2008’s new fad: “rating cliffs” and “credit cliffs”

Do you know what will be all the rage in 2008 in the wake of the subprime crisis? “Rating cliffs” and “credit cliffs” when firms that have seen a slow erosion of their credit will all of a sudden drop like a stone. As I devoted a whole chapter to the subject back in 2003 when drawing some lessons from Enron’s demise, I decided to revive it for your enlightenment. Here it is from
Paul Jorion, Investing in a Post-Enron World, McGraw-Hill, 2003.
Enjoy!

Chapter 13: The perils of cliffs

Once upon a time, a company named Enron was a utility, of sorts. It owned pipelines, and fuels flowed through them. It thought of itself as a utility, and more or less behaved like one.

Then, in August 1999, Enron started trading contracts on future delivery of energy. A psychological shift accompanied the strategic shift. Enron began thinking of itself as a financial company. This was gratifying, because it meant the company had moved into the fast lane – where the drama, excitement, and money were. Goodbye to the plodding old days of being a regulated utility; hello to the Big Time.

One of the most successful divisions of Enron, it turns out, was a hedge fund called ECT Investments. “The hedge fund, the brainchild of Enron’s former chief executive officer, Jeffrey Skilling, did quite well,” according to a report in The Wall Street Journal, “averaging annual returns of more than 20% after it was launched in 1996. In that period, the Dow Jones Industrial Average had returns of 11%. The hedge fund’s gains amounted to as much as 8% of Enron’s overall earnings in recent years. . . ”

But the transformation to a financial company also meant that Enron became susceptible to all the fragilities to which financial companies are vulnerable. One of the most pernicious of these is the Confidence Factor: How much confidence do your clients and shareholders have in you today? How much will they have tomorrow? Absent a Three Mile Island-type disaster, the Confidence Factor doesn’t vary much for a utility. But it bounces all over the place for a high-flying financial company, especially if the main financial product that the company is trading in is its own stock.

The business depended, in large part, on the stock being constantly on the rise – or at least not losing value. The reason was leverage, which has the unpleasant capacity to go from positive to negative overnight. Enron was perched on the edge of what Standard & Poor’s calls a “credit cliff,” meaning that any drop in its credit rating would materialize in a deterioration of its debt, leading in no time to a further downgrading. Although Enron’s financial health was an exercise in brinkmanship, what actually brought it down in just over six weeks was little more than a glitch, which on its own merits should have been survivable. The rest, as its former CEO would say, was only a “run on the bank.”

So the point of this chapter is to help you, the investor, understand and recognize a credit cliff, as well as its equally daunting sibling, a “rating cliff.” I’m confident that when you spot a company living on these cliffs, you’ll decide to stay away.

Enron and the rating agencies
On December 12th, 2001, ten days after Enron’s official filing for Chapter 11 protection, Standard & Poor’s issued on its web-based and e-mail driven RatingsDirect a commentary entitled “Playing Out the Credit Cliff Dynamics,” written by Solomon B. Samson. During that ten-day period, rating agencies, Moody’s Investors Service in particular, had been accused of precipitating Enron’s downfall. The press reported that the Houston energy trading corporation had been drawn into a downward spiral once Moody’s and Standard & Poor’s had downgraded its debt.

On Friday, October 26th, Enron CEO Kenneth Lay put in an urgent call to Secretary of Commerce Donald L. Evans. Evans was in St. Louis for the day, and wasn’t able to return Lay’s call until the following Monday, October 29th. According to James Dyke, a spokesperson for Evans, Lay “indicated that he would welcome any support the secretary thought appropriate” in dealing with the major rating agencies — and with Moody’s Investors Service in particular, which had expressed its intention to downgrade Enron’s credit rating.

On November 28th, 2001, Enron’s smaller rival Dynegy Inc. — in talks since October about a possible acquisition of Enron — canceled any further discussions, claiming in a bitter statement that the Houston energy trading firm had misrepresented its own financial circumstances. The major credit rating agencies immediately downgraded Enron’s bonds to “junk” status (we’ll see why below, in Samson’s analysis). Four days later, on December 2d, 2001 Enron filed for Chapter 11 of the Federal Bankruptcy Code.

Living on the cliff edge
The following month, in another commentary — this time signed by Clifford M. Griep, the rating agency’s chief credit officer — Standard & Poor’s announced a change in its rating policy. The reason, S&P explained, what that in certain (unnamed) corporations, the “credit cliff” previously spotlighted by Solomon B. Samson was now materializing as a “rating cliff.”

Griep’s paper was entitled “Credit Policy Update: Changes to Ratings Process Address Economic Conditions and Market Needs.” That somewhat opaque title was clarified in the press release accompanying Griep’s analysis: “S&P Comments on Changes to Credit Ratings Process, Says ‘Triggers’ Should Be Made Public.’”

To understand this significant step, we need to dig into Samson’s December 2001 commentary. In that commentary, using Enron as his main example, Samson had explained that certain companies have their finance structured in such a way that embedded “triggers” can lead the credit rating of the company to suddenly plunge by several notches, rather than degrade gracefully under financial pressure.

The introductory paragraphs in Samson’s study had a somewhat defensive tone, as if Samson (and his company) were responding to some reproaches made in the previous days about what some saw as a pro-active role played by the rating agencies in precipitating Enron’s demise. Samson wrote: “The credit cliff dynamic figured prominently in several recent severe credit downgrades – including the California utilities (PJ: Pacific Gas & Electric and Southern California Edison) and Enron Corp. Observers accustomed to gradual changes in credit quality questioned the wisdom of the original ratings, but, in fact, it was merely the credit cliff dimension that played out.”

Illustrations involving Enron figured prominently in Samson’s analysis. Out of the eight type of business configurations embedding credit cliffs, Enron was mentioned in three: “Event-specific Dependencies,” “Confidence-Sensitive Entities” and “Rating Trigger Situations.”

And as I’ll show, two other types of credit cliffs — “Capital-Intensive Entities” and “Structured Finance” — clearly applied to Enron, as well.

Ratings, and why they matter
To understand the concept of credit or rating cliff, it’s important to grasp the role that rating agencies play in the economy, and how their downgrading of Enron’s debt impacted the company in the days preceding immediately its Chapter 11 filing. A good place to start is with the credit of individual consumers.

Most people understand what is a credit report is, and how the information contained in it impacts an individual’s access to credit. As long as you’re a conscientious borrower – meaning mainly that you pay a reasonable amount against your debt each month, before the deadline — further credit will be extended to you on favorable terms. If you’re not so conscientious, future credit will be complicated. You may be told you can only get it at a higher rate, or you may be told you can’t get it at all.

Ever wondered who came up with the idea of working out these individual credit ratings? The answer is Fair, Isaac & Company, headquartered in San Rafael, California. Fair, Isaac has designed a complex method for assessing a person’s financial history, which is summarized in something called a “FICO Score,” with values theoretically between 0 and 900, and effectively between 500 and 800.

This may sound somewhat remote to the average borrower, but that’s absolutely not the case. Your personal FICO score – which already exists, unless you’ve been living in a cave – can have an enormous impact on your financial life. For example, using figures borrowed from a Los Angeles Times article from March 2002, the same fixed 30-year mortgage could be obtained at a rate of 6.556% by a borrower with a FICO Score in the 720 to 850 range, at a rate of 8.508% in the 620 to 675 range, and at a rate of 11.164% in the 500 to 560 range. In other words, you’ll pay twice the interest if you have a shoddy FICO score.

This might seem to be a dirty trick to pay on the less affluent among us – who after all are more likely to miss some scheduled payments – but in fact, it objectively reflects the credit risk that lenders incur when lending to a “bad risk” consumer. So the pricing of debt includes what might be called “risk logic”: To the price paid by the less credit-worthy for borrowing is added a premium that compensates for the additional risk involved. This is the equivalent of an insurance premium for the lender, offsetting the risk that the borrower won’t be able to meet the terms of the outstanding debt.

Some advocates for the less affluent have argued that this is a vicious circle. Poor people have to borrow to get access to necessities – for example, housing, insurance, and transportation – for which rich people can pay cash. As a result of being compelled to pay an interest rate differentially higher than what the rich would pay, poor people are pretty likely to stay poor. In recognition of this self-fulfilling prophecy, the states of Washington, Utah, and Idaho recently have passed laws prohibiting insurers from using credit scores when setting rates for on home and auto insurance. Similar legislation, restricting the use of credit-scoring in one way or another, is already on the books in more than twenty other states.
This brief sideways look at credit on the personal level helps to set up the discussion of corporate credit that follows.

Rating agencies and corporate credit ratings
Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are the three “Nationally Recognized Statistical Ratings Organizations,” a label assigned by the Securities and Exchange Commission (SEC) that authorizes them (and only them) to come up with certain kinds of bond ratings.

Rating agencies deal with corporations in roughly the same way that credit-scoring companies do with consumers: They assess their creditworthiness, and advise prospective lenders about the default risk that a corporation presents in its debt. They ask fairly predictable questions. What’s the proportion of debt compared to revenue? How good has the company been in making the repayments associated with its debt?

By grading corporations, the rating agencies determine by how much those companies will have to pay to gain access to additional credit on the markets. The grading system typically starts with AAA (pronounced “triple A”) as it highest rating, typically applied to the debt instruments (bonds, bills, and notes) issued by the most trustworthy of governments. It typically drifts all the way down to D, the lowest grade, assigned to highly speculative “junk bonds” and similar products.

Just as in the case of consumer debt, the rating that is assigned to a particular company determines how much of an added premium will be built into loans to that company, compensating for the risk of default that company presents. So, to give a simple-minded example, financial players will know that they can charge a “risk-free” AAA counterparty 6% for a loan, but that they need to charge a B counterparty 7.2%. Again, the 1.2% difference in interest rate reflects the increased default risk of a B rating compared to a AAA, is a kind of insurance premium against the added risk. When you buy a junk bond, you get a relatively high return – a premium – for putting your money behind a venture with a relatively low rating.

Standard & Poor’s assigns AAA rating to Government agencies (on the assumption that the Federal Government will never allow itself to default on its debt), down to D, through AA, A, BBB, BB, B, etc. “Junk” starts in the low Bs, and that is precisely the status that Standard & Poor’s and Moody’s assigned Enron in the aftermath of Dynegy canceling its prospective agreement to purchase the Enron corporation.

Indeed – as Standard & Poor’s emphasized in its press releases following Enron’s collapse — at no point had S&P assigned Enron particularly high marks. In a news release dated December 6th, 2001, Standard & Poor’s, under the pen of Tanya Azarchs, reminded the public that “As a triple-‘B’ category credit in a market that prefers very high credit, Enron frequently had to put up collateral to enter into trades with its counterparties, which were generally commercial and investment banks, utilities and other power companies.”

So corporate credit ratings are a big deal. Money is the lifeblood of business. By putting a price on money, the rating agencies have a lot to say about the cost of doing business: A low rating means hefty penalties for accessing the markets in search for new capital, and a high rating means highly favorable conditions.

Obvious, so far? What you may not know is that none of this is quite as hands-off as you might expect. Provisions have been made that, within limits, allow companies to negotiate their grade with the rating agencies. They can provide the agencies with detailed nonpublic financial information — inaccessible to other analysts because of securities regulations — in an attempt to obtain either an initial assessment of their creditworthiness, or an upgrading of their existing rating.

This is just more evidence that the three rating agencies have enormous power over the fate of individual companies, especially those in less than stellar financial health. This amount of power residing in the hands of three private entities is an anomaly in the financial landscape, and – not surprisingly – there have been calls to see their number increased. For instance, in March 2002, Senator Jim Bunning, (Republican, Kentucky), himself a former investment broker, said that “we obviously need more credit-rating agencies.”

Others have drawn legislators’ attention to the need for increased accountability on the part of entities with such far-ranging influence on the operation of the financial markets. As Senator Joseph I. Lieberman (Democrat, Connecticut), chairman of the Senate Governmental Affairs Committee, declared after a March 2002 hearing about the role played by the rating agencies in the Enron collapse: “They see themselves as private, but they’re playing at least a quasi-governmental role in this unusual system that has built up where the laws give them the authority to decide where literally trillions of dollars can be invested or borrowed, depending whether they say this company is O.K. or not. And we hold them to no accountability. Congress ought to consider such legislation.”

And I’m sure Congress will do so. On balance, though, I’d argue that the rating agencies perform a crucial function, and they perform it well. One measure of this performance is that throughout the entire seamy unraveling of Enron and similar messes, the rating agencies have only been criticized for having played their rule, thoroughly and consistently.
If you’re going to get criticized, that’s a good kind of criticism to get.

Back to the cliffs
The principle underlying the notion of a credit cliff is what is called in mathematics a “non-linearity.” A linear process is one where a small change in the cause produces a small change in the effect, and a large change in the cause leads to a large change in the effect. A car’s accelerator and brakes, for example, are designed to govern linear processes. You want gradual, in both cases.

A non-linear process has “thresholds,” or jumping-off points, whereby a small change can induce considerable consequences or, conversely, where a modification of wide amplitude in the cause only induces a small change in the effect. Non-linear processes involve big leaps, and associated consequences, where you might not expect them. Non-linearities can be associated with either good things or bad things. Among the bad things are phenomena like vicious circles, chain reactions, and domino effects.

Looking to the world of options, for example: If the strike price of a call is $83, the small price change from $82.99 to $83.01 takes the option from “out-of-the-money” to “in-the-money.” Meanwhile, the much larger price movement from $25 to $82 doesn’t make any difference: the option is “underwater,” and stays there until that seemingly insignificant threshold at around $83 is reached.

Or, looking to the physical world: If you pull on both ends of a rubber band, it gets longer and thinner. Within some limits, the process remains linear: an additional slight pull produces a limited thinning and expansion. There’s an upper limit to the tension, however, above which the band snaps. It’s the proverbial “straw that breaks the camel’s back.” The first 10,000 straws are bearable; the 10,001st is unbearable.

Perhaps it’s now easier to see why, in the eyes of the rating agencies, a credit cliff translates pretty quickly into a rating cliff. The presence of a credit cliff means that the given company’s credit risk is non-linear. When pushed over an edge, the credit risk the company represents will brutally amplify, and the rating agencies may translate that sharp fall into a downgrade of more than one notch, depending on the translation system from credit risk into rating grade. The accident-proneness is even more dramatic if the company has been so foolhardy as to make its financial soundness hinge upon a particular credit rating. Such was the case with Enron.

Non-linearities can manifest themselves in the workings of a corporation, especially one that, like Enron, has enormous complexity woven in its fabric. On November 8th, 2001, the day when Enron’s released its restatements, The Houston Chronicle cited a prescient analysis of the corporation’s circumstances by Jeff Dietert of Houston-based Simmons & Co. International. “’If Enron doesn’t move to calm investor fears, they could become a self-fulfilling prophecy,’ [Dietert] wrote in a research report. The vicious cycle potentially goes like this, he said: ‘Fears drive down the stock, the lower prices force credit agencies to consider downgrades, potentially lower credit ratings force trading partners to reduce business with Enron, and Enron’s ability to generate earnings and cash flow suffers’” This is an apt description of the rating cliff off of which Enron was soon to fall.

Samson’s cliffs
Earlier, I mentioned that Standard & Poor’s Solomon Samson produced an analysis spotlighting eight type of business configurations embedding credit cliffs, several of which Enron embodied. Let’s look at several of those categories.

In his first category, “Event-Specific Dependencies,” Samson discusses companies whose good health depends on the support of a stronger parent. “The credit rating for a weak company,” he wrote, “ordinarily takes into account expected support of a stronger parent company – or parent company-to-be. Such was one of the bases for the ‘BBB-‘ rating of Enron Corp. at the point following its widely disclosed problems: there was a signed agreement to be acquired by Dynegy, plus liquidity infusions from Dynegy and its affiliates to maintain Enron until consummation of the acquisition. When that agreement was renegotiated and ultimately abandoned, Enron’s rating dropped to ‘B-‘, ‘CC’, and ‘D’ in rapid succession. Even then, the ratings on Enron’s Portland General Electric Co. subsidiary were kept at ‘BBB+’, reflecting continued confidence that its sale to Northwest Natural Gas Co. would still go through. The alternative scenario – getting embroiled in Enron’s bankruptcy – obviously represents a serious credit cliff..”

In his second category, “Confidence-Sensitive Entities,” Samson pointed to companies whose main asset is their good reputation. Such companies are “confidence-sensitive,” and — in case of a corporate disaster — the individual investor might be the last informed. “Whereas a manufacturing company can continue to make and market its products even while facing a financial crisis,” he pointed out, “that may not be the case for a bank, insurance firm, or trading company. Any problem that erodes confidence in such financial institutions tends to lead to a downward spiral with severe consequences – the colloquial ‘run on the bank.’ Enron’s problems related primarily to the actual and potential loss of trading business, as a result of loss of confidence by its counterparties (in the wake of disclosures of unusual financial and accounting practices). This alone explains the drastic rating consequences – a decline to ‘B-‘ from ‘BBB+. . . .’”

“Run on the bank” refers to events that have tended to take place at the outset of the financial disturbances that ultimately tend to bring forth recessions, and even depressions. This was before there was a Federal Reserve insuring the mutual guarantee of financial institutions. Clients of a local bank would hear a negative rumor about its financial health, and “stampede” the bank in an effort to get their savings out. But the stampede caused the very event that the rumors (often false) had hinted at. Because part of a bank’s assets are always locked in investments and therefore are not immediately available in cash, a stampeded bank can quickly get insolvent, and be forced to fold.

“Run on the bank” was the phrase that Jeffrey Skilling, Enron’s one time CEO, used in his testimony before the House Energy and Commerce Subcommittee on February 7th, 2002: “a classic run on the bank,” Skilling said. He returned to that interpretation of what precipitated Enron’s downfall in his testimony before the Senate Consumers Affairs Subcommittee on February 26th. Here is what he said: “What happened is that [in] the old days, in the 1880s when there was a run on the bank, it was the bank that went under. What’s happens now is that the banks can pull their money out of a company that is threatened. And if somebody […] claim[s] [there is] an accounting fraud, it’s tantamount […] in the business world […] to walking into a crowded theater and screaming “Fire” – everybody runs for the exits. When they set up the Federal Reserve Board […] and deposit insurance [the intent] was to try to keep runs on the bank […] We have it now automatically built into the contracts, material adverse change clauses, which means that if anything happens to the borrower, the bank can come in and pull their money back.”

The following day, on February 27th, the Chairman of the Federal Reserve Board, Alan Greenspan, addressed the same issue of “confidence-sensitivity” in his testimony before the Committee on Financial Services, U.S. House of Representatives. “As the recent events surrounding Enron have highlighted,” Greenspan said, “a firm is inherently fragile if its value added emanates more from conceptual as distinct from physical assets. A physical asset, whether an office building or an automotive assembly plant, has the capability of producing goods even if the reputation of the managers of such facilities falls under a cloud. The rapidity of Enron’s decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation. The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot.”

In other words, companies with factories are that much less likely to make their way toward credit- or ratings cliffs. Companies that rely upon what Greenspan called a “capitalized reputation” are far more likely to wind up there.

Samson’s third category of business configurations that embed credit cliffs was the “Rating Trigger Situation,” which comprises companies that have linked their future fate to a particular level of credit rating. If and when their credit rating gets downgraded below that level by the rating agencies, this triggers a host of financial consequences. These, in turn, may lead the rating agencies to further downgrade the company’s creditworthiness.

Samson wrote: “Particularly insidious are situations where the company has tied its fate to maintaining a certain rating. It is one thing for a company to agree to pay a higher rate of interest on certain debt issues, if its rating were to go down; this normally would not have an immediate dramatic impact. It is another thing to have credit ‘puts’ that require the company to retire large chunks of its financing or posting of new collateral against trading positions in the event of a downgrade. These can easily precipitate a liquidity crisis – and even default – as the result of just a single-notch downgrade. Also, as a result, any proposed downgrade would be followed quickly with additional rating changes, or it would have to be larger in the first place – or both. […] And, yes, Enron also had such triggers aplenty – in both its trading contracts and its off-balance-sheet financings.”

Six weeks before Enron’s filing for Chapter 11 protection, Peter Eavis of TheStreet.com was analyzing one of Enron’s rating triggers, which was embedded in the workings of the Whitewing Special Purpose Entity: “… something […] has to happen before the trust investors can claim their money back […] Enron’s credit rating must fall below investment grade. That looks to be a long shot, since its rating is currently three notches above subinvestment grade. But it is something the market will watch after Moody’s said last week that it was putting Enron on review for a possible downgrade.” Eavis gets credit for having spotted one of the ticking time bombs in the shaky Enron structure.

In May 2002, under Solomon B. Samson’s signature, Standard & Poor’s released an investigation of companies from a “Rating Trigger Situations” perspective. The conclusions of the study were reassuring. Out of 1,000 large American and European companies investigated, only 23 (2.3 percent) seemed to have a built-in “rating cliff,” whereby a credit rating downgrade would trigger a further downgrade. Among the corporations exposed to the risk were energy companies Dynegy Inc., Reliant Resources Inc., and Williams Companies Inc., as well as European entertainment and utility giant Vivendi Universal S.A.

Still more cliffs
An additional type of trigger that Standard & Poor’s Solomon didn’t cover, but which proved to have a particularly perverse effect, is one mentioned by The Wall Street Journal in a March 2002 article. In this scenario, the downgrading of a corporation by one of the rating agencies – as a response to a credit decline – leads another rating agency to downgrade the same company within its own rating system: “Earlier this month, Standard & Poor’s lowered its credit rating on Chicago-based GATX Corp., which leases rail cars and aircraft. The reason? The company’s access to the commercial-paper market was curtailed, due to a downgrade by rival Moody’s, which cited concerns about volatility in the aircraft-leasing business.”

The peril associated with such a process can’t be overstated. It is easy to imagine a situation in which each downgrade by a rating agency triggers a further downgrade by either or both of the other two, pushing the company into a downward spiral not of its making, having been fueled by a single initiating event. This kind of effect is called a “positive feedback loop,” whereby information about a recent change triggers a new change in the same direction. Note that in this context, “positive” is definitely not a synonym for “favorable”; by definition, positive feedback always ends in disaster. A “negative feedback loop,” by contrast, is one in which information about a particular change triggers a change in the opposite direction, dampening the effect of the prior one. Fortunately, this is by far the more common kind of feedback loop.

The other types of business configurations mentioned by Samson in his “Playing Out the Credit Cliff Dynamics” as tending to embody either credit or rating cliffs were Government-Support Dependencies, Capital-Intensive Entities, Structured Finance, Insured Ratings and “Catastrophe Bonds.”

“Capital-Intensive Entities” and “Structured Finance” can be considered subsets of the “Confidence-sensitive” categories. “Government-Support Dependencies” refers to companies that are implicitly supported by the government, meaning that, should they default on payment, there is an expectation that the federal government would move in to prevent insolvency. Of this category, Samson wrote: “Standard & Poor’s assesses implicit government support – and regularly relies on such expected support to achieve ratings equal to or close to those of the government itself [meaning ‘AAA’]. In the rare instance that the government walks away from the entity in question, the result can be devastating. For example,[…] Standard & Poor’s concluded that there was only a remote risk that the State of California would allow its troubled utilities to go under; the ‘BBB-‘ rating reflected this conviction. However, when the needed support was not forthcoming – at least not in a timely fashion – the consequences were default for the two major utilities, Southern California Edison and Pacific Gas & Electric.”

In the wider context of financial institutions, the “Government-Support Dependencies” (GSDs) credit cliff applies in particular to the “Government Sponsored Entities” (GSEs) of the mortgage industry, whose task it is to “promote home ownership”. Fannie Mae (the Federal National Mortgage Association – FNMA, founded in 1938) and Freddie Mac (the Federal Home Loan Mortgage Corporation – FHLMC, founded in 1970) were once Government entities, but are not anymore. Their current status of “Government Sponsored Entities” represents the rating agencies’ view of them as a hybrid of government entity and public corporation. They embody, according to The Wall Street Journal, “an odd kind of corporate governance [for] an odd kind of company. Fan and Fred make private profits but with public risk.”

At the time they became public corporations, Fannie Mae and Freddie Mac kept their “AAA” rating, meaning that their debt is seen as being backed by a full government guarantee against credit default, just as is the case with Treasury debt instruments. This allows the GSEs to borrow at the lowest floating market rates. The assumption underlying their current AAA credit rating is that the Government will never permit them to default, in light of the decisive role they play in supporting the government’s housing policies.

Earlier, I mentioned that money is the lifeblood of business, and that the availability of money is largely a phenomenon of credit ratings. A great deal of the GSEs’ current business success can be assigned to their AAA rating. In recent years, their debt has been growing at an astounding annual rate of 25 percent. They’ve accumulated credit and prepayment risk obligations on that basis, worth — according to Moody’s Investors Service — $2.6 trillion at the end of 2000.

Good business for them, and with lots of salutary impacts on the housing markets. But it’s worth pointing out the dark side of that federal loan guarantee, as well. Should either or both of the GSEs ever default, the cost to the taxpayer will be colossal.

Enron as a GSD
Samson’s analysis of “Government-Support Dependencies” applied to some extent to Enron. Insofar as its foreign energy projects were concerned, Enron resorted extensively to the protection offered by two programs insuring American businesses against potential losses abroad: the Overseas Private Investment Corporation (OPIC), which was owed $453 million when Enron filed for Chapter 11 protection; and the Export-Import Bank, which was due $512 million. OPIC and the Ex-Im Bank have governmental status, and OPIC has a $4 billion reserve from the user fees U.S. businesses pay for its loans and insurance.

In the 1990s, Enron became OPIC’s largest customer, with $3 billion in OPIC loan pledges. Enron’s Cuiabá pipeline through Bolivia and Brazil – by most accounts, an environmentally dubious project at best — was only made possible when OPIC decided to back it. (No commercial bank was willing to do so.) In fact, as James V. Grimaldi wrote in The Washington Post, Enron and OPIC had developed a “a symbiotic relationship. While Enron was seeking billions in OPIC loans and insurance, the company lobbied Congress to save OPIC from extinction.” Enron lobbied hard for OPIC at the time of its reauthorization votes in 1997 and 1999. In 1999, for example, Enron’s Cuiabá lobbyist “led industry groups working Congress to save OPIC. Lay wrote every member of Congress in April seeking votes for OPIC reauthorization. The effort paid off, and, to celebrate, Enron executives joined trade groups to fete OPIC employees at a posh holiday party.”

This wasn’t a case of a company acting out of an urgent sense of public responsibility. In fact, Enron depended on the continued support of OPIC and the Ex-Im Bank. Revenues from the Cuiabá pipeline represented nearly 15 percent of Enron’s global income at the end of 1999. But even this picture was not exactly as it seemed. “In an interview with academic researchers nine months ago [May 2001],” Grimaldi wrote, “Jeffrey K. Skilling, who then was chief operating officer, conceded that Enron ‘had not earned compensatory rates of return’ on investments in overseas power plants, waterworks and pipelines. Skilling said the projects had fueled an ‘acrimonious debate’ among executives about the wisdom of its heavy foreign investments.”

Of course, beginning in 1999 with the failure of Project Summer – detailed in Chapter 7 X — Enron no longer worried excessively about operating like a traditional utility. It was now a financial company. Support from OPIC and the Ex-Im Bank were crucial, in the sense that Enron had started concentrating on pumping up the price of its stock, and window-dressing for its financial statements was of paramount importance.

“Insured Ratings,” another of Samson’s cliff-embodying business configurations, also applied to Enron: “An insured issue of even the weakest credit may be enhanced to the lofty level of the insurer. Accordingly, if it turned out that the insurance were not in force, the rating would drop precipitously. For example, Hollywood Funding No. 5 and No. 6 were rated ‘AAA’ on the basis of a financial guarantee insurance policy; they dropped to ‘CCC-‘ last February (2001) when the insurer, a subsidiary of AIG Inc., contested the coverage.”

Here’s a typical “insurance-sensitive” scenario: A secondary market mortgage company realizes that some of the loans it has purchased under the assumption that they are insurable turn out not to be. A double loss results. First, the bid to brokers has been overstated, and the price paid was too high. Second, because the loans are uninsurable, they won’t qualify for securitization, and may have to be redeemed on a so-many-cents to the dollar basis.

Finally, in the category of “Catastrophe Bonds,” Samson was examining the specific case of companies whose fate depends on a “low-probability” event – such as an earthquake — not taking place. The problem here, of course, is that low-probability events do take place.

As Samson wrote: “Ratings for this relatively new genre of financing rely on the statistical remoteness of the occurrence of specific events, such as earthquakes or windstorms. Those bonds that refer to a single event clearly represent an ‘everything-or-nothing’ proposition. … For example, the Residential Re 2001 deal is intended to cover some of the losses of insurer USAA with respect to a Category Three or higher hurricane, making landfall in certain geographies along the Eastern and Gulf coasts. The bonds will pay out 100% if no such hurricane occurs; were the storm to occur, the investors’ principal is likely to be completely lost.”

To Samson’s list, I would add what I call “Loophole-Sensitive Entities,” meaning a business configuration wherein the health of the business depends on a tax and/or legal loophole. The label certainly applies to Enron: The capitalization of its partnerships was based on the “synthetic lease,” enabling the company to claim simultaneously one favorable status for the sake of financial reporting and another for the purpose of reporting to the SEC.

True, when Standard & Poor’s decided that real estate operations shouldn’t be reported under its definition of “Core Earnings” in the case of companies for whom real estate is not part of their core business, this reduced the potential impact of closing the synthetic lease loophole. Should the synthetic-lease loophole be closed entirely, however, a considerable number of companies would have to report lower earnings, and might well be looking at the cliff edge.”

3 thoughts on “2008’s new fad: “rating cliffs” and “credit cliffs””

  1. I wonder what kind of cliff MBIA’s situation would be. The top-tier bond insurer knew a possible ratings cut was on the way, and got Warburg Pincus as an investor of up to $1 billion. Days after Warburg committed, Moody’s and S&P’s came out and changed the outlook for MBIA to negative. Shortly thereafter, MBIA published its $30.6 billion in CDO exposure, $8 billion of which were riskier CDOs known as CDOs squared. It’s share price dropped 33% that next day, and it is down 70% on the year.

  2. After I displayed this chapter from an old book of mine I felt like writing a note on the French blog on the same subject and believe it or not, the example that sprang to my mind was that of… the bond insurers !

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