The Hindu Business Line : Sovereign obligations deemed more risky!

It is now well-known that the present crisis enveloping the Collateralised Debt Obligations (CDOs) and securitised assets markets in general can be traced to the investment grade ratings showered liberally on these structured products by the world’s top credit rating agencies – S&P and Moody’s – despite the complexity of pricing them and their illiquidity.

With no market prices being available, their valuation became judgmental and sprouted new jargon – ‘mark to model’, meaning apply a formula to determine their worth. The cynical (Warren Buffet, the world’s most successful investor among them) called it ‘mark to myth’.

Credit rating started with methods and techniques to rate individual companies and balance sheets and their specific obligations. By and large, results have been satisfactory (forgetting spectacular blow-ups like Enron).

The problem starts with rating assets in combination. What about a pool of retail loans? There are no balance sheets, profit and loss accounts or businesses to evaluate. The exercise is reduced to statistics, assumptions on default rates and ‘credit enhancement’ – short form for the securitiser agreeing to bearing a proportion of defaults.

Credit enhancement seems to be the passport to getting ‘AAA’ ratings and offering a higher yield than ‘AAA’ bonds. But it is necessary to ask if this mere sleight is enough to equate a prime corporate obligation and securitised retail loans. With the ultimate borrower (a house or car owner) separated by layers of intermediaries and intermediation, the recovery process for the ultimate lender (investor) in the event of defaults will be expensive and time-consuming. Yet this has not deterred raters from rating a portfolio of a mass of individual borrowers in dispersed locations, of varying income stability, savings capacity, financial strength and integrity equal in terms of credit risk to reputed companies with proven business and financial track records. The cause of the sub-prime crisis obviously lies in this practice of putting corporate and retail obligations on a par.

Not that the Indian situation is very different. The folly is being repeated here. The unwary victims are – no prizes for guessing – public sector banks investing in securitised retail loans at the same yields as ‘AAA’ corporate paper simply because they carry the same label.

Worse is the sub-prime status awarded to the Tier II bonds of public sector banks while some private sector banks command better ratings. In other words, sovereign obligations (which is what the Government of India-owned public sector banks’ liabilities are) carry more risk!

Such is the pathetic state of the quality of credit ratings.

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