contracts is that less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater. But the evaluation of a counterparty's creditworthiness should be done at the outset of the transaction, and reflected in the initial margin required. Less creditworthy counterparties should have to put up more initial margin (i.e., collateral), but after the initial margin is posted, any additional margin calls should be based on changes in the value of the underlying security. Evaluation of a counterparty's creditworthiness shouldn't be outsourced to the rating agencies, which is essentially what ratings downgrade triggers do. Personally, I'd like to see an explicit ban on ratings downgrade triggers in derivatives contracts. They're lazy and unreliable in their accuracy. But worst of all, as AIG and the monolines have demonstrated, they're extremely dangerous.


Don said...

"less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater."

I thought that it was also to stop a Calling Run. If I see that AIG is bleeding money and burning reserves, then I'm calling my money in if I can. If they can post more collateral, that keeps me from pulling my money out because I see that they have the liquid resources should I need my money.

It's true that, if they don't have the resources to come up with more capital, then they're in trouble, but they're also going to be in trouble, at least with me, if they are losing money and are simply asking me to be patient. If I've loaned them money that I can call in, I might not like the idea of being patient.

I don't disagree with you about ratings companies or posting more capital at the beginning of the transaction, but the fact that companies can't come up with cash is a real worry. The solution is to build up reserves in the good times, not concoct exceptions to prudence.

Don the libertarian Democrat

Christopher Wheeler said...

Perhaps a temporary suspension of ratings triggers is called for during the current extraordinary circumstances. But under more normal times, the markets provide more ways to raise the extra collateral than are available today.

The key is the "fire sale prices" for assets you referred to in your post. Two years ago, if AIG had been downgraded, they could have sold off pieces of the company to raise capital. The new owners would have (presumably) made better use of the assets they purchased.

The whole point of the ratings downgrade is to recognize that a party that was more creditworthy at some time in the past has changed status.

On a side note, do the credit agencies ever upgrade their rating? Would that casue a return of collateral?

Robert said...

I agree. I think it is an extreme case of the almost insane faith in the ratings agencies. They can't be perfect and the more their ratings, as such, have direct consequences the harder it is to restore their almost miraculous integrity.

For 30 years I have been amazed that private firms could be so powerful and not abuse that power. It took a while, but the world has converged to my initial impression that private ratings agencies can't work.

We know they can work fineand we know that they haven't been working recently. I think it is clear that explicit references to ratings in regulations made the gains from uhm consulting excessive.

In the case of AIG, I suspect that Basel I regulations were part of the problem. Banks bought AIG CDSs to satisfy capital requirements. The requirements depended on AIG's rating (IIRC insured by an AAA firm counted as if the debt were AAA debt). So the ratings triggers protected clients from suddenly being hit by a jump in capital requirements.

Now a simple solution is to not take account of CDSs at all in capital controls (so insured debt is trated as uninsured debt). This is crude, but, given the AIG fiasco, seems to me to be better than current regulations.

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