Tuesday, January 22, 2008

Turbulent times put rating agencies to the test

By: Daryl Ching, Clarity Financial Strategy

Yesterday, the TSX saw the largest one-day drop since the September 11 attacks. The TSX has dropped over 1,500 points over the last week, with a minor recovery today after the Fed’s surprise announcement of a 75 basis points rate cut. Stock markets all over the world have experienced extremely volatility as fears of a US recession are looming. Several corporate entities have fallen victim to the global credit crunch. Quebecor World announced yesterday that it will be filing for creditor protection. Credit insurers like ACA are hanging on by a thread.

Clarity Financial Strategy recently published a white paper to explain the spread-loss trigger in the ABCP restructure proposal. The largest component of the ABCP is directly linked to corporate credit defaults swaps, which make bets on corporate defaults. Mr. Crawford’s Committee has the challenge of setting a trigger so that the chance of a draw on the margin facility will be extremely remote. The probability of a draw is directly linked to corporate credit performance.

The rating agencies will be put to the test with the ABCP restructure. Have they sized the spread-loss trigger at a level that can withstand today’s current credit environment? Is the margin facility large enough to cover the potential defaults? JP Morgan as advisor is currently faced with a very difficult task. They need to size the spread-loss trigger large enough that a chance of draw is a remote, but at the same time, keep the bank counterparties happy that they are sufficiently protected. The bank counterparties that sold the CDOs prefer a smaller trigger so that they can draw on the margin facility to protect themselves against corporate defaults in the event that the markets experience greater volatility.

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