• 29 Nov 2011 at 6:35 PM

The OCC And I Work Hard To Guarantee Investment Returns

This is shaping up to be CFA week for me, and with my impending triumph/humiliation I’ve pretty much stopped thinking about much else. I’ve also stopped reading about much else, putting aside Trotsky temporarily to focus on those six stupid books. Yesterday was corporate finance – I can now unlever and relever betas like a champ – and portfolio management, which I got about halfway through before falling asleep. Today is equity and fixed income. The end is in sight!

But there’s still occasionally time to think about blast-from-the-past favorite topics, like the slow-motion disaster that is the US regulatory effort to end official reliance on ratings agencies. The latest is the OCC, which released a proposed rule today that will change the definition of “investment grade” securities, which banks can invest in, from “rated in one of the four highest rating categories by two or more NRSROs” to this:

Investment grade means the issuer of a security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure. An issuer has an adequate capacity to meet financial commitments if the risk of default by the obligor is low and the full and timely repayment of principal and interest is expected.

How would you know? Well, the OCC offers some guidance:

The OCC expects national banks and Federal savings associations to conduct an appropriate level of due diligence to determine that an investment security is a permissible investment. This may include consideration of internal analyses, third party research and analytics including external credit ratings, internal risk ratings, default statistics, and other sources of information as appropriate for the particular security. The depth of the due diligence should be a function of the security’s credit quality, the complexity of the structure, and the size of the investment. The more complex a security’s structure is, the more credit-related due diligence an institution should perform, even when the credit quality is perceived to be very high. Bank management should ensure they understand the security’s structure and how the security will perform in different default environments, and should be particularly diligent when purchasing structured securities. The OCC expects national banks and Federal savings associations to consider a variety of factors relevant to the particular security when determining whether a security is a permissible and sound investment. The range and type of specific factors an institution should consider will vary depending on the particular type and nature of the securities. As a general matter, a national bank or Federal savings association will have a greater burden to support its determination if one factor is contradicted by a finding under another factor.

There’s even a handy matrix of factors to consider for various types of bonds, like “Confirm risk of default is low and consistent with bonds of similar credit quality” (applicable to all bonds, and also, what?) and “Evaluate and understand the quality of the underwriting and of the underlying collateral as well as any risk concentrations” (applicable only to structured products and now you tell them). “External credit ratings,” which I bolded up there, doesn’t make the checklist.

Now a thing that I find charming about the CFA because it exists in an ideal world where everyone thinks about investment decisions from a variety of complementary perspectives, does a ton of research, recommends an approach to a client while describing its risks and tradeoffs clearly and appropriately, and then sits back and smiles wisely while the client, who in this scenario is some guy who just won the lottery and is wearing a bowling shirt and hasn’t paid attention to anything you said, says “yeah put it all in those things you said were good, equities was it?”

In my experience, the advisory banking business actually involves a fair amount of exactly that. Investment bankers aren’t particularly paid to be right. Your job really is to bring data and analysis and intelligence to bear in helping clients with their decisionmaking process. You listen to their problems, tell them a lot of facts, run numbers, make pretty charts, format the pitchbook beautifully and generally provide a range of alternatives while thoughtfully laying out the pros and cons of each. Then the client makes a decision, because that’s their job.

I’m not sure that managing assets, at a hedge fund or mutual fund or, say, an OCC regulated bank, works that way. Being balanced and thoughtful and wise is not as good as making good decisions that get outsize returns. Investors do not like getting a thoughtful letter saying “here’s why we were wrong” nearly as much as they like getting a postcard saying “Up 50% vs. S&P down 10%, see ya bitches.”

In any case, in both advisory and decisionmaking businesses, there are times and places to think deep thoughts, and there are times and places for quick rules of thumb, bright-line cutoffs, and vaguely understood benchmarks that more or less work even though you don’t understand them. Listing a bunch of factors, and saying that there is “a greater burden to support its determination if one factor is contradicted by a finding under another factor,” is a pleasant way to sound responsible, but it doesn’t provide much in the way of guidance. It washes out to “use your best judgment to find securities that won’t default,” which mostly works fine, until it doesn’t. Though I guess the same is true of ratings.

But when you want to stand for quality and integrity – whether you’re the CFA Institute or the regulatory agencies – the need for bright lines and rules of thumb can be hard to acknowledge. The CFA books don’t mention rational ignorance. There’s no chapter on “just use 12% for the WACC, good enough.” There is a chapter making the wholesomely nerdy pitch for using NPV to evaluate projects, and then a sheepish admission that the less-delightful IRR (underdetermined with alternating inflows and outflows!) is more popular among actual managers and that the utterly dopey undiscounted payback period is pretty close.

Similarly, it is of course entirely sensible to ask banks to do credit diligence, think about whether the bonds they buy are likely to be repaid, and then only buy the ones where they can say with heart and mind “yes, they’re good.” And in a good and just world, they would do exactly that rather than just rely on ratings from agencies who hate them anyway. And, if they failed to do so, the perfect-world regulators would find out and yell at them and make them do better diligence.

But in the actual world, why on earth would you count on banks to confine themselves to the safest assets without any external metrics? And why would the OCC want to wade into a bank’s books without any sort of handy, external, imperfect but roughly useful rule of thumb to evaluate their credit risk?

Probably because they wouldn’t. I highlighted that “including external credit ratings” for a reason: something tells me that that’s gonna get a lot of weight from both the banks and the OCC. I feel their pain. Like them, I’m going to spend the next week talking a good game about subjecting every investing decision to careful diligence and deep from-the-ground-up analysis. And, for me and for them, that impulse will eventually fade and I’ll go back to bumbling along simplistically and hoping things work out okay.

OCC Proposes Rule to Remove References to Credit Ratings and Guidance on Due Diligence Requirements in Determining Whether Investment Securities Are Eligible for Investment [OCC]

Are Rating Firms Getting a Free Pass? [BW]

68 comments (hidden to protect delicate sensibilities)
Show all comments ↓

Comments (68)

  1. Posted by The Truth | November 29, 2011 at 6:56 PM

    CFA > blogger studying for Level I > MBA

  2. Posted by GueSt | November 29, 2011 at 6:58 PM

    Wow, the fun police wrote this article didn't they?

  3. Posted by Avid Reader | November 29, 2011 at 7:06 PM

    LOVE it.

  4. Posted by guest | November 29, 2011 at 7:08 PM

    i got 99 problems but your CFA exam aint one

  5. Posted by bluehorseshoe | November 29, 2011 at 7:15 PM

    By the way, did I mention that I'm taking the CFA this Saturday?

    – Matt Levine, Future CFA exam-taker

  6. Posted by Chevy_Chased | November 29, 2011 at 7:15 PM

    At least the tags are funny

  7. Posted by geoffgeoffgeoff | November 29, 2011 at 7:21 PM

    I wouldn't send my maid's kids to Oakland Community College.

    -Former Oakland County Michigan Resident Quant

  8. Posted by Guest | November 29, 2011 at 7:37 PM

    That's a really expensive Kindle book.

  9. Posted by Rob Schneider | November 29, 2011 at 7:45 PM

    You like-a the Secret Sauce, eh? Sauce is good, no?

  10. Posted by Hungus | November 29, 2011 at 9:10 PM

    Passing the lottery is easier than winning the CFA.

    UBS Luck Futures

  11. Posted by otcbb | November 29, 2011 at 11:49 PM

    I miss Kouwi

  12. Posted by Guest | November 30, 2011 at 1:59 AM

    I am looking forward to reading about the outcome of this weekend's festivities.

  13. Posted by Anonymous | November 30, 2011 at 8:45 AM

    poor effort Matt, just go study.

  14. Posted by Wharton MBA | November 30, 2011 at 11:40 AM

    Or 18 months if you pass Dec-June-June and already have the work exp.

    -Guy who enjoys pointing out GIF fails

  15. Posted by dirty_dirty_harry | November 30, 2011 at 1:06 PM

    Will Matt’s Facebook page from prison include come-on’s to women pen pals?

  16. Posted by deskdweeb | November 30, 2011 at 2:36 PM

    CFA was so much fun, I think I'll take it again (yes, I passed). On second thought, I'll just chew tinfoil while brushing my hair with a cheese grater.

  17. Posted by Guest | November 30, 2011 at 2:50 PM

    We're all very impressed you've given up your grueling independent research of Russian history to take the CFA. Please continue to give us topic-by-topic updates on your studying.

  18. Posted by cheap bookmarking service | September 9, 2012 at 10:13 PM

    gJsG7I Thanks for sharing, this is a fantastic post.Much thanks again. Cool.

  19. Posted by cheap bookmarking service | September 9, 2012 at 10:48 PM

    QS2Q6n This is one awesome article. Awesome.

  20. Posted by bookmarking service | September 10, 2012 at 9:56 PM

    Zeqpmo I value the blog. Awesome.

  21. Posted by Commission loophole | September 11, 2012 at 12:49 PM

    Hey, thanks for the article.Really thank you!

  22. Posted by Passer annonce immobiliere | September 12, 2012 at 6:12 PM

    Muchos Gracias for your post.Really looking forward to read more. Fantastic.

  23. Posted by satnam | September 12, 2012 at 11:45 PM

    Thanks for the blog.Thanks Again. Want more.

  24. Posted by KANSAS CITY AIR DUCT CLEANING | September 13, 2012 at 10:08 AM

    Appreciate you sharing, great post.Thanks Again. Awesome.

  25. Posted by Monster Beats Solo | September 13, 2012 at 8:08 PM

    Received the letter. I agree to exchange the articles.

  26. Posted by Yoga Classes in Punjabi, Surrey, BC | September 15, 2012 at 6:18 AM

    I really enjoy the blog.Much thanks again. Great.

  27. Posted by rent water slides | September 17, 2012 at 10:11 AM

    Thanks-a-mundo for the article post.Much thanks again. Fantastic.

  28. Posted by joshua voiles | September 17, 2012 at 1:40 PM

    Really informative blog.Really looking forward to read more. Cool.

  29. Posted by Healthy Lifestyles | September 17, 2012 at 6:17 PM

    Thank you for your blog post.Really thank you! Will read on…

  30. Posted by Rottweiler allevamenti | September 19, 2012 at 12:45 AM

    Great, thanks for sharing this blog post. Great.

  31. Posted by porn videos | September 19, 2012 at 3:27 AM

    A big thank you for your post.Much thanks again. Great.

  32. Posted by xxx videos | September 19, 2012 at 3:27 AM

    I really liked your blog article.Really thank you! Awesome.

  33. Posted by website designer perth | September 19, 2012 at 6:23 AM

    wow, awesome blog post.Much thanks again. Awesome.

  34. Posted by hip hop artist | September 19, 2012 at 8:10 AM

    Enjoyed every bit of your article.

  35. Posted by free classified ads Philippines | September 19, 2012 at 10:21 PM

    Very neat blog post.Much thanks again. Really Great.

  36. Posted by installment loans online | September 20, 2012 at 12:12 AM

    I really like and appreciate your blog article. Keep writing.

  37. Posted by buy twitter followers cheap | September 20, 2012 at 8:39 AM

    Thanks for sharing, this is a fantastic article. Keep writing.

  38. Posted by dat ing | September 20, 2012 at 9:47 AM

    Appreciate you sharing, great blog post.Thanks Again. Will read on…

  39. Posted by Registrar Transfer | September 21, 2012 at 3:34 PM

    Muchos Gracias for your article.Much thanks again. Awesome.

  40. Posted by gay friends | September 21, 2012 at 9:02 PM

    Thanks for sharing, this is a fantastic blog.Really thank you! Really Great.

  41. Posted by room plus | September 22, 2012 at 1:22 PM

    I really like and appreciate your post. Great.

  42. Posted by panic attacks cure | September 22, 2012 at 3:11 PM

    wow, awesome article post. Will read on…

  43. Posted by cheap term life insurance | September 22, 2012 at 10:36 PM

    Im obliged for the article post.Thanks Again. Keep writing.

  44. Posted by Alexander Mans | September 24, 2012 at 8:05 AM

    Thanks so much for the blog.Much thanks again. Keep writing.

  45. Posted by stock market training courses | September 25, 2012 at 11:41 AM

    Im thankful for the blog post.Really looking forward to read more. Much obliged.

  46. Posted by hypnosis books | September 26, 2012 at 12:39 AM

    Thanks again for the blog post.Much thanks again. Want more.

  47. Posted by Learn more on African Mango | September 26, 2012 at 10:00 PM

    I needed to write you the tiny observation in order to thank you so much the moment again about the awesome strategies you’ve provided here. This is simply remarkably generous of you to allow unhampered what most of us would have offered for sale for an e book in making some bucks for their own end, notably given that you could possibly have done it in the event you desired. Those principles additionally worked to become a good way to be aware that the rest have similar zeal much like my personal own to grasp a good deal more with reference to this matter. I’m sure there are lots of more pleasant moments ahead for individuals who look over your website.

  48. Posted by bookmarking submission | October 6, 2012 at 8:21 PM

    Cr69Cp Thank you ever so for you blog.Thanks Again. Keep writing.

  49. Posted by motor club of america benefits | October 9, 2012 at 3:59 PM

    Say, you got a nice blog article.Really looking forward to read more. Really Great.

  50. Posted by Sex Anzeigen | October 10, 2012 at 6:54 PM

    I truly appreciate this article post.Really looking forward to read more. Really Cool.

  51. Posted by Reputable Poetry Contests | October 10, 2012 at 10:38 PM

    Thanks again for the article post.Much thanks again. Much obliged.

  52. Posted by Gourmetblog | October 11, 2012 at 7:50 AM

    Thanks again for the blog.Much thanks again. Want more.

  53. Posted by Cho Yung Reviews | October 11, 2012 at 9:54 AM

    Comrade kill yourself.

  54. Posted by ionic case 4s | October 11, 2012 at 10:44 AM

    I loved your blog article.Much thanks again. Keep writing.

  55. Posted by concept artist | October 11, 2012 at 9:43 PM

    Appreciate you sharing, great article post.Really thank you! Really Cool.

  56. Posted by candidates | October 12, 2012 at 6:01 AM

    Really appreciate you sharing this blog post.Thanks Again. Much obliged.

  57. Posted by Peter Francis-Macrae | October 12, 2012 at 6:06 AM

    I really like and appreciate your blog article. Will read on…

  58. Posted by indian wedding photography | October 12, 2012 at 9:35 AM

    Really appreciate you sharing this article.Much thanks again. Really Great.

  59. Posted by Domestic Cleaner | October 12, 2012 at 1:44 PM

    Wow, great article post. Want more.

  60. Posted by Peter Francis-Macrae | October 12, 2012 at 2:53 PM

    Awesome blog.Really looking forward to read more.

  61. Posted by resveratrol | October 12, 2012 at 2:57 PM

    I would add something else, of course, but in fact almost everything is mentioned!…

  62. Posted by New Car Pricing | October 12, 2012 at 11:51 PM

    I cannot thank you enough for the blog post.Thanks Again.

  63. Posted by amiright | October 15, 2012 at 1:15 PM

    Thanks for sharing, this is a fantastic blog.Thanks Again. Much obliged.

  64. Posted by payday loans online | October 16, 2012 at 12:15 AM

    Hey, thanks for the post.Really looking forward to read more. Really Cool.

  65. Posted by eye exams | October 16, 2012 at 6:08 PM

    Wow, great blog post. Much obliged.

  66. Posted by kitchen cabinets toronto | October 16, 2012 at 8:00 PM

    Hey, thanks for the blog.Really thank you! Great.

  67. Posted by young professional | October 16, 2012 at 8:00 PM

    Thanks a lot for the article.Much thanks again. Cool.

  68. Posted by Lighthouse Point real estate | October 16, 2012 at 9:52 PM

    Thanks a lot for the blog. Much obliged.