This morning The Australian newspaper tells us that “NAB, ANZ most at risk, investment bank Citi warns,” – it probably isn’t the best constructed headline the world has ever seen, but it does get the message across… just.
We have to admit that we do always find it entertaining when one bank is passing judgement on another. It almost seems as though they are reluctantly breaking some secret covenant if they criticize the competition. Although their biggest fear is highlighting something in another bank which others may think is also the case in their bank.
For a start it seems odd that none of the banking analysts were able to pick up potential problems in the credit markets, despite these analysts having an in-depth knowledge of how these complex products work.
44 Pages You DON’T Want to Read
Despite this warning by Citi, the bank has still decided that both NAB and ANZ make a worthwhile investment and have upgraded both companies to Hold. After glancing at the 44 pages of charts, tables, ratios and acronyms we will just have to take their word for it! We try to be briefer with our research at the Australian Small Cap Investigator.
But perhaps this is the very reason the analysts missed all the warnings that were soon due to explode onto credit markets. They just couldn’t see the woods for the trees.
And maybe, just maybe they didn’t understand how complex products such as Collateralised Debt Obligations (CDOs) worked. They can’t take all the blame though, as they were ably assisted by credit ratings agencies (Standard & Poor’s, Moody’s, Fitch) who allowed their ratings to be manipulated and distorted to such an extent that the genuine meaning of a AAA credit rating went out of the window.
All You Need to Know About CDOs
How so? We don’t have the space to go into it in any great detail, so here’s the thirty second version. A Triple A credit rating is normally reserved for those companies or governments that are deemed by the rating agency to be so financially reliable – beyond almost any doubt – that they will have no problem in repaying their debts. For example the Australian government has a AAA credit rating.
The less the expectation is that a company or government can repay its debt the lower the credit rating, eg. AA, B, B-, C, etc… Bonds with a rating of less than B are typically termed as being “Junk Bonds.”
Needless to say, the greater the credit quality, the lower the interest rate as there is perceived to be lower risk. The lower the credit quality the higher the interest rate in order to compensate for the higher risk.
The problems with CDOs is that the investment banks would take a bunch of mortgages for example and split them into tranches. The tranches may be exactly the same ‘quality’ however, they had a different order of priority that would effectively subject the first tranche to any defaults first up to a certain level. Once that level was breached then the second tranche would be subjected to any defaults, and so on until finally the last tranche would start to be allocated any defaults.
When is Triple A Not Triple A?
You’ve guessed it, this last tranche was deemed to be Triple A rated debt by the ratings agencies. To investors it was placed on the same risk level as major corporations and governments despite the fact that it was just a big pool of home mortgages.
Did the likes of NAB and ANZ know this? You would have thought so, but based on the ANZ report into its securities lending business where it claimed that staff didn’t know what they were doing, then perhaps it didn’t.
