Monday, September 30, 2013

Bill Gross and Moody's US Ratings

Last week, Bill Gross sent a tweet suggesting that investors should not trust Moody’s US sovereign rating. Given my own concerns about biases in sovereign ratings generally and a review of recent Moody’s pronouncements on US debt, I think Gross has a valid point.

On July 18, the agency affirmed America’s Aaa rating and raised its outlook from negative to stable. The timing of Moody’s action looks a bit odd in an environment of budget gridlock and threats of default if Congress fails to raise the debt ceiling. In 2011, US credit downgrades were sometimes justified in terms of political dysfunction. Since ongoing deficits will necessitate further debt ceiling hikes in coming years and we continue to face a Cold War style domestic political environment, future drama is all but inevitable. Stable, triple-A sovereigns are not supposed to be a source of drama.

Back on July 13, 2011, Moody’s placed the US rating on review for downgrade “given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on US Treasury debt obligations.” We are now in the same situation, yet Moody’s has not initiated any sort of review. Worse, on September 11, 2012, Moody’s wrote the following about its plans for the 2013 debt ceiling debate: “the government's rating would likely be placed under review after the debt limit is reached but several weeks before the exhaustion of the Treasury's resources.” This is where we are now, so what happened to the review?

After the 2011 debt ceiling increase, Moody’s affirmed its Aaa rating but assigned a negative outlook to US sovereign credit. It gave four conditions that could trigger an eventual downgrade, one of which was the failure to adopt further fiscal consolidation measures in 2013. No such measures have been adopted this year, nor are any feasible in the current political climate. We did see a resolution to the fiscal cliff debate back in January, but that was not a fiscal consolidation measure. Had nothing been done in January, all of the Bush era tax cuts would have expired. Instead, these cuts were made permanent for 99% of Americans at an estimated ten year cost of $3.6 trillion.

In its September 11, 2012 update, Moody’s conditioned the country’s Aaa rating on the adoption of “specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term.” In lay terms, Moody’s was asking for a grand bargain which would address taxes and entitlement reform. But, as we all know, there has been no grand bargain nor is it reasonable to expect one until 2015 at the earliest.

Based on Moody’s 2011 and 2012 pronouncements, it is hard to justify the agency’s July 2013 action. Moody’s rationalized it on the grounds that “the US government's debt-to-GDP ratio through 2018 will demonstrate a more pronounced decline than Moody's had anticipated when it assigned the negative outlook”. 

Since Moody’s appears to rely on CBO numbers, it is worth checking this contention against changes in the CBO budget baseline. In August 2011, CBO’s baseline budget projection called for a 65.2% debt to GDP ratio in 2018. The latest CBO forecast estimates a 68.4% ratio in 2018. So things actually look worse in 2018 than originally anticipated, yet Moody’s reaction is an upgraded credit outlook.

So we now see the basis for Bill Gross’ tweet. Moody’s pronouncements on US debt are inconsistent and thus not useful to the investment community. Changes in the rating stance do not appear to have a basis in policy; instead they seem to portray a reluctance to offend the federal government. 

From the perspective of Moody’s shareholders, however, this may be a wise approach: given S&P’s claim that the federal lawsuit it faces was payback for its having downgraded the US debt, Moody’s shareholders may (rightly or wrongly) be fearful that their stock would lose value should Moody’s downgrade the US. Bill Gross may be saying that the presence of such a conflict can undermine any hopes for independence or integrity in the ratings process.

Friday, September 27, 2013

In Trust, We Trust

PIMCO's Bill Gross put out a curious statement on his Twitter account on Wednesday.

A company spokesperson reportedly told media outlets that Gross' remark was in regards sovereign credit ratings, not necessarily all credit ratings. 

No support is given for either claim - that Moody's and the US Treasury are in cahoots, or that we can trust S&P, Fitch and Egan Jones as alternative providers. 

Why So Curious? 

What's also got to be at least mildly interesting is that if his comment isn't investment advice, it must be close to it: he's suggesting whose credit opinions are trustworthy (or reliable?) and can be taken into account when considering an investment. Given there's no substantiation for his claims, different from a developed theory, he's saying: "trust me, you can trust these guys."  Is he putting his name or rep behind the future performance of sovereign ratings issued by these three companies? 

And of course, we're all clinching our seats in anticipation: Does PIMCO have proof that it hasn't yet shared, either of Moody's-Treasury collusion or that S&P's, Fitch's, and Egan-Jones' (sovereign) ratings are all trustworthy?  These claims should be "provable" after all, shouldn't they? 

We'll let you know if we find out. 

In the meantime, perhaps this speaks to the development of at least one positive trend: that investors will be encouraged to differentiate between and among the rating agencies - preferably not purely on Bill Gross' say-so, but maybe on performance. Rating agency ABC has a more formidable methodology over here, whereas rating agency DEF's ratings hold greater predictive content over there. 

If no differentiation is made by investors, rating agencies will have few reasons to spend moneys improving their systems, or turn away business in a fight for higher standards or increased accuracy.

Tuesday, September 17, 2013

Crystal-Clear Country Ratings

If you're one for ratings transparency, you'll be somewhat enthusiastic about Moody's changes to their methodology for rating sovereign debt.

Moody's previous methodology was more of a framework -- there were no "numbers" for the mathematicians among us.
Aa credits had – "Very high economic, institutional or government financial strength and no material medium-term repayment concern."
A credits exhibited – "High economic, financial or institutional strength and no material medium-term repayment concern."
The new methodology provides significant mathematical guidance for those looking to independently verify what a country's rating ought to be, either to prepare for an upgrade or downgrade, or to begin the ratings process for an unrated sovereignty.

It looks like Moody's has taken the stance that their ratings process should be somewhat visible, or "reversible."  The language, too, has changed from their methodology of 2008 to their September 2013 release.

The old methodology held that (emphasis added): 
"There is no adequate model for capturing the complex web of factors that lead a government to default on its debt. Rating sovereign entities involves an unusual combination of quantitative and qualitative factors whose interaction is often difficult to predict." ... "a mechanistic approach based on quantitative factors will be unable to capture the complexity of the interaction between political, economic, financial and social factors that define the degree of danger, for creditors, of a sovereign credit. ... This [ratings methodology's] step by step approach produces a narrow rating range. In some instances, however, the final rating may diverge from the range – in other words, the unusual characteristics of a sovereign credit may not be fully captured by the approach.
Moody's new methodology offers to provide more than a road-map (emphasis added):
"The aim of this methodology is to enable issuers, investors and other interested market participants to understand how Moody’s assesses credit risk in this sector, and explain how key quantitative and qualitative risk factors map to specific rating outcomes. Our objective is for users to be able to estimate the likely credit rating for a sovereign within a three notch alpha-numeric rating range in most cases."
Importantly, the new methodology affords Moody's analysts some (possibly substantial) flexibility when applying its model, in the form of what they call in-model "adjustment factors."  If properly applied, the adjustment factors can allow analysts room to maneuver to the extent the pure mathematical model alone isn't capturing the risk they're identifying. (As an aside, we would recommend investors push for adjustment factors to be disclosed, so that they cannot be arbitrarily influenced to suit an analyst's opinion: if they can be changed to produce a pre-defined rating expectation, it becomes questionable what the point is of having the model!)

The implementation of the adjustment factors is, unfortunately, not well-defined in any sense.  If, how and when they will be enforced is somewhat unclear -- and the magnitude of their impact is only partially developed, with the implementation and effect of the "diversification" adjustment factor being especially vague:
"This ‘credit boom’ adjustment factor can only lower the overall assessment of the sovereign’s Economic Strength. For most countries, the ‘credit boom’ risk will be Very Low or Low; in these cases, the ‘credit boom’ adjustment factor will be neutral for the assessment of Economic Strength. However, when the combination of the probability of excessive credit growth and its severity lead to a Medium, High or Very High score, this can result in the assessment of Economic Strength being lowered by between one and six scores in the 15-notch Factor 1 score (which translates into a lowering by up to two rating notches). Additional adjustment factors may be considered in the assessment of Economic Strength if deemed appropriate.

Second, the ‘diversification’ adjustment factor allows for the shock absorption capacities afforded by a developed country’s degree of economic diversification and flexibility to lift its overall assessment by one score. We determine the potential for such an adjustment based on the distribution of different sectors’ gross value added in the economy’s annual output. The ‘diversification’ adjustment factor can also lower the overall assessment of a sovereign’s Economic Strength, if, for example, a country is significantly reliant on a single industry or commodity.

Additional adjustment factors may be considered in our assessment of Economic Strength over time if we find that another indicator can provide a universally high degree of explanatory value for Economic Strength." (emphasis added)
While the new methodology doesn't look likely to meet its objective of allowing a market participant to predict a rating "within a three notch alpha-numeric rating range," it must be considered a step in the right direction, at least for those seeking ratings transparency.


Reference Documents (may require Moody's log-in):

2013 Methodology
Associated Document -- Refinements to the Sovereign Bond Rating Methodology
2008 Methodology