Australia’s Aaa ratings are based on the country’s very high economic resiliency, very high government financial strength, and very low susceptibility to event risk.
– Moody’s Investors Services
Our old pal, Sound Money, Sound Investments editor, Greg Canavan might have something to say about ‘event risk.‘
Arguably Australia has one of the biggest potential ‘event risks‘ on its doorstep – China.
And yet China barely warrants a mention in Moody’s report on the Australian economy. In fact, Moody’s mentions China just three times in the 16-page, 6,444 word report.
Of course, as history tells you, you can take anything the credit agencies say on risk with a pinch of salt, as we’ll show you today…
Let’s step back in time to 21 September 2006, in New York. We can picture it; a warm but crisp early autumn day.
We can picture bright sunshine with barely a cloud in the sky. We can see the warm breath seeping out into the cold air as Manhattanites march single-mindedly to their sky-high office buildings.
On this particular morning we imagine the Moodys analyst sat at a desk thumbing through a file. The file has the following note on the cover: ‘IndyMac INABS 2006-D’.
The analyst reviews the file. This would be easy. He or she has reviewed and rated hundreds, perhaps thousands of these securities investments.
Barely audibly the analyst mumbles ‘Aaa’ and casts the file into the out tray.
Mixing the Good with the Bad
It’s hard to blame the analyst. All these securities are the same. Each one comprises a number of different assets.
The best quality assets get an Aaa rating. So do the next four assets – these are the cream of the crop.
The next asset gets a slightly lower credit rating – Aa1. The next slightly lower than that – Aa2. This goes on until the analyst reaches the lowest quality asset in the security. It gets a Ba2 rating.
But all up, the security is rated Aaa – Moodys’ top rating.
The investment banks structure securities like this for a number of reasons. The main reason is that on their own there would be little demand for the higher risk loans in the investment markets.
Or if there were demand investors would want a higher interest rate that the borrower may not be willing or able to pay.
The second reason is that the banks can write a bunch of junk loans knowing that as long as they package it with ‘good’ stuff they can flog it to investors. The more loans, the more deals…and more commissions.
So, what was or is ‘IndyMac INABS 2006-D’?
You’ve probably guessed. But if you haven’t, what we’ve just described is a collateralised subprime mortgage deal.
The way these securities worked is that the banks figured only a small percentage of the higher risk assets would default and would be more than offset by the loan interest charged on all the other loan assets in the security.
That’s the theory anyway. That’s how things worked in September 2006…that was just about the time the US housing market began to crumble.
They Didn’t Bank on This ‘Event Risk’
But as Moodys noted in its original rating decision on 21 September 2006:
‘The ratings are based primarily on the credit quality of the loans, and on the protection from subordination, overcollateralization, excess spread and an interest rate swap agreement provided by Bear Stearns Financial Products Inc. Moodys expects collateral losses to range from 5.35% to 5.85%.‘
If the reference to subprime loans doesn’t give the game away to how things turned out, then the reference to Bear Stearns should. Bear Stearns went bust in 2007.
So how did things turn out? Moodys gave this security (along with thousands of others) a top rating because, well, things couldn’t possibly go wrong. There was no ‘event risk’ on the horizon.
To cut a long story short, as you know, there was an ‘event risk’. It began with the collapse of Bear Stearns in 2007 and reached a climax in late 2008 when the entire global financial system looked set to fail.
As a result, the securities top-rated by Moodys with forecast losses of only 5.35% to 5.85%, suddenly became untradeable. Nobody wanted them.
And it turns out the ‘event risk’ that Moodys had missed resulted in much bigger than expected losses for the IndyMac INABS 2006-D.
The Australian Economy’s Biggest Danger
According to the latest statement, of the original USD$928 million face value, the security has realised losses of USD$171 million. Ouch! You do the maths on that.
Of course, it’s not all over for investors in this security. It still holds about one-third of its original assets, on which it’s still earning interest from mortgage repayments.
But even so, investors still won’t get back the original face value of the security. And most likely the original investors sold out long ago for even bigger losses.
In short, as confident as we are of the stock market grinding higher over the next two years, don’t fall for the idea that everything is fine for the world economy.
When Moodys tells you they don’t see any ‘event risk’ for Australia, don’t trust them. Australia has one of the biggest ‘event risks’ of all time on our doorstep – China.
If you want to successfully make (and save) money over the next two years, you need to understand the risks before you make educated bets on the market.
You need to punt on stocks (we like dividend payers and speculative growth stocks) but you also need a strategy to protect your wealth if things don’t go to plan.
Where do you start? We suggest checking out Greg Canavan’s latest timely analysis here.
Cheers,
Kris
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Australian Small-Cap Investigator:
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