Procyclicality of Through-the-cycle and Point-in-time

[Liming]

Dear David,

There are a few concepts on Procyclicality I need to clarify with you:

1) Does Procyclicality refers to the reinforcing effect of credit rating (whether through the cycle or point in time)?

2) Do both through the cycle and point in time create such effect? Do credit rating agency create such effects with through the cycle rating by requiring credit enhancement that varies with housing market and economy conditions: worsening conditions requires additional enhancement in the structure? and does point in time mainly talk about lending decisions influenced by current economic conditions and thereby reinforcing it (ie. under lending that we experienced in year 07-08 or so called "credit crunch", exacerbating the crisis) ?

3) Specifically,I don't understand the role of "funding cost and leverage" in this whole picture and "as the housing market slows down, the rating agency removes leverage from the structure". My understanding about through the cycle is that it create this effect through the fact that credit rating agency did not adjust their loss distribution and credit enhancement in time to new housing market condition; whereas point in time create such effect by employing models such as Mertons that looks at the near term.

Thank you for your correction of my imperfect understanding!

Cheers
Liming
7/11/2009

 

[David Harper CFA FRM]

Hi Liming,

The concept of Procyclicality is (IMO) broad and a bit fluid ... last year I thought chi made some observations that prompted by to summarize my view at the time:
http://forum.bionicturtle.com/viewthread/741/#1719

1) Yes, i agree with you. I would elaborate and (again, just my interpretation of the FRM generally, I feel some of this is debatable) express as:
Procyclical refers to any of several dynamics which exacerbate a downturn rather than mitigate (e.g., systemic procylicality).
And this include ratings, both through the cycle or point in time (support: see link re: de servigny. Also, most arguments re Basel)
However, between TTC and PIT, following de Servigny, PIT (e.g., where Merton/KMV is most representative) model is ought to be the "more procyclical"

2) and 3) appear to me to be related, and both seem to refer specifically to the Ashcroft reading. Ashcroft summarizes with this graphic (borrowed from this thread: http://forum.bionicturtle.com/viewthread/367/#1715)

http://learn.bionicturtle.com/images/forum/subprime_fig11.png

I perceive (at least) two points by Ashcraft:

1. In regard to "My understanding about through the cycle is that it create this effect through the fact that credit rating agency did not adjust their loss distribution," I think Ashcraft is rather saying: if the credit agency does not change the credit enhancement required to maintain a AAA rating, when the economy deteriorates, then (i) the AAA rating will be unreliable (riskier than perceived) and (ii) eventually, the rating will need to be abruptly (rather than gradually) adjusted to reflect reality (i.e,. rating instability).

2. (the procyclical point, but reminder this is specifically structured finance). Ashraft is saying that "through-the-cycle" ratings are especially procyclical because: assume unrealistically simple capital structure (80% AAA and 20% lower-rated; per our other thread, as you Know Liming, this is unrealistic because I omit the equity/"excess spread" tranche). The cost to fund is 80% * lower cost + 20% * higher cost.
Now assume economy shifts into deterioration: if the rating agency is using TTC, it must avoid the problem of (1) above (i.e., inaccurate and instable ratings) by requiring more credit enhancement. So, the AAA now needs 30% subordination.
With 70% * lower cost + 30% * higher cost, the cost of funds just went up!
...and the higher cost of funds must be met with (i) higher yields on the mortgage loans and/or (ii) tighter lending standards to reduce expected losses. This has the effect of reducing the supply of credit in the system.
...and that is the procyclicality that Ashcraft refers to, and again, it's very specific: in (subprime) structured finance, TTC ratings are procyclical b/c they will tend to reduce the supply of credit.

I hope that is helpful, it certainly help me to improve my own understanding (this is a hot topic, but i just noticed that 'procyclical' does not seem to appear in the 2009 AIMs, although it did appear last year).

David