Adventures in Structured Credit, Ratings Edition

Take a bunch of AA-rated securities. Boring, I know. So instead of just buying them, buy them with leverage, to boost their returns. Now, take that bundle of leveraged AA-rated debt, and tranche it, so that there's a super-senior AAA-rated tranche, and presumably at the bottom of the waterfall an insanely volatile piece of equity. Sell off the AAA-rated tranche at a low yield to investors who require rock-solid investments, and make lots of money!

Or, alternatively, see the whole thing blow up in your face.

Floyd Norris has discovered a curious animal called a “variable leveraged super senior certificate”, issued by an Irish vehicle known as Foraois Funding Limited. Somehow this certificate managed to get itself a AAA credit rating, despite the fact that the issuing entity had shedloads of leverage, and was exposed to the mark-to-market price of the underlying AA-rated securites.

The upshot is that the underlying AA-rated securities are still AA-rated: they're just as creditworthy as they always were, at least in the eyes of Moody's. But the variable leveraged super senior certificates have had their rating cut from AAA to – get this – Caa2. A C rating: that's not just junk, that's nuclear waste.

Norris actually spoke to Moody's group managing director for US derivatives, Yuri Yoshizawa. And whaddya know, she started blaming the market.

The ratings were based on 10 to 15 years of experience with securities such as these. She tells me that the moves in price seen in recent weeks are many times greater than anything ever seen before.

If I may, I'd like to introduce Ms Yoshizawa to JP Morgan's Michael Cembalest. He's mainly upset at fund managers, but his sentiments can be applied equally to ratings agencies:

Advice to portfolio managers around the globe: please stop referring to "7-standard deviation events" when describing performance.
Whether it's the decline in home prices in real terms, a sudden widening of credit spreads, the impact of too much leverage on previously uncorrelated hedge fund strategies, a sudden shift in liquidity, a selloff in riskier emerging market stocks and bonds despite no change in fundamentals, unexpected outflows from fund investors, problems with credit derivatives or declines in bank credit lines, this has all happened before.
The smartest managers had prepared for volatility.
The good ones will learn from what's happened and make adjustments.
Those that spend too much time explaining why it wasn't likely in the first place fall into the bottom category.