11 Dec Rating Ford’s Bonds

When an airplane crashes, people always die, which is not normally the case when a car crashes.

Compare these outcomes to what happens when a structured deal crashes, a now unremarkable event during which no one has ever died. The point is this. The average intellectual ability that can be reasonably expected of senior executives in any industry is directly proportional to the severity of the empirical consequences of a crash in that industry. The aerospace industry is arguably the most demanding, sophisticated and rigorous of all simply because amateurishness cannot be tolerated there for the same reason it is so commonplace in finance.

A case in point is the fate and fiscal health of Ford Motor Company, which of course makes cars. As a CEO, Mulally professes expertise only on the left side of Ford’s balance sheet. By contrast, most of us in attendance that evening claim expertise on the right side. Thanks to his relentless work, Ford’s asset side now seems to be in great shape, but what can be said of its liabilities? According to Wall Street, not much except the perennial and naïve buy recommendation. Much more could be done by research analysts to benefit Ford directly and significantly, at literally no expense to Ford or the investor public. Many of Ford’s corporate bonds only have a few months of remaining life. Consequently, these particular securities’ default probability is virtually zero. Therefore, their credit rating is AAA by definition. This is not true of longer-dated securities because, in spite of what credit rating agency analysts might say publicly, corporate credit ratings are based on cumulative default probabilities. If rating agencies were actually doing what they are well paid to do, i.e. their job, Ford’s corporate bonds would be upgraded on a timely basis to their actual credit quality as they get closer to maturity.

Regular upgrades should be conducted so that one of two things could then happen:

• the bonds could be resold in the secondary market at a premium to par (credit spread compression) or
• the bonds could be restructured on the spot, alleviating the firm’s interest rate burden

Where this new, dynamic equilibrium would wind up is anyone’s guess–most likely a AAA rating. By reducing in real time Ford’s interest rate burden, regular upgrades would further improve the company’s key accounting-ratios, leading to another round of upgrades, and so forth. In mathematical parlance, this can be expressed by saying that although the macro-canonical ensemble would remain unchanged, the micro-canonical ensemble would have been altered. Under this framework, either Ford’s investors in the secondary market or, even better, the company itself would experience a welcome cash boost, this as a result of having either borne or paid for credit risk. Should both parties opt to share the attendant economic benefits equally, everyone would end up better off at no cost as if by magic.

In the final analysis, the magic of properly executed structured finance is precisely that there is no magic. Ladies and gentlemen, unlike market risk, credit risk is not a zero-sum game. When a dilettantish rating agency analyst says these dynamics “do not matter” to the firm’s credit rating or that “we rate through the cycle,” he is assuming that the universe of Ford investors is static and unchanging. This assumption is patently false, not to mention crassly self-serving. On the one hand, it enables financial neophytes to sit on their proverbial behind while hard-working Americans at Ford and elsewhere struggle against the forces of nature, and without earning a single dime from their operational excellence or marketplace validation. On the other, Ford is still paying dearly, and indefinitely it seems, for its erstwhile marketplace failures. Clearly, such people have never heard of the ergodic hypothesis, but Mulally most certainly is comfortable working with it.

Ford Motor Credit is a benchmark player in automobile structured finance. Not only is cyclicality in credit space symptomatic of Ford’s balance sheet, but the vast majority of its ABS securities also experience dynamic, telescoping credit ratings. This is because the value of structured securities is dynamic by its very nature. Even if credit ratings fail to track these dynamics, the credit risk will change naturally with the passage of time, improving or deteriorating. Therefore, structured bonds must be re-analyzed each time a new servicer report is made available so their current credit quality can be reassessed. Doing less amounts to a betrayal of Ford workers.

At the very least, investment banks who really want to add value to their customers’ ABS offerings should be facilitating credit rating changes, routinely and pro bono. In point of fact, this would not be new. In the good ole’ days 15+ years ago, Ford was one of the few frequent ABS-issuers whose subordinated ABS were regularly upgraded. Nobody should be surprised to hear that neither Ford nor its investors called up to request a downgrade. In other words, what exactly investment bankers do with monitoring information remains at their sole discretion. We are not talking about a no-holds-barred, tell-all page-turner here, but only about actually doing what one claims to be doing in the first place.