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 http://www.bfna.org/.

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.