Intelligentguess

First there was Carina

Now, Adams Square Funding I Ltd - A Credit Suisse managed hybrid CDO has gone into liquidation recently (Bloomberg Report).

Further discussions at FT Alphaville and Calculated Risk show that even holders of AAA securities under the said CDO received nothing. Notable is the fact that this CDO was originated just a year ago.

So, it took all of one year for the highest rated securities to go into default. This must be one of the fastest moves from AAA to D. (though S&P had been putting such structures on rating watch - that’s no solace however for investors who believed in the ability of the rating folks to assess credit risk)

Soundly illustrates the power that rating agencies had begun to command and the lack of homework or due diligence being done by investors.

A lesson in all this is - if you can’t understand it do not invest in it. Did someone say Caveat Emptor.

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So, State Street (the manager) has begun liquidating securities held by the Carina CDO.

Consequently the rating agency has to downgrade the senior classes (rated AAA earlier) by as much as 18 notches (to CCC- in some cases).

Yup - You read it right - 18 notches in one go. What’s more the rating agency says that if the process of liquidation is halted, the ratings of some of the classes of securities would have to be lowered even further.

So much for all the fancy packaging and repackaging and the redistribution of risk.

When liquidity dries up, everything goes for a toss. That fat tail that we  keep ignoring.

I remember my days of fund management when fancy investment bankers would tout the virtues of having a core illiquid portfolio to improve gains (yield pick up is the jargon they would use) and all my talk on the virtues of liquidity (especially in a completely illiquid market like that in India) would be laughed at and jeered.

I was never very popular with these bankers. After all they used to make a multiple of what I used to - for selling us (the fund managers) all that junk while preaching sound risk management techniques at the same time.

Well, the lessons from the mature markets are there for all of us to learn.

PS : It needs to be clarified that State Street only manages the portfolio. It is not an investor in the CDO. Hence it does not face a loss due to the liquidation or downgrade of the securities. Ultimate investors (unknown to us) in the CDO would be the ones worst hit. This would include dealers like the investment banks, hedge funds etc.

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Credit rating agency Fitch, today, downgraded bonds issued by ITI Limited, a (sick) Government of India owned telecom equipment manufacturer to default grade “D (Ind) (SO)”.

This, in itself, may not be much newsworthy, except for the fact that these bonds carried the highest possible rating “AAA (Ind) (SO)” prior to this downgrade to default category. The AAA rating had been assigned on the basis of an unconditional irrevocable guarantee given by the Government of India.

It appears that a few investors had opted to exercise their put option. These included a large (politically connected) residuary non banking finance company, a bank and a provident fund. However, there seems to be an inordinate delay in the repayment of principal leading to the downgrade by the rating agency.

This leads us to the question;

• Isn’t an unconditional, irrevocable guarantee as good as an obligation of the Government? Especially, since the defaulting entity is also owned by the government.

To my mind this is as good as a default by the government on debt denominated in (believe it or not) domestic currency. And this is a government which is proudly of its fiscal record.

Frankly, this is not the first time that the government has displayed such disregard for its contractual commitments to investors. We’ve had such instances in the past too.

Which leads me to another closely related issue;

Provident Funds are effectively forced to invest in such bonds, due to the statutory investment pattern. The statutory investment pattern is supposedly devised to eliminate such risks of default. On the contrary, provident funds have piled themselves with such and similar other junk debt. It’s another time bomb waiting to explode.

High time, our communist buddies understand and appreciate market realities and help in bringing about pension reform. Till such time, we are doomed with our retirement funds  invested in such junk investments.

Update (May 25, 10 AM India Time) : The Times of India has some additional details. It appears that Canara Bank, the trustee to the bonds, have not invoked the guarantee. Now, that raises questions on trustee responsibility. Incidentally, Canara Bank is also owned by the Government.

It also appears that the folks at the Times of India read this blog. Notice the similarity in the language.

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