Friday, February 15, 2013

Moody's "Expects" DoJ Lawsuit to Cost S&P Less than $10mm

Wow, we're finally talking "expect[ed] loss."

So here's the theory.  Moody's and Fitch have both been considering downgrading S&P's debt since September 2011.  Apparently there was much uncertainty which has been removed now that a multi-billion-dollar lawsuit has been filed, and both rating agencies have quickly downgraded S&P: Fitch downgraded from A- to BBB+ and Moody's from A3 to Baa2.  (How similar their opinions are!)

It's easier to dig a little deeper on Moody's side -- Moody's rating speaks directly to an expected loss.  

According to Bloomberg data, McGraw Hill has two debt issues outstanding, each for $400mm, with one maturing in 2017 and the other in 2037.  The ratings are identical for each issuance, irrespective of its maturity.

For the 2017 bond, the rating downgrade from A3 to Baa2, maps to an increased expected loss estimate change from approximately  0.3% to roughly 0.66% (using 4-year maturity as an estimate).  The difference is 0.36%, which comes out to about $1.5mm on a $400mm bond.

For the 2037-maturity bond, the downgrade maps to an expected loss estimate that increases to 6.35% from 4.17%  (using 24-year maturity as an estimate).  Even that's not too much - roughly $8.7mm.

In sum, Moody's is saying that thanks to the DoJ's filing, S&P's bondholders are "expected" to lose the present value of less than $10mm down the road. ("Less than" - because S&P was already on watch for downgrade prior to the Dept. of Justice's filing.)

We are the first to agree this analysis is imperfect, but it's worth discussion and we welcome refutations!  Tell us why we're wrong.

Tuesday, February 5, 2013

The S&P Lawsuit: Can It Fix the Rating System?

The government's lawsuit against S&P has triggered speculation about why DOJ singled out just one agency  and whether cases against the other two (Moody's and Fitch) will be forthcoming. One theory is that S&P was chosen because it downgraded US Treasury bonds in 2011. Two other options seem more likely: (1) the other two agencies may still be in settlement talks with DOJ, or (2) DOJ has a better case against S&P.

I was in Structured Finance at another rating firm in 2006 and 2007, and recall the headiness of the time. Revenues were exploding and half the money fell to the bottom line. Analysts were under pressure to keep up with the rapid flow of new securitization deals pouring in from Wall Street. Management had trouble hiring good people in the highly competitive environment. Meanwhile, everyone was aware that business could quickly be lost to competing rating agencies if investment banking clients were dissatisfied with the speed or nature of our conclusions.

In short, it was an environment that encouraged the cutting of corners - in terms of research quality, and, if the government allegations hold true, in terms of ethics - in fact, if the allegations are true, it seems S&P transcended the realm of ethical lapses and entered the land of outright fraud.

According to the complaint, S&P management instructed employees not to publish software and data updates that would have resulted in lower ratings. For example, pages 42-48 of the complaint detail how S&P management suppressed an update to the agency's LEVELS tool that relied on a much larger and more representative set of mortgages. (Recall the US Senate testimony of former S&P analyst Frank Raiter: “…S&P had developed better methods for determining default which did capture some of the variations among products that were to become evident at the advent of the crisis. It is my opinion that had these models been implemented we would have had an earlier warning about the performance of many of the new products that subsequently lead to such substantial losses. That, in turn, should have caused the loss estimates mentioned above to increase and could have thus caused some of these products to be withdrawn from the market as they would have been too expensive to put into bonds.”).

By cancelling a previously announced upgrade to LEVELS at the end of 2004, S&P was allegedly able to perpetuate the use of a flawed methodology which allowed investment banks to create deals with insufficient collateral subordinated to the senior AAA tranche. While cancelling this upgrade allowed S&P to remain competitive with Moody's and Fitch, it (allegedly) did a huge disservice to AAA investors such as the Western Federal Credit Union, on whose behalf the government filed its complaint.

Naturally, S&P denies this allegation and it remains to be seen whether the government can prove its case. While the gory details of who knew what will undoubtedly fascinate, I hope that the debate around this lawsuit has room for a discussion about how to solve the fundamental rating agency problem. Rather than merely consider who is to blame, we should focus on how to change the institutional structure of the industry to incent more positive behavior.

First, why should we even care about the rating agency business enough to bother reforming it? After all, as depicted by Michael Lewis in The Big Short and in other financial crisis chronicles, rating agency employees are just a bunch of bottom feeders wearing J.C. Penney suits and sucking up to the investment bankers who might one day hire them.

Whatever we think of rating agency employees (I, for one, never shopped at Penney's), the inescapable fact is that their output shapes much of our financial conversation. Discussion around the US budget deficit and the Eurozone sovereign debt crisis often focuses on how rating agencies will respond to political measures. S&P's upgrade of California - raising it above Illinois in state bond rating purgatory - was a major local news story last week. Enron filed for bankruptcy because it lost its investment grade rating. And, of course, toxic assets poisoned the financial system in the years leading up to 2007 because of the high ratings they received.

Ratings are essential to the financial system because they help direct the flow of capital. By bucketing debt instruments into different risk categories, rating agencies help determine their interest rates. This function - if executed well - optimizes the use of society's savings and thus contributes to economic growth.

Given the importance of ratings, we need alternatives to the way they are now produced, i.e. by for profit companies with known conflicts of interest using proprietary data and analytics together with closed door rating committee meetings.

A much better alternative would be a system based on open source rating software, with fully transparent inputs and outputs, and no rating committee discretion. This fully open, fully deterministic approach controls biases regardless of whether the analysis is funded by investors, issuers, foundations or governments. It also allows a distributed peer review process to occur over the internet. An excellent case for open source ratings appeared recently on Naked Capitalism. PF2 has advanced this idea by supporting my Public Sector Credit Framework - a simulation tool for rating government bonds.

The first question I get when I propose such an approach is how are you going to make money? I have thoughts about that, but let me respond here with another question:  why aren't more academics, pundits, politicians and regulators thinking of ways to make this operational model work?

Universities and foundations could fund rating transparency projects. The only such example right now is the National University of Singapore's Risk Management Institute. I have yet to find any foundation or academic willing to create such an institution in North America or Europe. 

Easy to blame a bunch of greedy people at rating agencies for the financial crisis. Much harder to put the proper incentives in place, to do the heavy intellectual lifting needed to really fix the rating system.

Friday, February 1, 2013

California v Ontario - The Deep Dive

In a previous blog post, I reported some figures showing that California is in significantly better fiscal condition than Canada’s largest province, Ontario. Those findings appeared in a Fraser Institute study published on January 31. In this post, I supplement the Fraser report with a comparison of health, expenditure and pension costs borne by these two systemically important sub-sovereign issuers.

Health and Education Expenditures

In both Ontario and California, health and education are the two largest categories of spending. Health is the largest category in Ontario while education (including post-secondary education) is the largest category in California.

In fiscal 2012, health accounted for 38% of Ontario’s overall spending and 41% of programmatic spending. Over the last 30 years, Ontario health expenditures grew at an annual rate of 7.2% from $5.776 billion in fiscal 1982 to $46.476 billion in fiscal 2012. According to StatCan data, consumer price inflation during this period averaged 2.8% annually while Ontario’s population growth averaged 1.4%. Thus, the province’s long term health expenditure growth cannot be explained exclusively by increasing population and general inflation: real per capita health spending increased 2.9% annually over the 30 year period.

While a number of factors are driving Ontario’s health cost escalation, one contributor is hard for policymakers to address: population aging. Since 1982, the population of those over 65 has increased by 2.7% annually – in contrast to the 1.4% increase for the overall population. Given the aging of the postwar baby boom and today’s relatively low birth rates, Ontario is likely to see a further rise in the proportion of senior citizens. Since this group makes more intensive use of health services, cost pressures on Ontario’s health system are likely to continue.

While California also faces high and rising health costs, it only funds health services for certain categories of residents. Most of the state’s health spending is in the MediCal program – California’s implementation of the federally sponsored Medicaid system. Under Medicaid, California and the federal government share responsibility for the cost of providing care to several groups of economically disadvantaged residents, especially low income mothers and children. Under the 2009 Patient Protection and Affordable Care Act more people will become eligible for Medicaid. Also, some moderate income individuals without employer health insurance will become eligible for state and federal insurance subsidies when purchasing coverage on a new state administered health insurance exchange. Finally, MediCal pays for nursing home care once seniors exhaust most of their assets. It is only this last category of MediCal spending that is substantially exposed to population aging.

In the US, most government health expenditures benefiting senior citizens are directly incurred at the federal level through the nation’s Medicare program. While there is wide agreement that this program is fiscally unsustainable, it does not directly affect the budget of California or any other US state. That said, states do provide medical coverage to their retired employees. But this cost burden is limited by two factors: (1) state workers only account for 0.9% of the population and (2) these workers are also eligible for Medicare. The impact of the second point is complex. Since most state workers can retire prior to becoming eligible for Medicare, the state is wholly responsible for their healthcare costs in the years immediately following their retirement. Further, since state retirees are eligible for a better benefit package than that provided under Medicare, the state still has to pay for insurance that provides incremental coverage to its Medicare-eligible retirees. Finally, it is worth noting that Ontario also pays for supplemental retiree health benefits, including dental and supplementary hospital costs.

Despite these advantages relative to Ontario, California also has a serious disadvantage: it is burdened by the high rate of US health cost inflation. Over the last 30 fiscal years, Canadian health care CPI has risen 3.2% annually while US medical CPI has grown 5.2% per year. Overall consumer price inflation has been quite similar in the two countries – 2.8% in Canada versus 2.9% in the US.

The sum of California’s MediCal and state retiree health costs rose from $5.419 billion in 1982 to an estimated $46.673 billion in 2012, representing an annualized increase of 7.4%. Real per capita cost rose 2.9%, similar to Ontario’s cost trend. However, because California’s health care responsibilities are less comprehensive than Ontario’s, health expenditures comprise a lower proportion of its overall spending – roughly 24% in fiscal 2012.

In fiscal 2012, education, post-secondary education and training accounted for 25% of Ontario’s overall spending and 27% of programmatic spending. Over the last 30 years, Ontario expenditures in these categories grew at an annual rate of 6.5% from $4.715 billion in fiscal 1982 to $30.709 billion in fiscal 2012. By contrast, education spending in California rose at an annual rate of only 4.7%.

The difference appears to arise from California’s balanced budget requirement. When state revenues fall during recession years, the governor and legislature cut education spending. These cuts have been especially noticeable at the post-secondary level, where state colleges and universities have imposed tuition increases to offset reduced state funding. The overall effect has been a long term shift in the revenue mix away from taxpayer support and toward student funding. This trend has also been evident in Ontario, but to much more limited extent.

For example, in the University of California (2011a, 2012b) system, average annual in-state undergraduate tuition has risen from $938 in the 1981-1982 academic year to $12,192 in 2011-2012, representing an 8.9% annual rate of increase. By contrast, StatCan figures show that annual tuition in Ontario for domestic, undergraduates increased from $936 in 1981-1982 to $6815 in 2011-2012 – an annual increase of 6.8%. According to the University of California (2012) budget, “All tuition and fee increases since 1990-91 have been a direct result of inadequate and volatile State support (p. 101).” Historical data from the California Legislative Analyst Office (2012) show reductions in state aid to the University following the 1991-1992, 2001 and 2007-2009 recessions.

Pension Obligations

Pension provision is one area in which Ontario outperforms California.

As shown the accompanying table, four of the five funds to which the Province contributes are fully funded. By contrast, California’s Public Employees Retirement Fund was only 80% funded as of 2010, and the California State Teachers’ Defined Benefit Fund was just 72% funded at that time. But the difference in these ratios understates the real discrepancy. California’s largest pension funds base their funding ratios on more aggressive return assumptions. CalPERS (the California Public Employee Retirement System) and CalSTRS (the California State Teachers’ Retirement System) use 7.75% return assumptions while Ontario’s provincially supported funds use assumptions ranging from 5.40% to 6.75%. If California funds used similar assumptions to their Ontario counterparts, their funding ratios would be significantly lower. According to calculations published by Nation (2011), CalPERS and CalSTRS funding ratios would each fall by about 15% if they used a 6.2% return assumption rather than the current 7.75% rate.

During recessions, California politicians are often tempted to meet balanced budget requirements by skipping or reducing actuarially required or even statutorily required pension contributions. On the other hand, public employee unions and the courts apply pressure to maintain funding and meet legal commitments. For example, in 2003 the state withheld a required a $500 million payment to CalSTRS. The pension plan sued, and a Superior Court judge compelled the state to make the contribution (CalSTRS, 2005).

The state’s two biggest pension obligations – payable to CalSTRS and CalPERS – are both subject to important limitations. In the case of CalPERS, only about three in ten of the system’s members are state employees; local governments in California are responsible for the remaining obligations. In the case of CalSTRS, primary responsibility rests with local school districts; the state’s contribution is a fixed percentage of covered payroll. By contrast, the provincial government makes the vast majority of Ontario Teacher’s Pension Plan employer contributions.

Although Ontario has done a superior job of funding its pensions relative to California, it is worth noting that the province also has a greater obligation due to its higher rate of public sector supported employment. According to StatCan data (series 183-0002), Ontario had 87,851 general government and 238,905 health and social service public employees in March 2012, which works out to 24.1 provincially supported workers per 1000 residents. In California, total state government employment was 343,767 for fiscal 2011-2012, or 9.1 state workers per 1000 residents (California, 2012). Both of these calculations exclude teachers.


California (1983). Governor’s Budget, 1983-84.

California (2012). Governor’s Budget, 2012-13, Schedule 6.

California Legislative Analyst Office (2012). Historical Data.

California Public Employees Retirement System (2012). Comprehensive Annual Financial Report for the Year Ended June 30, 2011.

California State Controller’s Office (2011). Comprehensive Annual Financial Report, 2011.

California State Teachers’ Retirement System (2005). Text of the Judgment in TEACHERS' RETIREMENT BOARD, ET AL. v. CAMPBELL, ET AL. Attachment to Agenda Item 15 for the Teacher Retirement Board Meeting of June 2, 2005.

California State Teachers’ Retirement System (2011). Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2011.

Canada Department of Finance (2012). Fiscal Reference Tables.

Canadian Taxpayers Association (2004). Ontario Superior Court Filing No. 04-CV-269781 CM1.

Nation, J. (2011). Pension Math: How California’s Retirement Spending is Squeezing the State Budget. Stanford Institute for Economic Policy Research.

Ontario Ministry of Finance (1982). Public Accounts 1982.

Ontario Ministry of Finance (2012). Public Accounts 2012. Retrieved from

Ontario Pension Board (2012). 2011 Annual Report.

Ontario Teachers’ Pension Plan (2012). Annual Report 2011.

OPSEU Pension Trust (2012). Delivering Sustainability: Annual Report 2011.

University of California (2011a). Historical Fee Levels 1975 - Present.

University of California (2011b). 2011-12 Tuition and Fee Levels as Approved by the Regents.

University of California (2012). Budget for Current Operations: Summary and Detail, 2012-13.

University of California Retirement System (2011). Annual Financial Report 10/11.