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Outlaw Ratings Downgrade Triggers

By Anonymous

One of the biggest contributors to the financial crisis has been ratings downgrade triggers, sometimes known as ratings-based collateral calls. These are provisions in financial instruments (especially derivatives) that automatically trigger collateral calls when a counterparty has its credit rating downgraded. AIG failed because ratings downgrade triggers in its credit default swap (CDS) contracts forced it to post $15 billion in collateral when Moody's and S&P downgraded its credit rating immediately after Lehman failed. AIG couldn't come up with that much cash on short notice, especially with markets essentially frozen due to the Lehman bankruptcy. Enter the U.S. taxpayers.

Similarly, the monolines (e.g., MBIA, Ambac) teetered on the edge of failure in January 2008 because the rating agencies were threatening to downgrade their credit ratings (then AAA), which would have forced them to post billions in collateral that they simply didn't have. All the various rescue plans that were floated that month were aimed at staving off a rating downgrade.

Ratings downgrade triggers force a company that is already struggling (hence the downgrade) to then post billions in extra collateral. In other words, the company is being forced to post billions in collateral at precisely the time it's least able to raise that much cash without seriously damaging the health of the company. This creates a downward spiral where the company is forced to liquidate assets at firesale prices in order to post the required collateral, leading to another rating downgrade, which triggers further collateral calls, and another round of forced liquidations, and so on. This could very easily cause a company to go directly from AAA-rated to bankruptcy (which completely distorts the idea of "credit ratings" in the first place). In fact, this almost happened with MBIA and Ambac?had they been downgraded from AAA in January 2008, they would almost certainly have been forced to file for bankruptcy.

The justification for including ratings downgrade triggers in derivatives contracts is that less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater. But the evaluation of a counterparty's creditworthiness should be done at the outset of the transaction, and reflected in the initial margin required. Less creditworthy counterparties should have to put up more initial margin (i.e., collateral), but after the initial margin is posted, any additional margin calls should be based on changes in the value of the underlying security. Evaluation of a counterparty's creditworthiness shouldn't be outsourced to the rating agencies, which is essentially what ratings downgrade triggers do.

Personally, I'd like to see an explicit ban on ratings downgrade triggers in derivatives contracts. They're lazy and unreliable in their accuracy. But worst of all, as AIG and the monolines have demonstrated, they're extremely dangerous.

Full post as published by Economics of Contempt on March 18, 2009 (boomark / email).