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

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