In this irregular series, you can see that I wrestled with the concept of credit quality. I built my own models. I did not trust the rating agencies. Why did I not trust the rating agencies in 1998-2001? What great errors had they committed? They had not created many errors at all… but I knew my job was to uncover value, and take risks where they were warranted. Ratings will not help you there. That said, many of the rating agency writeups and presale reports were quite erudite. As our saying goes,”Ignore the rating, but read the writeup.” After all, the rating agencies are “inside the wall,” unlike most, and often disclose bits of insider information that are no longer totally insider. The rating agencies offer valuable information; the problem is that their ratings are less than golden.
In 2000, I remember going to a CMBS Conference where there was a young woman from Principal Financial, who ran their CMBS portfolio. She said something to the effect of, “Because we know that defaults in CMBS are unlikely, we buy all of the mezzanine and subordinated tranches of most deals. It’s free money.” We had a different opinion. We knew that liquidity had value, so we rarely bought non-AAA bonds. You could not easily trade bonds that were not AAA.
Once I became the CIO in 2001, I decided that we would look at older deals where wanted to sell BBB bonds. I would subject them to my usual standards, and analyze the properties in depth. I didn’t buy much, but what I did buy was quality. Though markets were tough, all of them paid off.
An example was when JP Morgan did what they called a “kick-out” deal. All of the properties that the B-piece cartel had refused to finance were in that deal. The spreads were very wide, and I bought all of the AA & A-rated tranches. I did a lot of due diligence, and I knew that the taint of the collateral was more than compensated for from the amount of subordination.
That was one of my lessons — be willing to buy things that are tainted in the eyes of many, so long as you have adequate protections, and a decent yield.
At the Life Insurance Conference
Though I was not a bond manager at the time that I went to a Life Insurance Conference in 2006, there were several themes in play. Here are two of them.
1) Odd Types of Collateral: there was the sense that new and odd types of asset backed securities [ABS] should be bought with abandon because the past experience has been so great.
I did not buy that idea. Most ABS requires a steady cash flow stream, and many industries don’t have that.
2) One guy said AAA bonds never default. I stood up and told him that AAA bonds that I had bought in franchise loans did default, so it was not true. That said, losses were not large.
At the conference, I managed to speak to the CEO of Principal Financial, and tell him that he faced considerable credit difficulties in his CMBS book. He was a big guy, tall and muscular, so he looked at me, average guy that I am, and told me he would consider it. The look on his face disdained me, but I am used to that. My appearance has never been my leading attribute.
Manufactured Housing ABS
In 2001, I came up with the idea that the Manufactured Housing ABS market was bifurcated. Current deals were lousy in their credit metrics, so we stopped buying any current deals. But older deals from GreenTree were seasoned and would likely deliver value. Lehman Brothers shared with me their default database, and I built my model, and it told me that deals from 1998 would allow tranches A and above to get their money back. It also told me that deals from 1997 and prior would allow tranches BBB and above to get their money back.
This proved to be true, but it meant that those that held the securities to maturity had to endure a time when the offered prices for the securities were far less than par, though all paid their principal and interest to maturity. I don’t feel bad about my purchases, because I looked long-run, and knew I had a strong balance sheet behind me.
Now in late 2001, the new CIO came to me and said, “I’m taking over the CMBS, MBS, and ABS portfolios.” I told him, “They are yours now, do what you like, do not care for my own preferences, do what you think is right.” As it was, he panicked, and sold many things that would later be money good, and he blamed me, according to friends.
So what? I have my own share of blame here, because you never want to buy near par something that will test your willingness to hold it. Though what I bought went through the valley of the shadow of death and came out whole, there is a cost to making everyone worry; and many in the same situation would sell and take losses that they should not have.
All of the Big Boys know you should never trust a rating
When I was a mortgage bond manager, I did my own work. I did not trust ratings, but did my own due diligence. I would analyze loss statistics where I had them, and some up with my own risk assessments.
This is why I don’t favor the prosecution of the rating agencies. The rating doesn’t matter, and if people are willing to trust a ratings scale, rather than a description of the business of those that are rated, they deserve the bad result.
It is utterly puzzling to me why the government is going after the rating agencies, because they just did their jobs. Yes, their models were flawed, but many ignored them in the insurance industry and elsewhere. Ratings are not guarantees, they are opinions, and so the Supreme Court will rule eventually.
By David Merkel, CFA of Aleph Blog