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?

1 comment:


The only solution to the euro debt crisis is Jim Rogers solution Default and start over.