Sins of the Son visited upon Father - Trading on a Good Name

I recently read an article on people "renting out" their credit rating. This allowed people with weaker credit scores to borrow their good name to get loans etc. Although it sounds awkward and causes large problems in the credit industry, many of us may be familiar with this practice, having a parent or guardian act as a guarantor for a student loan for your university or college degree. This means that you are borrowing the credibility of your parents to secure a loan.

What happens if you can't pay? The bank will chase you as well as your guarantor. As we'll soon see through this post, there are many forms of improving credit ratings (for individuals as well as corporations) which have had mixed results.

This type of challenge presents an interesting "middleman" opportunity for funds (or organizations with good credit ratings and cash flow) to trade on their good name for a profit by enhancing credit ratings (what AIG did with its credit default swaps on CDO's of sub prime mortgages to insure the senior tranche receivables).

Without a middleman, a corporation with a lower rating (BBB) also has the option to create a credit enhanced "special purpose entity / vehicle", a non-operating entity created to carry out a specified purpose, in this case to finance or securitizing receivables. In other words, you separate the receivables from the debt rating of the issuing company.

A question I would then ask is what is the rating based on? I would have to assume that it would be more reflective of the rating of the company from whom the receivables are owed against (with some additional margin premiums for business transaction risks etc).

Sound familiar yet dangerous? This is a very similar structure to what Andy Fastow did with Enron's assets (like investment bank purchasing "receivables", overinflated marked-to-market accounts which would never be collected) through LJM and other limited partnership special purpose entities. However, rather than treat this as debt, he inappropriately hid this as earnings through LJM. Arthur Anderson fell apart by overlooking practices such as this which are incredibly deceptive.

There exists an opportunity for investors to do this on their own as well by trading bonds of other companies. For instance:

Look at a company A who has a AAA rating bond instrument and company B who has a AAA rating bond. Assume the companies have fundamentally similar characteristics (they should be priced the same).

Assume (due to market inefficiency) that there is a scenario where demand for company A's bond is very high, and B's is low. An investor who spots this inefficiency can short bond A and go long bond B.

Or for management in company A, they can issuing more A bonds and buy B bonds. This is equivalent to using their good name to raise funds for a third party. From a market net neutral perspective, you are profiting in the difference in credit ratings (or a lack of cash flow or other yield metric).

Whatever the cause of the premium on the cost of debt, by taking this long / short position you are bearing the risk / reward associated with this spread.

The most common example of this type of "credit swapping"? Sale of receivables or collateralized borrowing.

The catch? If B's bonds get downgraded (or defaults etc) A is left holding the bag. In the same way that the sins of the son would be visited upon the father, so too should companies trading credit be aware.

However, this is a dangerous game to play. Most (if not all) frauds and financial collapses have involved the improper use and accounting of debt.