Monday, December 31, 2012

A New Free Sovereign Risk Database

Happy New Year Readers!

Today we are introducing a free, public database of historical sovereign risk data. It is available at

The database contains central government revenue, expenditure, public debt and interest costs from the 19th century through 2011 – along with crisis indicators taken from Reinhart and Rogoff’s public database.

Why This Database?

Prior to the appearance of This Time is Different, discussions of sovereign credit more often revolved around political and trade-related factors. Reinhart and Rogoff have more appropriately focused the discussion on debt sustainability. As with individual and corporate debt, government debt becomes more risky as a government’s debt burden increases. While intuitively obvious, this truth too often gets lost among the multitude of criteria listed by rating agencies and within the politically charged fiscal policy debate.

In addition to emphasizing the importance of debt sustainability, Reinhart and Rogoff showed the virtues of considering a longer history of sovereign debt crises. As they state in their preface:
“Above all, our emphasis is on looking at long spans of history to catch sight of ’rare’ events that are all too often forgotten, although they turn out to be far more common and similar than people seem to think. Indeed, analysts, policy makers, and even academic economists have an unfortunate tendency to view recent experience through the narrow window opened by standard data sets, typically based on a narrow range of experience in terms of countries and time periods. A large fraction of the academic and policy literature on debt and default draws conclusions on data collected since 1980, in no small part because such data are the most readily accessible. This approach would be fine except for the fact that financial crises have much longer cycles, and a data set that covers twenty-five years simply cannot give one an adequate perspective…”
Reinhart and Rogoff greatly advanced what had been an innumerate conversation about public debt, by compiling, analyzing and promulgating a database containing a long time series of sovereign data. Their metric for analyzing debt sustainability – the ratio of general government debt to GDP – has now become a central focus of analysis.

We see this as a mixed blessing. While the general government debt to GDP ratio properly relates sovereign debt to the ability of the underlying economy to support it, the metric has three important limitations.

First, the use of a general government indicator can be misleading. General government debt refers to the aggregate borrowing of the sovereign and the country’s state, provincial and local governments. If a highly indebted local government – like Jefferson County, Alabama – can default without being bailed out by the central government, it is hard to see why that local issuer’s debt should be included in the numerator of a sovereign risk metric. A counter to this argument is that the United States is almost unique in that it doesn’t guarantee sub-sovereign debts. But, clearly neither the rating agencies nor the market believe that these guarantees are ironclad: otherwise all sub-sovereign debt would carry the sovereign rating and there would be no spread between sovereign and sub-sovereign bonds - other than perhaps a small differential to accommodate liquidity concerns and transaction costs.

Second, governments vary in their ability to harvest tax revenue from their economic base. For example, the Greek and US governments are less capable of realizing revenue from a given amount of economic activity than a Scandinavian sovereign. Widespread tax evasion (as in Greece) or political barriers to tax increases (as in the US) can limit a government’s ability to raise revenue. Thus, government revenue may be a better metric than GDP for gauging a sovereign’s ability to service its debt.

Finally, the stock of debt is not the best measure of its burden. Countries that face comparatively low interest rates can sustain higher levels of debt. The United Kingdom avoided default despite a debt/GDP ratio of roughly 250% at the end of World War II. The amount of interest a sovereign must pay on its debt each year may thus be a better indicator of debt burden.

Our new database attempts to address these concerns by layering central government revenue, expenditure and interest data on top of the statistics Reinhart and Rogoff previously published.

A Public Resource Requiring Public Input

Unlike many financial data sets, this compilation is being offered free of charge and without a registration requirement. It is offered in the hope that it, too, will advance our understanding of sovereign credit risk.

The database contains a large number of data points and we have made efforts to quality control the information. That said, there are substantial gaps, inconsistencies and inaccuracies in the data we are publishing.

Our goal in releasing the database is to encourage a mass collaboration process directed at enhancing the data. Just as Wikipedia articles asymptotically approach perfection through participation by the crowd, we hope that this database can be cleansed by its user community. There are tens of thousands of economists, historians, fiscal researchers and concerned citizens around the world that are capable of improving this data, and we hope that they will find us.  To encourage participation, we have supplied a comments feature and plan to add more participatory functionality in late January.

Sources and Acknowledgements

Aside from the data set provided by Reinhart and Rogoff, we also relied heavily upon the Center for Financial Stability’s Historical Financial Statistics. The goal of HFS is “to be a source of comprehensive, authoritative, easy-to-use macroeconomic data stretching back several centuries.” This ambitious effort includes data on exchange rates, prices, interest rates, national income accounts and population in addition to government finance statistics. Kurt Schuler, the project leader for HFS, generously offered numerous suggestions about data sources as well as connections to other researchers who gave us advice.

Other key international data sources used in compiling the database were:

  • International Monetary Fund’s Government Finance Statistics
  • Eurostat
  • UN Statistical Yearbook
  • League of Nation’s Statistical Yearbook
  • B. R. Mitchell’s International Historical Statistics, Various Editions, London: Palgrave Macmillan.
  • Almanach de Gotha
  • The Statesman’s Year Book
  • Corporation of Foreign Bondholders Annual Reports
  • Statistical Abstract for the Principal and Other Foreign Countries

For several countries, we were able to obtain nation-specific time series from finance ministry or national statistical service websites.

We would also like to thank Dr. John Gerring of Boston University and Co-Director of the CLIO World Tables project, for sharing data and providing further leads as well as Dr. Joshua Greene, author of Public Finance: An International Perspective, for alerting us to the IMF Library in Washington, DC.

A number of researchers and developers played valuable roles in compiling the data and placing it on line. We would especially like to thank Charles Tian, T. Wayne Pugh, Amir Muhammed and Anshul Gupta, as well as Karthick Palaniappan and his colleagues at H-Garb Informatix in Chennai, India for their contributions.

Finally, we would like to thank the National University of Singapore’s Risk Management Institute for the generous grant that made this work possible.

Thursday, December 27, 2012

Sovereign Debt Ratings - How High is High?

The ratings agencies' country debt ratings have received a double blow from Bloomberg News in the last 10 days.

First, Bloomberg unleashed a piece entitled "Moody’s Gets No Respect as Bonds Shun 56% of Country Ratings" that argued that movements in bond yields more often disagreed (versus agreed) with a ratings change. If the argument is true, the result would then be that, in trying to predict future market movements, flipping a coin might be more constructive than basing your decision on a ratings action.

Less than a week later, Bloomberg released "BlackRock Sees Distortions in Country Ratings Seeking Revamp" which claims upfront that "Credit rating companies are distorting capital markets by assigning the same debt ranking to countries from Italy to Thailand and Kazakhstan, according to BlackRock Inc. (BLK), the world’s biggest money manager."

These are both punishing blows, but they also force us to reconsider what a rating is, what a rating means. Unfortunately, if we cannot ascertain what the rating describes, we cannot reasonably judge a rating agency's performance.

How High is High?

On a fundamental level, imagine we rank restaurants differently. One ranking may take only the quality of the meal into account. Another may consider the peripherals to the meal, or ambience - the relative comfort of the seats; the temperature; the noise level; the view etc. Can we really compare two ratings provided under different measures?

Unfortunately, is not only that investors are failing to assess what the rating depicts, but the rating agencies are choosing to keep the question open. Why box themselves in?

When things go wrong, rating agencies advertise that they actually got it right - their ratings are only RELATIVE measures of risk. They are trying to predict which countries or companies will be more likely than others to default or suffer impairment. But if you look at their actual ratings actions, and their action definitions, there is often little evidence of relative measurement.

Let's suppose one downgrades the UK. A relative action might read something like this "the UK has grown its debt-to-income ratio more than other countries." But one seldom sees this - they're almost always cardinal (i.e., absolute) and seldom ordinal (i.e., relative rankings).

One does well to ask, if ratings are relative, why when times are rough are we seeing more downgrades than upgrades? Are they all getting relatively worse than each other? In a relative system, one would hope they would roughly equate.

An Example

When Chinese rating agency Dagong put the USA on negative watch on Christmas, we looked a little deeper into the reasons. Their actual release is a little more detailed, but the Financial Times breaks it down for us as follows:
In placing the US rating on negative watch, Dagong cited five factors: 
1. The US is at an impasse in budget negotiations 
2. With no plan for maintaining solvency, the US is monetising its debt 
3. US government debt is growing much faster than fiscal revenue 
4. The fiscal cliff could lead to a US recession in 2013 
5. Frequent emergencies such as the fiscal cliff and debt ceiling deadlines add to the risks
Nothing relative there, so we went to Dagong's website to look at their definitions.

See the following excerpts:

AAA denotes the "lowest expectation of default risk"
AA "ratings denote expectations of very low default risk"
BB "ratings indicate that the issuer faces major ongoing uncertainties..."
B "ratings indicate that expectations of default risk are relatively high but a limited margin of safety remains." (emphasis added by us)

What does "very low" mean - very low relative to others, or to some absolute standard? To borrow from Arturo Cifuentes, what would it mean to restrict a company from building a "very high" building in New York? Would it be relative to the other buildings or relative to a specific measurement of "high"?

"Lowest" sounds absolute.  "Very low" could go either way.  "Faces major ongoing uncertainties" sounds cardinal, or absolute.  And "Relatively high" is certainly ordinal.  So, we're still not sure - relative or absolute, or a little of each? Does anybody know?

Friday, December 14, 2012

Monitoring Ratings Monitoring

Today's "Administrative Action" announced against Standard & Poor’s Ratings Japan K.K. hones in on just the sorts of problems our transparent ratings "drive" would protect against. 

For those of you who haven't been following, PF2 consultant Marc Joffe's open-source PSCF model has been gaining widespread attention, with Marc being recently commissioned by the California State Treasurer's office to further develop the PSCF default probability model for municipal bonds. 

Japan's FSA makes a strong case for promoting ratings transparency.  Having a transparent model allows others to catch ratings errors before they become too problematic - a positive feedback loop that lends to market stability and to investor confidence. 

It also encourages (or forces) rating agencies to keep current their ratings, minimizing the possibilities for larger rating changes (mostly downgrades) if and when raters notice their ratings are out of sync. 

An excerpt from the Japanese FSA's Administrative Release reads as follows (emphasis added):
"[S&P failed] to properly confirm important information that affects Synthetic CDO ("SCDO") credit ratings

[S&P] did not properly take stock of the cumulative loss amount pertaining to the reference obligations that affects the credit rating of SCDOs. The Company did not take measures such as confirming with arrangers of SCDOs whether there had been any credit events relating to the reference obligations.

Therefore, some cases were identified where incorrect credit ratings had been assigned to certain SCDO products for a significant period of time until just before the withdrawal of the credit ratings due to the redemption of those SCDO products.
The Company has continued publishing the credit ratings of the relevant SCDOs without confirming whether there were any credit events.
The Company incorrectly maintained until October 2010 a credit rating of a SCDO product that should have been downgraded in January and further in February of that year. This is due to input to the Company’s system of incorrect notional amount data in relation to the reference obligations in the monitoring process of the SCDO credit rating.

The Company has not implemented a verification process whereby a second person checks the accuracy of the data input."

Thursday, December 13, 2012

The Real Fiscal Cliff

Recent developments in the fiscal cliff negotiations should put to rest any hope that this process will produce a meaningful solution to the nation’s long term fiscal imbalance. For advocates of fiscal sustainability, the negotiation suffers from two serious flaws:

(1)    The fact that the party leaders are still playing to their respective bases, rather than having serious, closed door discussions. Since real long term reform would be very complex and politically painful, it requires time to run the numbers and build support for the sacrifices required on both sides. If these activities are telescoped into the last two weeks of December, they cannot be accomplished effectively. What we are likely to see then is a deal lacking in specifics with numbers that don’t add up.

(2)    Attention is mostly focused on avoiding the immediate emergency posed by the fiscal cliff and on the top two income tax brackets (the adjustment of which can only generate a small part of the solution). To the extent that attention focuses on the Armageddon that awaits us on 1/1/2013 or the morality of tax rates, less space is available to educate the public about the need to address long term sustainability issues.

To the extent that budget impacts are being considered, the discussion has focused on how to achieve $4 trillion of deficit reduction in the next ten years. The debate typically obscures the question of what “base” the $4 trillion in savings will come from. This base scenario is most certainly not current law – since that would include all the spending reductions and tax increases that compose the fiscal cliff. In fact any fiscal cliff compromise is likely to entail higher ten year aggregate deficits than those that would occur under current law.

Moreover, ten year scoring of budget proposals takes attention away from the most important fact. Under current policies or anything approximating them, the US will probably run deficits of several trillion dollars each year during the late 2020s and early 2030s. This is precisely when the greatest burdens will be placed on Social Security and Medicare because the maximum number of baby boomers will be both alive and retired. Since these big deficits will be piled onto an already large stock of debt, they are likely to trigger some form of sovereign debt crisis. Such a crisis would have devastating effects on taxpayers, government employees, beneficiaries and bondholders – as it would be manifest in some combination of sharp tax increases, deep spending cuts, inflation, and possibly an outright default on Treasury obligations. Some of these effects would probably trigger widespread civil unrest similar to the violence we have been seeing in Greece. Unlike today’s fiscal cliff, which can be avoided through simple legislation, this future crisis would be far steeper and far more difficult to side-step:  revenue and expenditure would be forced to immediately converge due to the unaffordability of deficit financing.

Since I am a financial analyst and not a politician, the preceding narrative contains two serious flaws. I have told you that any crisis is 15 to 20 years away and that it is likely rather than certain. I would better command your attention by claiming that there will be an immediate crisis if nothing is done, but that isn’t credible. Since I am writing for a thoughtful audience, I am confident that you will read on.

Due to the existing low interest rate environment, debt service cannot become an unbearable burden anytime soon. Given the amount of global liquidity and the fact that US debt contains a substantial component of long dated bonds, there is no reasonable scenario under which rising interest rates will trigger a crisis in the near term. To say otherwise might make for a great rhetorical flourish on a talk show, but it just has no economic or mathematical basis.

In the longer term, a crisis is only likely rather than certain for a number of reasons. In general, it is fair to say that any long term prediction has to be qualified just because of the sheer weight of accumulated uncertainties. In this specific case, it is possible that we will be saved by some new innovation that sharply increases productivity thereby generating enough incremental revenue to get us over the hump. Another possibility is that interest rates won’t revert to post-World War II historical averages. Perhaps we have entered a new normal in which massive global savings will continue to compete for an insufficient supply of fixed income investments, or one in which large portions of the federal debt can be monetized without price inflation (due to declining monetary velocity).

On the other hand, there are also extreme scenarios that could exacerbate any future fiscal crisis. A medical breakthrough that significantly extends life spans under the current fixed retirement age system would greatly increase dependency ratios. A major war or series of large natural disasters could sharply increase deficits at any time.

Putting all these tail scenarios aside and focusing on outcomes nearer the median, the fact remains that population aging will probably cause a long term fiscal crisis in the absence of major reform. Failure to plan for this eventuality seems to me to be the height of irresponsibility.

Given the size of America’s fiscal gap and the division of power, the only politically feasible plan is one that increases revenues and reduces spending growth in multiple areas, including discretionary spending, Social Security and health care entitlements. Unless the plan distributes the pain across all areas, it will probably be either too small or unable to become law.

If voters demand government services that roughly approximate those now available, it will not be possible to hold spending to 18% of GDP – a limit suggested by Republican leaders in the 111th Congress. As more and more people draw Social Security and use Medicare services, spending will rise sharply, even if these entitlements are adjusted somewhat. Simply taxing the rich won’t be sufficient to fill the fiscal gap. Higher income taxes at all levels and/or new consumption taxes will be required. As a libertarian, I personally oppose taxes and believe that it would be both morally preferable and economically more efficient to cut spending enough to achieve a primary budget balance without increasing revenues.  But since my party received 1% of the vote in the Presidential election, this plan will not be enacted. Instead, we will either have a plan that includes considerable, broad-based tax increases or one that doesn’t solve the problem.

Prevailing wisdom suggests that domestic, non-discretionary spending programs are individually too small and have too much political support to contribute much to closing the fiscal gap. Cutting them across the board may have adverse unintended negative consequences.  Earlier decades have bequeathed us two ideas that can be used to achieve significant savings in these programs. Zero based budgeting, properly understood, involves a complete reappraisal of all spending items. It is designed to address the question of whether each program remains cost effective or is just continuing due to inertia. Because Congress is too politically conflicted to successfully implement zero based budgeting, it should delegate this responsibility to a bi-partisan commission as it did when base closings were required at the end of the Cold War. A politically neutral zero based budgeting commission could wring substantial savings out of domestic discretionary spending without disrupting truly valued services.

Advocates of military spending often remind us that defense is not a driver of the impending problem because it represents a stable or declining share of GDP – depending upon the base year used. However, if that base year was during the Cold War, the comparison isn’t meaningful. The country no longer needs to stare down the Soviet Union and its network of clients. Rather than exaggerate the threats posed by China, North Korea, Iran and al Qaeda, defense advocates should be supporting the elimination of Cold War oriented weapons programs that are not designed for today’s lesser security issues. Also, since the US represents a far diminished share of world GDP, its relative responsibility for funding alliances like NATO needs to be reconsidered. While it is true that entitlement spending will be the driver of future budget imbalances, there is no reason that offsetting savings cannot be found elsewhere in the budget. A dollar spent on defense has the same budgetary impact as a dollar spent on Medicare. The budget can and should shift away from defense and toward entitlements.

Social security proponents take a similar tack to the defense hawks: “our favorite program is not really the problem so let’s look elsewhere for savings.” Often the argument revolves around the fact that the Social Security trust fund is not expected to be drained for a couple of decades. But since the trust fund is simply money that the government owes to itself, it is not fiscally significant. More important is the annual gap between social security tax revenues and benefits. Until recently, this difference was positive, now it is near zero and by 2030, it will be negative to the tune of half a trillion dollars annually. While incremental reforms cannot eliminate this annual social security deficit, they can reduce it to the extent that added revenue and other budgetary savings can offset it. The most obvious reforms include making the retirement age a factor of life expectancy – as Italy has recently done – and making downward adjustments to benefit formulae.

While everyone agrees that Medicare is a huge budget problem, the solutions offered often fail to miss the fundamental issue this system poses – an issue that also applies in part to Medicaid and future Affordable Care Act benefits. The US health care system is unique in that it largely fails to use either of the two proven methods known to control costs. In a totally free market system under which patients are fully responsible for their own medical bills or insurance, cost growth is limited by the fact that many people will be unwilling or unable to pay for certain medical services. Since this results in richer people getting better care – an outcome that most people find offensive – all advanced countries have some form of government-sponsored third party payment. However, most countries that have government controlled health systems use non-price rationing to control costs. These rationing tools include waiting lists and “death panels” that deny certain types of care. A meaningful solution to Medicare and other health entitlements is going to require some form of rationing – either through greater patient responsibility as advocated in the Ryan budget or through a strengthened version of the Independent Payment Advisory Board (IPAB) included in the Affordable Care Act. A compromise approach might involve some sort of bimodal system in which beneficiaries could choose between a government -managed HMO (akin to the public option discussed during the health reform debate) and a market based option under which patients receive limited premium support.

Reforms of the type discussed here cannot be formulated and sold to the American people during a couple of weeks in the holiday season. They need to be well designed in order to limit adverse unintended consequences and carefully balanced to ensure that enough House and Senate votes can be cobbled together from those closest to the political center. In the absence of evidence that these planning processes are occurring, I am left with the assumption that any end of year package won’t avert the long term fiscal crisis we now face.

Tuesday, November 27, 2012

Not for Profit Sovereign Ratings Become a Reality

Last week, the Bertelsmann Foundation issued ratings and supporting research for five sovereign bond issuers – Brazil, France, Germany, Italy and Japan. The individual country reports, a summary and a description of the rating methodology are available at

The publication of these reports marks a substantial milestone. The Foundation has delivered on the ideas outlined in its April 2012 blueprint for an International Non-Profit Credit Rating Agency (INCRA). It has shown that a not-for-profit organization can produce quality sovereign credit research competitive with that offered by incumbent rating agencies. Further, unlike commercial players, this not-for-profit agency consistently implements a transparent rating methodology.

Last week’s reports show that the Bertelsmann Foundation can produce very detailed research. This should not come as a surprise, since the Foundation has experience in producing comprehensive research in support of its Sustainable Governance Indicators and Bertelsmann Transformation Index. Many think tanks and academic research groups produce reports that compare multiple governments and other institutions. The data collection and interpretation processes used by these non-profits are analogous to those required to rate sovereign governments.

The consistency and transparency of the reports is also noteworthy. The Foundation scores each country according to several dozen macroeconomic and forward looking indicators. The score for each indicator is reported, a published algorithm is used to aggregate the scores and the composite score is converted to a letter grade via a standard mapping.

It is not clear whether the Bertelsmann Foundation plans to issue more sovereign rating research. Comments from organizational leaders suggest that this set of reports constitute a pilot and further steps would have to be taken by a new organization – ideally one supported by an endowment to the tune of $400 million. The endowment would enable the rating organization to operate free of the need to generate income and the temptations for bias such a need entails.

My own view is that biases can be addressed through transparency. If others can look under the kimono, assumptions and procedures that introduce bias can be flagged - placing pressure on the rating issuer to correct them. Since $400 million is not likely to be found in the NGO world, there has been some discussion of securing INCRA funding from the G-20. But a group of sovereigns funding a sovereign rating process could be an invitation to bias.

Friday, November 2, 2012

Rated vs. Unrated Bonds

One of PF2's experts recently testified that a rated bond is worth more than an unrated bond. Was he right?

Let's consider this from the perspective of structured finance. One often hears the question: "how can you take all this sub-prime and make AAA out of it?" Of course, that's the whole premise of structured finance - that one can take a portfolio of (more) credit risky assets and create at least some less credit risky (AAA) assets out of it. 

But if we dig deeper into what's happening, we see it's simply a ratings transformation that's taking place. The securitization process enables a bundle of unrated securities (e.g. mortgage loans or credit card receivables) to be "converted" into a set of (tranched) rated notes. 

The rated notes - in higher demand, more liquid, and demanding less regulatory capital - are cheaper to issue, creating the so-called "excess spread." In sum, acquiring a cheap rating enables the wider dissemination of all sorts of securities, through the securitization process. 

The rating provides this value - liquidity, increased demand, lower capital requirements. And so a rated bond is worth more than an unrated bond. What do you think?

Note: Keep in mind the argument is not that ALL rated bonds are worth more than ALL unrated bonds, but that all things equal the rated bonds are worth more: that the rating, reliable or not, provides a value.

Thursday, October 18, 2012

Canadian Provincial Debt

Marc's recent research on the financial strength of the Canadian provinces was (finally) published yesterday and is getting some good attention today. 

If interested, have a look at the Wall Street Journal's coverage here.

- PF2

Monday, September 24, 2012

Bringing Academic Rigor to Government Bond Ratings

Since peaking in July, yields on Italian and Spanish long-term bonds have dropped by about 150 basis points. While the headlines attribute this sharp adjustment to the availability of a new ECB bond buying program, neither country has expressed an intention to use it, so perhaps the headline writers are missing something. Looking back, our July 23rd research note concluded that the spread between Italian and German bond yields was excessive given the low probability of an Italian sovereign default.

A Problem of Information

Market volatility is compounded when market participants lack the information necessary to appropriately value investment securities. When rumors and announcements penetrate the information vacuum, investors often overreact. If this vacuum is instead filled with high-quality information and analysis, volatility and mispricing diminish.

Equity market investors can obtain research and analysis from numerous banks and brokerage firms. While much of this research suffers from conflicts of interest, it also contains large volumes of fact and analysis that investors find useful.

For government bonds, the traditional source of analysis has been the major credit rating agencies. Unfortunately, these firms have faced widespread criticism in recent years, leaving their reputations in tatters and their guidance in doubt. Although the highest profile failures have been in structured finance, critics have also questioned whether incumbent rating agencies have sufficient staffing and resources, adequate procedures, and the intellectual capability to meaningfully gauge sovereign default risk.

Potential Ways Forward – A Call to Academics

A number of parties have recommended alternatives to the incumbent rating agencies, including at least four not-for-profit initiatives offering sovereign ratings.

To have a beneficial impact, a non-profit rating agency will have to gain credibility with investors. After all, if ratings don’t guide investment decisions, what value do they have? A not-for-profit credit rating agency can gain credibility by having a strong methodology and solid institutional support. Both of these factors can be advanced by the academic community. Economists, political scientists, statisticians and financial engineers associated with a major university could generate the kind of quality, branded sovereign research that would command the attention of investors.

In hopes of focusing more academic attention on government credit risk, I have contributed an article to the new issue of Economics Journal Watch – a peer-reviewed economics journal freely available online. The article describes problems with the rating agency model, surveys some of the previous literature on government default probability modeling, and offers a research agenda as well as one possible solution.

Academics can deliver the intellectual rigor missing from both status quo rating analysis and some of the alternatives we have been seeing. The thorough data collection procedures, advanced modeling techniques, and peer review practices employed by social scientists can raise the level of sovereign risk analysis.

Wednesday, September 19, 2012

One Bond, One Price

The contemporaneous "scandals" recently covered in the media - the alleged manipulation of LIBOR and the possibility that JPMorgan used its VAR model to help disguise the riskiness of its portfolio - return us directly to the very shortcomings that led to, or exacerbated, our financial crisis. 

They provide ready examples of the frailty of our financial controls, and acute reminders of what can happen when financial institutions have the incentive, and capacity, to massage financial data and disclosures. 

It ought not to surprise anybody that, when trying to maximize their gain under a poorly-designed incentive structure, financial market professionals might choose to manipulate valuations or massage disclosures to their advantage. Would not most players maneuver to their benefit? 

The problem here, of course, is their capacity to massage important data on a large scale. Back in 1994, Kidder, Peabody's Joseph Jett was purportedly able to exploit an anomaly in Kidder's accounting system, booking substantial profits in the absence of any genuinely profitable trades. 

Almost twenty years after the "Kidder Scandal," our system remains open to abuse. 

The lack of transparency in our reporting, and the ability to finesse asset valuations, create an environment in which the value of a bank's assets quickly becomes whatever the bank wants it to be. Banks and funds need little incentive to inflate their asset prices: higher asset valuations typically lead to improved performance, which enables banks or funds to raise more capital at reduced rates. Imagine if mortgage borrowers could value their own houses and have their mortgage rates reduced based on their own inflated appraisals! 

It is time to realize that the current system does not work - it cannot. We can no longer rely on an institution to accurately evaluate its own assets, while being knowledgeable of the many and material conflicts it faces. We also cannot blindly trust the auditing firms to catch the cover-ups. Their success rate has been too low. 

One advantage of the ratings-based system - a system from which we're energetically moving away - is that it provided a single rating for each bond. It is true that banks may reserve different amounts of capital against each rated bond, but at least we knew that it was always one bond, one Moody's rating.  

Right now, however, there is virtually no pricing control - no consistent mechanism for the valuation of complex and illiquid transactions. One bond can have many prices, depending on who provides the price. We see regular examples of traders who mark their own portfolios, while earning bonuses and promotions based on their self-constructed performance. We often find that two similar banks, supervised by the same regulator, can hold the same security at materially different prices. JPMorgan itself was recently reported to have held the same bond in two different divisions at different prices. Banks can "shop" for opportunistic evaluations, just as they could actively seek the highest ratings, which precipitated a lowering of ratings standards. How does this all promote shareholder confidence, or cross-institutional comparability? 

Goldman Sachs, Wachovia, Bank of America, Citigroup and others have recently been accused of mispricing securities in one way or another. Traders at UBS, Deutsche Bank, Credit Suisse, RBS have been criticized for mismarking bonds. Hedge funds and asset managers have been accused of overvaluing their funds' positions and the audits of Deloitte, PwC and KPMG have all come under scrutiny for their failure to capture their clients' misrepresentations and securities mispricings. 

The list keeps growing. In last week’s case filing In re Lehman Brothers Holdings Inc., et al v. JPMorgan Chase Bank NA, the Lehman plaintiffs argue that the JPMorgan entities’ derivatives claims are inflated as a result of procedures including “the inconsistent valuation of trades to the JPMorgan Entities’ advantage.” 

While the problem of inconsistent, utility-maximizing pricing is overwhelming, the solution is simple. It only requires the political power for its implementation. All financial institutions should be forced to carry the same bond at the same price. Any digression from market pricings should be accompanied by appropriate disclosure that describes the reason for, and magnitude of, the deviation. Furthermore, any internally-marked positions should be open to public scrutiny especially for those institutions considered "Systemically Important Financial Institutions" (or SIFIs). What is there to hide, anyway? 

Supervisory authorities would have only to decide on the framework for deriving the ultimate price. There are several options available, not the least of which is to follow the precedent set by the National Association of Insurance Commissioners. The NAIC selected PIMCO and Blackrock Solutions, respectively, to help it determine risk-based capital requirements for insurers’ holdings of residential and commercial mortgage-backed securities. Rather than calculating capital reserves, one could implement an algorithm that produces a price. Another approach would be to create a central pricing repository which would accept a range of prices submitted by regulator-approved price providers. The final price could then be determined by applying an averaging process, for example, or by taking the median of the submissions. 

Pricing transparency, and a forum for the provision of feedback to the extent assets are being mispriced, would enhance investor confidence in the reliability of banks' balance sheets. Confidence and transparency, of course, lead to market liquidity. After the crisis of confidence we have had, and the associated liquidity freeze, wouldn't that be nice? 

Additional Resources 

Thursday, August 16, 2012

This Just In: Thousands of Secret Municipal Bond Defaults

The Washington Post, New York Times and other media are reporting on a Federal Reserve blog post revealing the existence of over 2500 municipal bond defaults not previously reported by the major rating agencies. Before municipal bond investors panic, we need to consider several points.

First, this large number of defaults should be considered in the context of the number of issuers and the length of time examined. There are approximately 60,000 municipal bond issuers and this number has not changed that much in recent decades. The Fed data contains 2521 defaulting issuers for the 42 year period ending 2011. That represents an average of about 60 defaults annually and an average annual default rate of roughly 0.1%.

Second, similar default statistics have been reported before. Anyone who subscribes to Richard Lehmann's Distressed Debt newsletter and database knows that he has cataloged about 3500 municipal bond defaults since 1980 (this number refers to the number of defaulting bonds rather than bond issuers - which is one reason that it is higher than the Fed's number). Lehmann's data was summarized in a 2011 Kroll Bond Rating Agency Municipal Default study that I co-authored. So the Fed's findings really aren't news.

Third, as mentioned in the Fed blog post and elsewhere, the vast majority of the defaults are not General Obligation or tax supported issues of states, cities, counties, towns or villages. Instead, they are mostly revenue bonds financing specific projects or facilities. So these situations should not be conflated with the cases of Stockton or San Bernadino.

Finally, most of the defaulting issuers are quite small. For example, as Bloomberg reported recently, a large concentration of municipal bankruptcy filings occurred in Nebraska.

Almost all of these filings were by Sanitary and Improvement Districts (or SIDs). Approximately 45 of these districts have filed municipal bankruptcy petitions since 1982. The bulk of these bankruptcies have occurred in Douglas and Sarpy counties. Douglas County includes the City of Omaha, while Sarpy County includes most of Omaha’s southern suburbs.

SIDs finance sewer, lighting, paving and other improvements in unincorporated areas selected by developers for the creation of new subdivisions. Costs for these improvements are financed by special property tax assessments on lots within the subdivisions. Bonds are often financed by the SID with special assessment revenues, typically collected over a period of ten years, generating funds to redeem the bonds. SIDs are typically quite small, encompassing one subdivision or a small number of subdivisions. Most of the bankrupt SIDs I examined had fewer than 200 lots. Their size is thus similar to that of a Home Owners Association, although the range of services provided differs.

So the conclusion is that a lot of small revenue bond issuers have defaulted over the years. This is not news and should not fundamentally alter the perception that municipal bonds in general - and tax supported bonds issued by states and larger cities - have relatively low default risk.

Friday, July 27, 2012

Agency Shortcuts and Shortfalls

Investors in certain "AAA" resecuritizations won't be happy. Late last night, Moody's downgraded a bunch of securities, even though they are supported by Agency-guaranteed RMBS.

Many of these were downgraded from Aaa to junk (some at Ba1, others all the way to B1) in one fell swoop, while others went only to A1.  (It looks like S&P still carries most of these securities at AA+, which is lower than Moody's Aaa as S&P has downgraded the United States to AA+.)

What's most interesting here is the reason.  It's not the case that either Fannie or Freddie hasn't paid up on their guarantees, but it looks like the deals may not have been modeled (possibly ever!) - or at least may not have been modeled correctly.  According to their press release, the resecuritization vehicles seem not to have the necessary protections in place to support the bonds issued, or the ratings provided.  Some of these deals were structured in 2007 and even late 2008.  Many of these deals are already suffering shortfalls.

From Moody's press release:
"The downgrade rating actions on the bonds are a result of continual interest shortfalls or lack of adequate structural mechanisms to prevent future interest shortfalls should the deals incur any extraordinary expenses."

... and ...

"Interest due on the resecuritization bonds is not subject to any net weighted average coupon (WAC) cap whereas interest due on some of the underlying bonds backing these deals is subject to a net WAC cap."

... and ...

"Since the coupon on the resecuritization bonds is currently higher than that of the underlying bonds, the resecuritization bonds are experiencing interest shortfalls which on a deal basis are accruing steadily."

Total issuance of $483mm affected, according to Moody's. Deals are of Structured Asset Securities Corp. and Structured Asset Mortgage Investments shelves.

Relevant CUSIPs Downgraded Last Night

Monday, July 23, 2012

Marc Joffe Discusses Pros of Open Source Rating Models for Sovereigns / Munis

On Friday night, PF2 consultant Marc Joffe was profiled on The Lang and O’Leary Exchange, a popular Canadian business program.

Tuesday, July 3, 2012

LIBOR and Transparency

Americans obsessing over last week’s healthcare decision or zoning out ahead of July 4th may have missed the latest episode in the financial industry corruption soap opera. Last week. Barclay’s agreed to pay a $453 million fine for misreporting the rates at which it borrowed funds to the British Bankers Association, thereby distorting the value of the London InterBank Offer Rate (LIBOR). The bank’s Chairman and COO have both stepped down.

This instance of financial industry malfeasance appears to lack the compelling narrative needed to upset the general public. For those advocating on behalf of the “little guy”, this scandal may lack appeal, since most of the LIBOR manipulation appears to have been downward -thereby lowering mortgage rates paid by ordinary borrowers. Financial industry critics seem less concerned by the fact that many “little guys” who directly or indirectly invest in LIBOR-based vehicles were cheated out of some income. Journalists and bloggers have thus focused their ire on the rich and powerful individuals who have been caught cooking the books. This is unfortunate, because chopping off a few heads is not the real solution. As we will see in the coming days and weeks, misreporting of bank borrowing rates was pervasive. It is simply too tempting for most of us mortals in the financial industry to resist.

Rather than focus on the people involved or expect bank executives to morph into Mother Theresa, we should instead direct our attention to fixing the institutional framework. The problem is with how LIBOR and many other financial market prices and rates are estimated and reported. The systems we have are too easy to game and the benefits of gaming them are simply too great to resist.

In the case of LIBOR - as with bank loan prices and CDS spreads - the mechanism involves dealers reporting their bids and offers to a data aggregator, like Thomson Reuters or MarkIt. The aggregator then averages the reported quotes, often dropping the highest and lowest marks from the composite. As we’ve now seen, these dealer quotes are subject to manipulation. In less liquid markets, they may not be updated regularly since the dealer does not see new bids or offers. In either case, the composite marks reported by the aggregator do not reflect actual value.

This should concern everyone (who pays taxes to bail out banks), because it means that we don’t really know what most bank assets are worth. A better alternative would be to require all bank transactions to be reported and made publicly available. Reporting should be real time, easily accessible on the internet and as detailed as possible. Specifically, consumers of the data should be able to identify inter-dealer trades that may be executed for the purpose of manipulating mark-to-market prices.

Comprehensive transaction reporting will not be welcome by many in the financial industry. Although the major complaint may revolve compliance costs, these should be minimal, since banks already have to collect all of the transaction data for their internal systems. The real concern will be the loss of income suffered by traders, who realize significant gains from the opaqueness of many markets. Of course, that issue is much less of a concern for the rest of us.

With a few spectacular exceptions, prices of equities and other exchange traded products have proven trustworthy because of their relative transparency. By making markets for bank funding, asset backed securities, derivatives and exotic fixed income instruments more transparent, we can restore trust in quoted prices, enhance liquidity and increase the stability of our financial system.

Rather than simply scapegoating those who were caught, let’s use the LIBOR scandal as an opportunity to provide more transparent and reliable pricing not only to the market for short term bank financing, but to all markets touched by our “too big to fail” financial institutions.

Friday, June 1, 2012

One Bond - Three Prices

The challenges of appropriately pricing illiquid assets have returned, with JPMorgan reportedly having valued the same trades at different prices in separate departments of the bank.  To be fair, the current pricing regime enables these types of discrepancies to occur, and it makes it difficult to catch them.

But this time, the problem was big enough to get some attention.  From Bloomberg's JPMorgan CIO Swaps Pricing Said To Differ From Bank:
The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., may have obscured by hundreds of millions of dollars the magnitude of the loss before it was disclosed May 10, said one of the people, who asked not to be identified because they aren’t authorized to discuss the matter.
We've been writing about this problem for while - that in some cases hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

The problem here is the same as with “ratings shopping,” where market participants seek the highest ratings on their securities.  Here, investors are financially incentivized to seek out the highest value they can find for each security: funds’ performance (and often their managers' bonuses) is directly determined from the valuations of their assets. Stronger performance, whether real or artificial, can even help a fund or company raise new capital.

In yesterday's Financial Times, Michael Mauboussin and Alfred Rappaport added to the conversation on pricing transparency. A solution they put forward is to add more meaningful disclosure around the asset pricing, rather than reporting a single estimate. Their approach isn't novel, but it's worth consideration.  They suggest a three-pronged approach: 
This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat. The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.
We're interested to hear what you think.

For a list of problematic asset pricings, click here.
For our suggestion of one solution to the problem, click here.
For more on this, including Citi CEO's Vikram Pandit's proposal and that of Barclays' Group Finance Director Chris Lucas, click here.

Tuesday, May 29, 2012

The Safety of State Bonds: A Historical Perspective

By Marc Joffe

The last state general obligation bond default occurred in 1933. Yet many state GOs yield significantly more than US Treasury bonds, reflecting investor fears of future defaults. While past results are no guarantee of future performance, history does offer investors valuable insights into our present situation.

As Table 1 shows, state and territorial bond defaults were relatively frequent during the 19th century.

Table 1. List of State Bond Defaults.
c. 1870

New York Times (1930)

English (1996)
Some bonds repudiated in 1884
KBRA (2011)

English (1996)
Territory; Debt repudiated
c. 1870

Ratchford (1941)

c. 1870

New York Times (1930)

English (1996)

English (1996)

English (1996)
Some bonds repudiated
KBRA (2011)
Due to failure of Hibernia Bank
English (1996)

English (1996)
Some bonds redeemed at 30%

Ratchford (1941)

English (1996)
Mostly repudiated
c. 1870

Smythe (1904)

North Carolina
c. 1870

New York Times (1930)

English (1996)

South Carolina
c. 1870

New York Times (1930)

South Carolina

KBRA (2011)
No loss of principal or interest; maturing bonds were redeemed with new bonds rather than cash.
c. 1870

Ratchford (1941)

c. 1930

KBRA (2011)
Interest and principal not remitted to certain state-controlled funds; individual investors do not appear to have been impacted.
c. 1870

Ratchford (1941)

West Virginia
c. 1870

New York Times (1930)

English, W. B. (1996). Understanding the Costs of Sovereign Default: American State Debts in the 1840's. The American Economic Review, 86, 259-275.
Kroll Bond Rating Agency (2011). An Analysis of Historical Municipal Bond Defaults Lessons Learned – The Past as Prologue.
New York Times. Old Repudiated Debts that Stir the British. August 10, 1930. Page X12.
Ratchford, B. U. (1941). American State Debts. Durham, NC: Duke University Press.
Smythe, R. M. (1904). Obsolete American Securities and Corporations. New York: R. M. Smythe.

Most of the 19th century defaults occurred in two waves: one that followed the Panic of 1837 and the other following the Civil War. The first wave of defaults happened after a number of states made heavy investments in canals and state-chartered banks. In the deflationary years that followed the 1837 financial collapse, eight states and the territory of Florida failed to service their obligations. A recent article by Jeff Hummel provides an excellent summary of this situation, along with references for further reading.

The post-Civil War defaults were concentrated in ravaged Southern states, many of which took on substantial loads of debt under “carpetbagger” controlled governments. The carpetbaggers – northerners who came down south with their possessions wrapped in old carpets – seized control of some state governments, issued bonds and then kept much of the proceeds. When local politicians regained control of state governments, they deemed the carpetbagger-incurred debt as illegitimate and repudiated it.

Since the 19th century, all states with the exception of Vermont have implemented balanced budget requirements and other restrictions on debt issuance. As a result, state bonded indebtedness as a percentage of GDP has remained relatively low, while the national debt has skyrocketed.

During the 20th century, there was only one case in which a state bond default resulted in losses for individual investors: the Arkansas default of 1933. Arkansas got into trouble after assuming a large volume of road bonds issued by local governments during the 1920s. This heavy debt load combined with sharply decreased property tax collections (the result of falling property values during the Depression) rendered the state insolvent.

Many readers will undoubtedly be skeptical of state balanced budget requirements given the many news reports of politicians circumventing these restrictions. While elected officials do employ many gimmicks, they also impose real spending cuts and revenue enhancements when closing budget gaps. The result is some growth in debt burdens, but not nearly enough to trigger a solvency crisis. Professors Daniel Bergstresser and Randolph Cohen provide a detailed discussion of constitutional balanced budget rules, methods used to circumvent them and their overall restraining influence in a recent Harvard Business School paper.

Evaluating a Government’s Debt Burden

A government’s debt burden is often stated in terms of a Debt-to-GDP ratio. This ratio scales debt to the size of the economy, thus providing a more consistent measure across political subdivisions with varying populations and wealth. The Bureau of Economic Analysis reports US GDP by State. This BEA measure is called Gross State Product (or GSP). The Census bureau collects state and local government financial data (including indebtedness) each year, with the most recent data being available for Fiscal 2009. By combining the BEA and Census data set, we can measure Debt/GSP by State, as we do in Table 2.

Table 2. Debt/GSP Ratio By State, 2009
Total Debt
Gross State Product
Debt/GSP Ratio
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Rhode Island
South Carolina
South Dakota
West Virginia
50 State Total

By international standards, these ratios are quite low – well below those of the US federal government and other major Western countries. They also compare favorably to large Canadian provinces such as Quebec and Ontario – which had bonded debt to gross product ratios of 44% and 30% respectively in 2009 (according to public accounts documents filed by each province).

Also, it is worth noting that the Census debt totals include much more than a state’s general obligation bonds. These totals also incorporate revenue bonds, industrial revenue bonds, pollution control bonds, special assessment bonds, certificates of participation (COPs), judgments, mortgages and construction loan notes (CLNs) – which are generally junior to general obligations.

When assessing states and national governments, rating agencies often consider the ratio of interest expense to revenue. This ratio is more useful that Debt/GDP because it also reflects the impact of interest rates and the government’s ability to derive revenue from the economy. Japan, for example, can sustain very high Debt/GDP ratios (above 200% by some measures) because it faces very low interest rates. Governments that have relatively limited ability to extract revenue like Greece (due to tax evasion) and the US federal government (due to difficulty of passing tax increases) may face crises at lower levels of Debt/GDP. American states also face lower ceilings on their Debt/GSP ratios because their ability to raise tax rates is limited by the relative ease of relocating to another state (as opposed to another country).

Table 3 shows Interest Expense to Revenue ratios based on Census data.

Table 3. Interest Expense to Total Revenue, 2009
Interest Expense
Interest/Revenue Ratio
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Rhode Island
South Carolina
South Dakota
West Virginia
50 State Total

These ratios reflect each state’s total revenue – not just its general fund revenue – and its interest expense on all bonds – not just general obligations.

When Arkansas defaulted in 1933, its interest to revenue ratio was about 30% - well above the level in any other state at the time and well above present levels. The only two other defaults during the last century by governments similar to US states in comparable nations (New South Wales, Australia in 1931 and Alberta, Canada in 1936) also occurred after the interest to revenue ratio exceeded 30%.

Applicability to Today

Could a state default with an interest to revenue ratio significantly below 30%?  While any financial result is possible, it is highly unlikely. Default is a political decision in which elected officials balance two considerations: (1) inability to spend money on programs due to debt service expenses versus (2) embarrassment and loss of bond market access by defaulting.

When interest expenses are a relatively low proportion of revenue, defaulting does not make any political sense. Indeed, defaulting makes much less political sense now than it did in the 19th century or during the Great Depression.

Most state debt in the 19th century was held in Europe. In 1933, most Arkansas debt was held by investors in other states - in New York and elsewhere. With the inception of state income taxes and their exclusion of most in-state municipal bond interest, a very large proportion of state bonds are now owned by high income residents. Since the bonds are in the hands of voters and campaign contributors, the choice to default is even more politically suicidal than in was in the 1930s.

Pensions and Retiree Benefits

Fears about current state credit quality center around public employee pensions and other employee benefits.  The size of this problem – from a credit standpoint – is often exaggerated because the unfunded liability is juxtaposed with the state’s annual budget. Since the unfunded liability is payable over many years, this comparison is faulty. Further, unfunded liabilities quoted in the media often apply to an entire pension system, whose costs are only partially borne by the state. For example, the State of California is responsible for only about 36% of the beneficiaries in the CalPERS system (according to page 151 of the CalPERS 2011 Comprehensive Annual Financial Report.

Underfunded state employee pensions are nothing new. The problem was also common in the 1970s and early 1980s – the last period of extended poor stock market performance – and did not produce any general obligation defaults. Statistics published by Alicia Munnell and her colleagues at the Boston College Center for Retirement Research show that pension contributions as a proportion of state budgets have yet to return to the peaks reached thirty years ago.

Unfunded retiree health benefits have also been a constant. While it is true that health care costs have risen substantially in recent decades, much of this extra cost is borne by Medicare.


When considering the risk of a state G.O. bond default, investors should be careful to separate their political views from actionable investment information. Inadequately funded retirement plans and political evasions of balanced budget requirements are bad public policies – worthy of criticism in the court of political opinion. Whether these issues are serious enough to trigger an outright default on principal and interest payments, is a very different question, and one that is best answered through historical research and quantitative analysis.

Marc Joffe is a consultant with PF2 Securities Evaluations, which recently published an open source Public Sector Credit Framework. In 2011, he researched and co-authored Kroll Bond Rating Agency’s municipal bond study. Prior to that, Marc was a Senior Director at Moody’s Analytics. Marc owns State of California bonds.