Several times a year, Standard & Poor’s Ratings Services reviews groups of peer insurance companies to assess and compare their financial and structural strengths. When viewing peer groups, subtle organizational and operatonal distinctions among the companies are brought to light and clarified, which permits us to tighten and refine our ongoing evaluations of each company.
S&P rates numerous U.S. public health insurance groups that provide managed care and personal health insurance as well as more specialized services, such as dental plans and behavioral health coverage. This review discusses eight of the largest consolidated health insurance organizations, which are differentiated from the rest of the sector by their size, diversity, and scope of operations. The eight factors used to compare the notional ratings for these groups of operating entities include competitive position, management and corporate strategy, enterprise risk management, operating performance, liquidity, investments, capitalization, and financial flexibility. This report can be purchased here.
CreditSights Head of Research Peter Petas contributed this piece to ResearchRecap. CreditSights is the leading provider of independent credit research as measured by scope of coverage, depth of research capabilities and number of subscribers.
Leveraged, Long & Liquid – For Now
Date Published: 18 Mar 2007, 22:41 EDT
While recent commentary has focused primarily on sub-prime and the potential for spillover into CDOs, we think that the big risk for the credit market is to be found more in the New Century meltdown and the bankruptcies of several subprime originators. Crises on Wall Street always start with an event – Russia, LTCM, Thrifts, Tequila, Drexel, Orange County, Asia – but the real problem is almost never the initial losses associated with the event. Even in a real subprime mortgage meltdown scenario, our financial services team estimated at worst a 3-15% hit to 2007e earnings for the brokers, with most brokers comfortably under 10% (see Mortgage Madness – The Blog Set). While a hit of that magnitude is certainly not going to put a smile on the faces of Dick Fuld, John Mack et al, the fact of the matter is that the broker dealers can and will live to fight another day and they retain considerable flexibility and resources to deal with market volatility. The words “contagion” and “systemic risk” only really start to surface as a result of a major shift in risk appetite that causes a big pullback in the counterparty lines that the Street is willing to extend to leveraged players. The bottom line is that when it comes to counterparty risk, the banks will act quickly and decisively to protect their capital regardless of the implications for the borrower.
In the New Century case, as subprime started to erode, banks started pulling their lines, which started a liquidity death spiral that no finance company in recent memory (from Integrated Resources to Lomas Financial to Finova to Enron) has been able to recover from. And while the banks usually take some near-term hits to their stock price and possibly reserves, they are also usually in secured positions and are able to pick up assets at distressed levels and ride them back to par or, if not par at least to profit. For example, the banks that then-chairman Greenspan urged (maybe compelled is a better word) to pick over the carcass of Long Term Capital Management ended up with a huge profit on those positions once markets normalized. And there was certainly some speculation around the collapse of Amaranth last fall that the banks picked up hugely profitable natural gas contracts on the cheap.
So where does that leave the credit markets? The short answer for right now is levered, long and fairly liquid. Not necessarily a bad place to be. Remember though that it’s not the excessive speed of a car hurtling toward a wall that kills the occupants: it’s the sudden stop. The extra speed just makes the crash that much more spectacular. The real questions are 1) what could prompt the Street to tighten lines of credit and 2) what would be the effects of that pullback on leveraged players and market liquidity. The answer to the first question is a matter of picking your poison – China and the subprime market sparked the recent stock turmoil, default rates are likely to pick up, geo-political risk remains high, the effects of housing on the economy could be more severe than anticipated, and the list goes on. It is almost always folly for strategists to try to predict a crisis since by their very nature they are unexpected. (Of course, that won’t stop many from claiming to have predicted them ex post.) Too many “broken-clock bear” strategists lay claim to predicting 100% of the crises without highlighting that they missed 1,000% of the rallies. For “the short,” the latter can also be fatal. For those that sell their longs into the initial mini-panic only to see the sharp rebound kick in, the feeling can also be pretty dismal. So the stakes are high.
Before we get to anything resembling a crisis or a credit crunch though, we would expect to see a repricing of risk and some defensive moves from the banks (see Risk Appetite Requiem). So far we’ve seen very little sign that the leveraged loan and other markets are at risk of seizing up and demand for credit appears to remain strong. For those worried about a significant retrenchment in demand for unsecured BBB and crossover credits there is also some comfort that these middle tiers of the credit spectrum can turn to secured loans or unsecured credit facilities with any range of defensive structural features to benefit the banks (from tighter covenants to springing liens as we saw frequently back in the 2002-2003 period). This would obviously be negative for unsecured bondholders in terms of structural subordination risk, but it is not an even-more-damaging credit crunch. As has already been made painfully evident in the building wave of LBO deals, there is significant carve-out room in public bond indentures to pledge assets and get the next level of borrowing done to fund working needs, pledge a significant portion of plant and equipment, and place liens on non-US assets. Ford Motor Company is perhaps the starkest reminder to the market that you can drive a fleet of F-150s through the typical investment grade bond indenture.
The second part of the question – the effects of a pullback in counterparty lines on leveraged players and the market – is one that is probably the more interesting as it is largely untested in the credit markets. The ability for investors to take leveraged positions in the corporate credit markets did not really exist (outside of emerging markets) prior to the advent of the default swap market.Pre-default swaps it was difficult to express a large leveraged short since repo lines had to be sourced and technicals in the cash market could be brutal. Leveraged longs were theoretically possible but most of the purchasers of corporates were real money investors (pension funds, insurance companies, mutual funds) who did not employ leverage.
CDS changed everything. Born out of the need for banks to hedge loan exposure, the CDS market evolved rapidly into a vehicle for broker dealers and leveraged players to take positions and also made possible the explosion in the CDO market. The British Bankers Association estimates that the CDS market grew to $20 trillion notional in 2006 from virtually nothing in 1996, easily dwarfing the amount of cash bonds and loans outstanding. Not unexpectedly, the largest increase in terms of market participants has been among hedge funds, which in 2004 made up 16% of protection buyers and now make up 28%. Protection selling via credit derivatives – or taking of credit risk rather than shedding – by hedge funds has grown even faster constituting 32% of the market now, up from 15% two years ago.
In addition, with the exception of 2002 when CDS notionals were still relatively small and largely related to bank loan hedging, the CDS market has grown up in a protracted bull market for credit. There have been a few wobbles (the most notable being the unraveling of auto correlation trades in March – May 2005) that have caused liquidity to dry up and generated extreme market movements that were totally disconnected from fundamental risks, but nothing as yet that has led to systemic concerns. Although the prevailing wisdom since June 2004 has been that Fed rate hikes would start to bite and lead to spread widening, leveraged long credit has been the profitable path to take with credit naysayers in the hedge fund community meeting with very little success. Outright long players migrated steadily down the credit spectrum from high yield to distressed debt to leveraged loans and private equity plays. The other very successful leveraged credit strategy is to go long structured product and delta hedge based on a view of the strength of the underlying credits and their potential to introduce idiosyncratic risk into the portfolio. As spreads have tightened, CDOs have been cubed and the latest rage is CPDOs and also CDOs using the relatively new loan default swaps (LCDS) as collateral. While a few funds were shaken out after May 2005, by and large this long credit strategy has proved profitable.
As hedge fund participation in credit has increased, the Street’s counterparty exposure to leveraged players has also increased. When a fund sells CDS protection, banks usually require that only a fraction of the notional value of the trade be posted: traditionally 3% though we have heard that more like 50 times leverage (a 2% haircut) has been doable, even for high yield credits. Of course, the Street will argue that they are hedged and that the historic trading pattern of the underlying assets falls well within their risk tolerance limits. Those limits, however are typically based on a rolling measure of volatility. Given the one-way direction of volatility in the past five years (the last of the 2002 vol will be rolling out by midyear), our guess is that most of the models do not adequately anticipate the potential effects of a large deleveraging event. Of course, no models probably do. We remember in 1998 when the relationship between Argentina Par bonds and FRBs moved several dozen standard deviations – for practical purposes, it was pretty much over for the leveraged relative value players and longs after the third sigma.
Our financials team uses counterparty exposure of unrated entities as a proxy for hedge fund exposure since the banks do not disclose their lines to hedge funds separately. As the accompanying chart shows, banks’ exposure to hedge funds increased markedly in 2004 and has generally remained at elevated levels since then. This makes sense. Ten years ago, the 20% in the old 80-20 rule (80% of your profitability comes from business with 20% of your customers) were all real money investors; today, we believe that the rule is closer to 95-5 and that the 5% are mostly hedge funds. Research, sales and trading at the bulge bracket is increasingly focused on the leveraged crowd and on prop trading. This has allowed disintermediation of traditional sell-side cost centers like published research (to CreditSights and others) and trading of commoditized, low-margin products like floaters, odd-lots and short-dated paper to firms like MarketAxess and other ECNs.
A logical trend that has followed the explosion of CDS notionals and the increased participation of leveraged players in the credit markets is the proliferation of CDOs and other leveraged structures. According to the BBA, the notional outstanding in CDS indices was $6 trillion, roughly equal to that in single-name CDS, in 2006 having been just $450 billion in 2004. Over the same period, the notional value of non-standard portfolios, CDOs, outstanding grew a more modest 150%. The slower growth is likely the result of the increasing popularity of single-tranche CDOs where banks are able to sell just one slice of a portfolio’s capital structure without having to find protection sellers for the remainder. Such single-tranche CDOs are created by dynamically hedging the bank’s residual exposure to credits using CDS. The notional value (the total portfolio being referenced, not just the money at risk from the single tranche) of such transactions increased 400% between 2004 and 2006 to $2.5 trillion. And the value of tranched indices has grown by 1400% to $1.5 trillion from 2004 to 2006.
As for what an unwind of leverage the credit markets might look like today, we are in uncharted territory. In the past, the only real leveraged player in credit was the Street as hedge funds preferred to make large liquid macro bets (think Soros, Tiger) or large leveraged relative value trades (LTCM) in the most highly liquid spectrum of the currency and fixed income markets. The unwind of these trades tended to be nasty, brutish and short. The last big deleveraging event (LTCM/Russia) only affected investment grade corporates and high yield as a second order effect, i.e., spread widening to reflect greater global risk aversion. Emerging markets were a different story as hedge fund and prop desk activity was relatively high and most desks and several dozen hedge funds disappeared in the wake of Russia’s default and the accompanying market convulsions. What may be most instructive though from the post Russia experience in EM was the marked difference in trading between large liquid bonds (Cs, FRBs, etc.), which continued to trade in relatively tight markets and off-the-run securities (EM corporates, MinFins, etc.) where there was virtually no bid. At the time, there was even talk that some liquidating hedge funds would be forced to give participation in various illiquid instruments to their investors if they couldn’t find a reasonable cash bid. All this was less than a year after the tight print on the EMBI in October 1997.
So what might happen if credit markets are at the center of a deleveraging event instead of on the periphery? The one lock in our view is that banks and the Street will behave as they have every time in the past and as they are now with the pure-play subprime lenders. They will cut counterparty lines and act decisively to reduce their exposure and limit their downside via margin calls and increased collateral requirements. As we’ve seen in mini-deleveraging events, CDS spreads blow out and liquidity dries up substantially under panicked conditions. CDS quotes that were 10 x 10 million work for only 1-2 million and the bid offer widens. In addition, the only liquidity in CDS is in the 5-year sector which can cause gamma problems for those scrambling to hedge. Cash bonds remain very illiquid and, as always, there are big risks of jump moves in particularly thinly traded sectors in the investment grade and high yield markets. And that is panic; we have yet to see what forced selling and liquidations look like.
LTCM has been estimated by some academics to have been a 1 in 50,000 years event. The good folks at Amaranth also used elaborate models to predict that their strategies had a high probability of success. It will be interesting to see how the big correlation models at the funds and the revamped risk management tools at the banks hold up in a deleveraging scenario.
In the coming days we will be exploring each of these themes in more detail, starting with more in-depth looks at current trends in the CDS and CDO markets.
Audit Integrity Chairman James Kaplan doesn’t believe shareholders should “be fined for the actions of company managers who engage in fraudulent activities…” His monthly Chairman’s letters have consistently encouraged regulators to throw the book at the offending management teams. His January 29th letter, which focused on Apple and Steve Jobs drew a barrage of criticism. This month he highlights the sheer size of some of the backdating offenses and points out that the statute of limitations is running out for SEC Chairman Cox to do something.
Audit Integrity is the leading provider of accounting and governance risk (AGR®) analysis on public companies. Through the forensic study of the factors behind fraud, Audit Integrity is able to determine the overall level of risk and the specific risk metrics in over 9,000 publicly traded companies. Check out Audit Integrity’s Product Overview and their Audit Integrity March Watchlist.
Deloitte’s Global Public Sector Research Director Bill Eggers has published a 40-page report titled Serving the Aging Citizen covering the implications of changing world demographics on governments. The report outlines four trends that will likely become more prominent in the coming decades:
- Tax system modernization. Governments will have to modernize their tax systems to reduce their dependence on personal income tax revenues. This means fewer exemptions that poke holes in the tax base and a shift away from narrow-based, idiosyncratic tax structures.
- Rises in the average retirement age. The erosion of the tax revenues from income and payroll taxes can be somewhat offset by extending the average retirement age. The retirement age in the OECD countries has started to tick up since the end of the 1990s, but a meaningful impact is unlikely without significant changes in the demand for older workers.
- Increase reliance on user fees. Citizens may be required to pay user fees for access to government services.
- Growth of public-private partnerships. The emergence of a much bigger and more sophisticated nonprofit sector will create new opportunities for partnering and leveraging private dollars for public causes.
The report has a number of charts and tables that highlight the world’s changing demographics. Although it’s written for a public sector audience, the report is worthwhile reading for those interested in demographic changes as an investment theme.
KPMG recently published a 36 page report titled The Impact of Digitalization. Targeted mainly at corporate executives who might be unfamiliar with Web 2.0 and the changing habits of Generation Y, the report covers, at a very high level, challenges facing traditional media companies such as user-generated content, the evolution of copyright and monetization models. Despite being written for those not near the cutting edge, the report gathers insights and comments from David Weinberger, co-author of The Clue Train Manifesto, Long Tail author Chris Anderson, Paul Saffo from The Institute for the Future and Cory Ondrejka of Linden Labs. One interesting observation from Saffo:
While MySpace and YouTube have snaffled the attention of millions of users and of deep-pocketed media behemoths, Saffo questions their long-term impact. They “have the feeling of electronic hula hoops. It really is a craze like CB radio was. It just got too popular. They are hugely important starts, but it is unlikely they will survive in their current form.” In contrast, Saffo believes that Second Life and other multi-player environments are pointers to the future.
It’s worth taking a look just for the interesting perspectives they gathered together.
In addition to the recent collapse of the sub-prime mortgage market, creditland has also been assessing the Incorporation of Joint-Default Analysis into Moody’s Bank Rating Methodology.
JDA functions on the principle that the risk of default for some obligations depends on the performance of both the primary obligor and another entity or entities that may provide support to the primary obligor.
The incorporation of JDA into our current ratings will therefore reflect more transparently both a bank’s standalone financial strength as indicated by the Bank Financial Strength Rating (BFSR) as well as Moody’s opinion of the probability that it’s operating parent, coop group, or local or national government authorities will extend support to a bank to prevent a default on local currency deposits.
In Moody’s Credit Perspectives on February 26, David Fanger, Moody’s chief credit officer for financial institutions said, “Overall there is likely to be a fairly significant number of upgrades of bank deposit ratings, with a fee downgrades. Some bank debt ratings will also be upgraded, although to a lesser extent because in some countries subordinated bank debt obligations benefit less from than systematic support than deposits.”
While Moody’s was obviously bullish about announcing and releasing their new methodology after years of work and market interaction, some were critical of the change. On Sunday Independent research shop CreditSights published Bank Ratings: Moody’s Makes Aaas of Itself and then followed up on Monday with U.S. Bank Ratings: Moody’s JDA Morass. From Bank Ratings: Moody’s Makes Aaas of Itself:
Most participants in the debt market have an intuitive feel for what a credit rating means. In simple terms it is a relative ranking of creditworthiness. Moody’s is now seeking to overturn established practice by assigning ratings that are designed purely to measure default probability (although its definition of default is quite generous – see below). And, surprise, surprise, Moody’s has discovered that when banks run into difficulties, most of them are bailed out, usually by the government, before they actually default. As a result, in most countries the larger banks (and quite a few smaller ones) will receive Aaa or Aa1 ratings. Thanks, Moody’s, but most of us knew that already – we don’t need a rating to tell us that many banks are too big to fail. Unfortunately, this means that Moody’s debt ratings are now very narrow in scope and worthless in terms of analysing relative value or relative creditworthiness.
To read a full explanation as to where Moody’s is coming from, read the Thomson StreetEvents’ Moody’s Investors Service Conference Impact of JDA Initiatives on Ratings in Nordic, Benelux, Baltic and Central European Countries Transcript