Europe

News and opinions on the happenings from the Old Continent

Rating the Agencies

Having just read a commentary from Philip Stevens from the Financial Times (link at the bottom) I feel a need to write a partial response relating to some of the issues raised. Stevens’ article focus without stating it as some kind of principal/agent dilemma, whereby the ratings agencies Standard & Poors, Fitch’s and Moody’s are an integral and dominant factor in World finance while having vested and different interests than the rest of the financial community. Specifically, he boils down the issue to a group of profit seeking enterprises with no measurable intellectual superiority to the rest of us, making their money on the back of sovereign States. So we are presented with some kind of moral hazard that affects the sovereignty of all States and Peoples subject to yet another market deficiency.

Now I’ll admit that Steven’s raises a few fair points such as the Agencies only proposing common sense policy solutions and I’ll further admit that for somebody who’s intentions are quite clear and provocative the tone was levelled, however I am going to be a stickler for some of his conclusions, which I believe to be out of sink with the facts.

The first accusation levelled at S&P is one of using its sovereign credit downgrades as a marketing ploy to increase the value of its credit ratings. How this is a problem I’ll admit to being at a loss. It was my belief that for a AAA to actually have value it needed to be hard to obtain and easy to loose. One of the accusations made against the ratings agencies in the early part of the 2008-2010 crisis was that they too willingly gave away AAA ratings much to the despair of the many banks, hedge funds and institutional investors who got clobbered in 09. Now we can all agree that the Agencies were guilty of that… So why reverse course, and lambast them now for trying to make up for past mistakes and right the ship? Ratings Agencies may be paid by credit issuers which can be seen as a morally hazardous when their stated goal is the protection of lenders. So when an agency, such as S&P begins acting zealously to protect the value of investors investments by valuing investment as rigorously as possible it is my feeling that we are actually distancing ourselves from the real moral hazards that underpinned the last crisis!

Let’s talk about the actual ratings for a minute. Now people seemed to be peeved most egregiously because a downgrade has more often than not led to or contributed to a rise in sovereign yields. Effectively the rate at which governments must refinance accumulated debts and the cost of borrowing to pay current budgetary deficits. So governments get understandably annoyed when their credit ratings get reviewed. Some argue that this gives immeasurable power to the Agencies away from democratically elected governments, an attack on a nations sovereignty for international relations profs or an economic coup d’état. This is a load of boll** if you ask me… When a nation develops a current account deficit it necessarily gives up some of its sovereignty to foreign credit markets, not to speek of the decision to live outside of autarky being essentially the same decision to outsource sovereignty externally in exchange for economic benefits. So any attack on a nation’s sovereignty is initially fomented by the economic decisions of that nation not by some imperialistic ratings agency. Secondly as most people have noted including Stevens in his own commentary, Ratings Agencies ratings are nothing more than a reflection of the markets. There is only limited evidence of an asymmetric information problem here, the Agencies only know marginally more than your average assiduous investor. They primarily serve investors and institutions that are too lazy to do their own investing due diligence.

AAA means an obligor has EXTREMELY STRONG capacity to meet its financial commitments. Wikipedia words not mine. Now does France fit that bill, the US or Japan? Although the US has a relatively good demographic profile, it has a rapidly mounting amount of intergenerational entitlement obligations. Assuming the US doesn’t curtail its entitlement obligations because of political inertia or other, Americans will not be able to meet their financial obligations. France and Japan on the other hand have much less stellar demographic profiles, Japan more so than France. The scope of entitlement programs in France is staggering! What do you get when you mix the most comprehensive healthcare system in the world with one of the most generous leave of absence programs, unemployment insurance and retirement schemes? Greece times 10? worst… France. The nation of Camembert and wine lovers is slated to pose the greatest financial risk to the integrity of the Euro after Italy. So was S&P’s call appropriate? no it wasn’t, it came much too late and in itself isn’t strong enough. My reading of the definition of Credit Ratings tells me France should be in the BBB range. In the long term Social unrest stemming from public outrage at entitlement curtailing will push France to the edge of fiscal sustainability. To be fair France isn’t the only G8 country who should have its AAA taken away. Germany with one of the worst demographic profiles in the world, substantial debt load, fast shrinking labour force and a rapidly growing list of Euro area commitments to lesser credit worthy countries isn’t deserving of the highest honour in the credit world. In a slightly different vein, Canada is no more deserving. With a mixed demographic profile, outrageous household debt load, large unfunded and unaccounted federal liabilities and a growing debt load at the Provincial level, all is not bright in the land of the true north strong and free.

The case for Ratings Agencies doing their job correctly seems solid in my mind, only one problem remains. Many want to regulate the Agencies’ credit market influence. Where does this influence stem from anyways? It comes from regulation. If it wasn’t for banking regulation forcing banks and other financial institutions to hold credit rated securities as part of their core ratios the Agencies would not have such a systemic importance in the financial world. Obviously finding a substitute to ratings for regulatory purposes isn’t easy. One possible solution is a blind follow the market approach, where the assets held by banks for tier 1 ratios or others are determined by the liquidity and low risk of an asset.  Only securities fitting the following formula would be eligible as core capital: θ • (99th centile of security liquidity) * (1 – θ) • (1st centile of security σ^2)

The above rule is just a suggestion with the intention of adjusting regulation to make it less Agency clout enhancing. If you’ve got a suggestion for a less market distorting rule please leave it in the comments section!

http://www.ft.com/intl/cms/s/0/b9aaf7b0-4291-11e1-93ea-00144feab49a.html