1. The, company loses access to short term credit and faces a liquidity crisis, so that
2. The company fails to pay interest and principal at a date certain, triggering a payment default, so
3. The payment default triggers cross defaults on all the other outstanding debt, so
4, Those defaults trigger cross acceleration, so that all the debt is immediately due and payable, so
5. The company is forced to file for bankruptcy, so that
6. Everyone waits until a bankruptcy judge determines what the creditors will eventually recover.
In a residential mortgage securitization, no one is actively working to forestall the possibility of a default. And once it becomes apparent that some tranches will lose money, nothing happens, since everything has been predetermined by the cash-flow waterfall. And since there's no fixed obligation to pay principal for 30 years, it may be several years before any payment default actually takes place. (Which is why the rating agencies are not forced to rush and announce a downgrade.) But eventual recovery is determined by the legal structure, not the bankruptcy court.
This is very obvious to anyone who has observed structured finance defaults over time. And that's why all these CDOs were conceived under a bogus premise, which equated corporate defaults with structured defaults.
CDOs: Bogus Default Correlations
If you buy a newly-rated triple-B corporate bond, the likelihood of default, over 10 years, is supposed to be about 5% But if you hold 100 triple-B bonds, what is the likelihood that more than five of them will default? If you toss a coin 100 times, you can calculate the odds that, say, 75 of the results will be "heads," because the result of each coin toss is totally uncorrelated to all others. But with different types of corporate bonds, the risk of default may or may not be correlated. Moody's came up with a way to measure that default correlation. It came up with the concept of a diversity score based on a methodology called the binomial expansion technique. It assumes that the greater the diversification among 30 different industry sectors, the lower the default correlation. All well and good.
But what about structured deals, most notably, residential mortgage securitizations? Moody's assumed that these bonds would deteriorate at the same rate at the corporate bonds and it initially used default correlations that were pulled out of thin air, or as Dr. Gary Witt quoted the original author of a seminal Moody's publication, "We just made them up." Later, Moody's came up with other default correlations, based on its history of downgrading mortgage deals during the bubble. Needless to say, those correlations had nothing to do with real life. Aside from a few regulated financial entities, there are no triple-B corporate bonds that are deeply subordinated to 20 times leverage at a business with a vacuum of leadership. The subprime collapse of the late 1990s demonstrated a very strong default correlation among hyper-leveraged companies in the mortgage business.
2. Our ratings on structured deals are merely opinions, protected by the 1st Amendment.
"Credit rating agencies are not gatekeepers. Rating agencies are credit market commentators." Ray McDaniel, Moody's
Credit ratings are never just opinions, like movie reviews or analyses published by the financial press. They are approbations, more akin to those awarded by the FDA to over-the-counter medications, or like those awarded by health inspectors to public restaurants. They are not guarantees of performance, but they are certifications based on an institutionalized vetting process. But with structured finance deals, they are something much more.
When a rating is awarded to a corporation, the two are clearly separate. The company had an existence that predated the rating. The opposite is true of a structured deal. All of these toxic structured deals were designed at their inception according to specific standards set by the rating agencies. Without their credit ratings, these would never have been created. This is especially true of CDOs, which are designed about credit ratings, not around cash flows. Consider Squared CDO 2007-1, Ltd., a J.P. Morgan deal that closed in May 2007. Upon completion of the ramp up period for acquiring assets, the deal would be forced to liquidate unless Moody's had confirmed the CDO ratings, which depended on compliance with, among other things, the "Moody's Asset Correlation Test," the "Moody's Minimum Weighted Average Recovery Rate Test," and the "Moody's Minimum Weighted Average Recovery Rate Test." Again, there are hundreds of other deals just like Squared CDO 2007-1, which happens to be one of the notorious Magnatar deals, which were all secretly designed to fail by a hedge fund.
Read the initial ratings "commentary" on Squared CDO 2007-1, and you'll notice that, like hundreds of other CDO ratings announcements, it reveals nothing that would enable an outside reader to form an independent judgement.
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