Tapley's Blue Dragon: Fitch Request for Comment

22 April 2011

Regarding the Superiority of a Joint-Criteria Rating and Other Aspects of Fitch's Request for Comment

To: Fitch Ratings

Fitch has had a stroke of brilliance. In essence, the rating agency proposes: "Instead of basing a rating upon part of the credit supporting a security, we shall rate based upon the whole."

Some may consider this merely a starting point for a rating agency. But when it comes to bond insurance, all three major rating agencies have a long history of not abiding by this principal. The substitution method of rating has dominated our past rather than the joint-criteria (or joint-default) method. The substitution method mathematical mathematical illogic that the sum of two positive numbers is equal to the greater of the two.

Systematized practices forge unnoticed and formidable chains. Fitch deserves commendation for a brilliant and simple proposition that heretofore has not been publicly proposed by any other rating agency, regulator, insurer, or other market participant as far as The Dragon is aware.

The need for change is strengthened by stark comparison. LOC-backed bonds, another form of credit enhancement, are and have long been rated with the joint-criteria method. None of this mattered when all of the major bond insurers were rated AAA. Perhaps this is why it was a non-issue before, but that is no longer the case.

Nonetheless, the particular matrix that Fitch presents for joint-criteria ratings is misguided. First, the substitution method or more modest upward ratcheting on the IFS still makes sense for a bond without an underlying ratings. Second, the underlying credit of a bond cannot provide negative credit, the IFS - like an underlying rating - should provide a ratings floor. For both these matters, the mathematical analogy is: "X + 0 = X"

The Blue Dragon encourages Fitch to explore the components of the risk premium when considering appropriate leverage metrics for bond insurers. The Dragon relates bank and guarantor leverage here. Additionally, Fitch may be overemphasizing leverage when considering the natural range of the guarantors ratings.

Fitch is correct to focus on tail risk. Insights are garnered from reasonable applications of depression scenarios and studies such as that by Hempel. Also important are other scenarios that consider exogenous shocks such as war and insurgency. (What would happen to Airport bonds with an immediate 80% reduction in flights lasting 5 years?)

Though Misters Frederico and Brown may disagree, The Blue Dragon views a less-rigid proposition as generally superior to a rules-only or rules-predominately proposal. I have been told "if you ain't cheatin', you ain't tryin'." And while I disagree with the quote, it shows that rules will be gamed. If Fitch would like to view our earlier response to S&P's request for comment, that is available here.