Thursday, January 31, 2013

The California Ontario Ratings Paradox

Today, the Fraser Institute published a compendium entitled “The State of Ontario’s Indebtedness” which includes my research comparing Canada’s largest province to California, America’s largest state. While media reports often suggests that California is on the verge of bankruptcy, the Golden State appears to be a model of fiscal probity when compared to Ontario. Consider these 2011 statistics from the report:

Total Bonded Debt
$236.6 billion
$143.9 billion
Bonded Debt-to-GDP
Bonded Debt Per Capita
Interest Expense
$9.5 billion
$ 5.5 billion
Interest Expense to Revenues
Deficit (Fiscal 2011)
$14.0 billion
$2.6 billion
Source: Fraser Institute based on California Comprehensive Annual Financial Report and Ontario Public Accounts. For comparability. California debt includes that of separately reporting component units.

Now, guess which of these sub-sovereigns has a lower rating. While reason suggests Ontario, the fact is California is rated below Ontario by the three major rating agencies. Here are the ratings:

Standard & Poor’s

Rating agencies have admitted to applying a different, harsher, scale to US municipal bond issuers – including states –compared to other types of debt. In testimony to a US Congressional Committee, Moody’s Managing Director Laura Levenstein reported that this dual scale (i.e., one more severe rating system for US municipal bonds and another, less punitive scale for all other long term instruments) originated when John Moody first issued municipal bond ratings over 90 years ago.

In an attachment to written testimony to the same Congressional committee, California State Treasurer Bill Lockyer reported that when the state issued a taxable bond in 2007, Moody’s assigned a rating of A1 on its municipal scale and Aaa on its global scale. The implication is that Moody’s would have assigned California its highest rating – above that of Ontario – if it employed a single rating scale.

After being sued by Connecticut Attorney General Richard Blumenthal (now a US Senator), Moody’s and Fitch rescaled their municipal bond ratings, while S&P claimed that no such adjustment was necessary.

Not only was such a rescaling sorely needed, but it appears that the rescaling that was performed was insufficient. As I’ve discussed on ExpectedLoss previously, the inconsistency between municipal and other ratings is harmful to taxpayers. Monoline insurers arbitraged this discrepancy by selling unneeded insurance to general obligation issuers that have a long-term historic default rate on the order of 0.1%. If corporate and municipal ratings reflected similar default risk, it would have been impossible for an undercapitalized insurance provider to sell a wrapper to the nation’s largest state. As long as municipal and corporate ratings remain inconsistent, the risk of the monoline insurance business returning persists.

Also, besides ensuring that ratings for different asset classes have consistent definitions in default probability (or expected loss) terms, rating agencies should improve their monitoring efforts by using models that can be automatically updated as new fiscal data becomes available.

For example, we recently learned that California’s budget deficits have been closed through a mixture of tax increases and spending cuts. Yet the state’s ratings remain fixed in single A territory. If rating agencies ran new revenue and expenditure figures through a fiscal simulation model - like our Public Sector Credit Framework - they would be able to adjust their ratings more promptly. 

In Part II of this blog post, I will provide some comparative information on California and Ontario education, health and pension costs.

Saturday, January 26, 2013

The Weak Underbelly of Capitalism

Appraisals. Auditing. Equity Research. Credit Ratings.

These four seemingly unrelated disciplines serve a common purpose. They inform investors about the value and risk of potential investments. If executed well, these services ensure that capital is invested wisely and in a way that promotes economic growth. If executed poorly, these services produce inefficiencies that hinder growth and, at worst, trigger recessions.

Headlines from the last two decades provide us with ample reason to believe that these services are not always performed well. Shoddy audits of Enron were a major enabler of that company’s massive fraud. The internet bubble was abetted by compromised research issued by analysts receiving a share of underwriting fees. Exaggerated appraisals and lenient credit ratings created the subprime bubble and heightened the magnitude of the reversal in home prices - the collapse of which still resonates.

The problem is that these four (supposedly independent) “gate-keepers” are often compromised by business considerations. The people who conduct these types of analysis are rarely at the top of the food chain in the industries they serve. They can be bullied or bribed by rainmakers at their firms or by clients to distort their findings. While outright fudging of the numbers often occurs, the more widespread problem is the selective use of “facts” to produce a desired result in line with preconceived notions. The product may not be an obvious, outright fraud, but even if it’s not, it is often harmful. Fraudulent and incomplete analysis causes the ongoing misappropriation of trillions of dollars of savings. One might call this situation “the weak underbelly of capitalism” – if you are willing to apply the term “capitalism” to today’s economic system.

The problem of biased, inadequate analysis is difficult to address through regulation alone. Even the best regulators can’t be in the room every time an analyst is encouraged to “massage” his or her findings. Much of the analysis is specialized and complex, rendering it difficult for individual regulators to identify shortcomings. Further, like analysts themselves, regulators are also not at the top of the financial industry food chain. Since both analyzing and regulating don’t offer the maximal compensation afforded by managing and rainmaking, members of the first two groups are often outsmarted or manipulated by those in the latter two groups.

Although these four services are products of the market, they can nonetheless be healed through market processes. How? It is often said that “sunshine is the best disinfectant.” In the financial industry, intermediaries maintain their margins by keeping information to themselves. But if more eyes are available to review any given analysis, the biases and distortions affecting this analysis are more likely to be identified and fixed. Further, best practice in each analysis profession can evolve rapidly through peer review, just as the highest visibility Wikipedia articles evolve rapidly toward accuracy and completeness.

The internet, and the Wikis and open source projects it nurtures, can provide the remedy to the “weak underbelly of capitalism” identified here. By making analyses public, and thus subject to widespread review, discussion and editing, these work products can converge toward an optimum.

This outlook motivated me to create an open source government bond assessment tool, the Public Sector Credit Framework (PSCF). This framework enables a user to build a multi-year budget simulation for any government and to use the results to estimate a default probability as well as an implied rating for that government. All source code for PSCF is posted on GitHub, a popular open source repository.

While I was getting started on this project, I learned about a parallel effort launched by a Swiss-based mathematician named Dorian Credé. His web site, Wikirating, directly applies Wiki technology to assessing a broad range of credit instruments. In November, Dorian and I announced a content sharing partnership. Maybe this can be the beginning of a network of mass collaboration efforts focused on improving the quality of credit ratings. And, perhaps, lessons learned in these endeavors can be applied to the other disciplines that inform investors.

Credit ratings, appraising, auditing and securities analysis are all important functions that need reform. Rather than seek top down solutions to improve these services – solutions which often come with adverse unintended consequences – let’s use the organizing power of the internet to find voluntary, collaborative alternatives.

We welcome any responses, and look forward to working with any academics or market participants out there who share a similar interest in creating an alternative, transparent framework that supports investment analysis.

An earlier version of this post appeared on The Progress Report.