Wednesday, August 10, 2011

The Downgrade Cometh

The concept of conflicted opinions is dear to us. When a conflict is more than a conflict it has the power to put the conflicted party in a false position; the conflict doesn’t act simply as a distracting factor which may throw doubt upon the opinions rendered – but it brings with it an uncanny ability to intrude on the precision of the supporting analysis, and the delicacy with which it is handled.

We have written before of potential conflicts inherent in the ratings model; today our guest author Marc Joffe brings the conflicts question closer to home in the context of S&P’s much debated US downgrade. While at PF2 we’re agnostic on the value added by the downgrade at this late stage, we are happy to host his views to encourage meaningful debate around the importance and implementation of sovereign ratings – and we welcome your comments.

The Downgrade Cometh

By Marc Joffe*

S&P took the right action last Friday. The timing may have been unfortunate. And while Treasury’s announcement of a calculation error was embarrassing, the fact is that $2 trillion is little more than a rounding error in relation to the $211 trillion overall fiscal gap calculated by Lawrence Kotlikoff. But rather than crucifying S&P, the media should be asking other rating agencies what numerical analysis they have done – if any – to justify their decision to maintain status quo.

The persistence of the US AAA rating in the face of high debt ratios and political paralysis was becoming an embarrassment for the rating industry. The ratings disconnect reminded one of the Enron saga, or the subprime misratings, which were sorely lacking in any intellectual basis. Let’s hope that the S&P downgrade begins the long march back to credibility.

Faulty ratings should be viewed in a much larger context of biased equity research during the internet bubble (Who is Jack Grubman?), Arthur Anderson’s failure to effectively audit Enron and more recently the phony appraisals and poor underwriting practices that triggered the foreclosure crisis.

Credit evaluation (whether by lenders or rating agencies), equity analysis, auditing and appraising are intimately related. All four of these disciplines affect the flow of capital, and professionals working in these fields are torn between cutting corners and ignoring professional protocol when conducting their analysis. Those of us who work in these professions face a stark choice: either (1) submit to management, public or client pressure to do a lousy job, or (2) perform thorough, unimpeded analyses that produces the most objective answer. If too many take the first option, funds are mismanaged, investors lose money and savings are curtailed. After all, if you can’t trust financial statements or credit analyses, what confidence can one have in her investment? A society in which the first choice dominates rapidly degenerates from a transparent advanced economy to a corrupt banana republic. This is the risk faced by the US today.

I see in the S&P Sovereign Group’s rating announcement that they had the courage to say what many of us already knew, and were willing to face public criticism when no money was on the line in the name of professional integrity. S&P’s action should remind all of us who assess debt, assets and financial reports to summon up the courage to speak the truth on a regular basis. The short term consequences may be difficult, but the benefits of an appropriate analysis include a clear conscience and a good night’s sleep. If all of us maintain our standards, we can create stronger financial markets and a healthier society.

* Marc Joffe ( is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

1 comment:

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