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.

Sources

California (1983). Governor’s Budget, 1983-84. http://archive.org/details/governorsbudget1983cali.

California (2012). Governor’s Budget, 2012-13, Schedule 6. http://www.ebudget.ca.gov/pdf/BudgetSummary/BS_SCH6.pdf.

California Legislative Analyst Office (2012). Historical Data. http://www.lao.ca.gov/laoapp/LAOMenus/lao_menu_economics.aspx.

California Public Employees Retirement System (2012). Comprehensive Annual Financial Report for the Year Ended June 30, 2011. http://www.calpers.ca.gov/eip-docs/about/pubs/comprehensive-annual-fina-report-2011.pdf.

California State Controller’s Office (2011). Comprehensive Annual Financial Report, 2011. http://www.sco.ca.gov/ard_state_cafr.html.

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. http://www.calstrs.com/About%20CalSTRS/Teachers%20Retirement%20Board/AGENDAS/BOD0605PDF/Regular0602/rm0615%20SBMA.pdf.

California State Teachers’ Retirement System (2011). Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2011. http://www.calstrs.com/help/forms_publications/printed/CurrentCAFR/cafr_2011.pdf.

Canada Department of Finance (2012). Fiscal Reference Tables. http://www.fin.gc.ca/pub/frt-trf/index-eng.asp.

Canadian Taxpayers Association (2004). Ontario Superior Court Filing No. 04-CV-269781 CM1. http://taxpayer.com/sites/default/files/downloadable/73.pdf.

Nation, J. (2011). Pension Math: How California’s Retirement Spending is Squeezing the State Budget. Stanford Institute for Economic Policy Research. http://siepr.stanford.edu/system/files/shared/Nation%20Statewide%20Report%20v081.pdf.

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

Ontario Ministry of Finance (2012). Public Accounts 2012. Retrieved from http://www.fin.gov.on.ca/en/budget/paccts/2012/.

Ontario Pension Board (2012). 2011 Annual Report. http://www.opb.ca/portal/ShowBinary?nodePath=/OPBPublicRepository/OPB/Publications/Investments/AnnualReports/en/Annual%20Report%202011.

Ontario Teachers’ Pension Plan (2012). Annual Report 2011. http://docs.otpp.com/annual_report/PDF2012/AnnualReport2011.pdf.

OPSEU Pension Trust (2012). Delivering Sustainability: Annual Report 2011. http://www.optrust.com/AnnualReports/AR2011/OPTrust_AR_2011.pdf.

University of California (2011a). Historical Fee Levels 1975 - Present. http://budget.ucop.edu/fees/documents/history_fees.pdf.

University of California (2011b). 2011-12 Tuition and Fee Levels as Approved by the Regents. http://budget.ucop.edu/fees/201112/documents/2011-12rev.pdf.

University of California (2012). Budget for Current Operations: Summary and Detail, 2012-13. http://budget.universityofcalifornia.edu/files/2011/11/2012-13_budget.pdf.

University of California Retirement System (2011). Annual Financial Report 10/11. http://www.universityofcalifornia.edu/finreports/index.php?file=ucrp/ar11ucrp.pdf.

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:

Indicator	Ontario	California
Total Bonded Debt	$236.6 billion	$143.9 billion
Bonded Debt-to-GDP	38.6%	7.7%
Bonded Debt Per Capita	$17,922	$3,833
Interest Expense	$9.5 billion	$ 5.5 billion
Interest Expense to Revenues	8.9%	2.8%
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:

Agency	Ontario	California
Moody’s	Aa2	A1
Standard & Poor’s	AA-	A-
Fitch	AA	A-

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.

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.

A New Free Sovereign Risk Database

Happy New Year Readers!

Today we are introducing a free, public database of historical sovereign risk data. It is available at http://www.publicsectorcredit.org/sovdef.

The database contains central government revenue, expenditure, public debt and interest costs from the 19th century through 2011 – along with crisis indicators taken from Reinhart and Rogoff’s public database.

Why This Database?

Prior to the appearance of This Time is Different, discussions of sovereign credit more often revolved around political and trade-related factors. Reinhart and Rogoff have more appropriately focused the discussion on debt sustainability. As with individual and corporate debt, government debt becomes more risky as a government’s debt burden increases. While intuitively obvious, this truth too often gets lost among the multitude of criteria listed by rating agencies and within the politically charged fiscal policy debate.

In addition to emphasizing the importance of debt sustainability, Reinhart and Rogoff showed the virtues of considering a longer history of sovereign debt crises. As they state in their preface:

“Above all, our emphasis is on looking at long spans of history to catch sight of ’rare’ events that are all too often forgotten, although they turn out to be far more common and similar than people seem to think. Indeed, analysts, policy makers, and even academic economists have an unfortunate tendency to view recent experience through the narrow window opened by standard data sets, typically based on a narrow range of experience in terms of countries and time periods. A large fraction of the academic and policy literature on debt and default draws conclusions on data collected since 1980, in no small part because such data are the most readily accessible. This approach would be fine except for the fact that financial crises have much longer cycles, and a data set that covers twenty-five years simply cannot give one an adequate perspective…”

Reinhart and Rogoff greatly advanced what had been an innumerate conversation about public debt, by compiling, analyzing and promulgating a database containing a long time series of sovereign data. Their metric for analyzing debt sustainability – the ratio of general government debt to GDP – has now become a central focus of analysis.

We see this as a mixed blessing. While the general government debt to GDP ratio properly relates sovereign debt to the ability of the underlying economy to support it, the metric has three important limitations.

First, the use of a general government indicator can be misleading. General government debt refers to the aggregate borrowing of the sovereign and the country’s state, provincial and local governments. If a highly indebted local government – like Jefferson County, Alabama – can default without being bailed out by the central government, it is hard to see why that local issuer’s debt should be included in the numerator of a sovereign risk metric. A counter to this argument is that the United States is almost unique in that it doesn’t guarantee sub-sovereign debts. But, clearly neither the rating agencies nor the market believe that these guarantees are ironclad: otherwise all sub-sovereign debt would carry the sovereign rating and there would be no spread between sovereign and sub-sovereign bonds - other than perhaps a small differential to accommodate liquidity concerns and transaction costs.

Second, governments vary in their ability to harvest tax revenue from their economic base. For example, the Greek and US governments are less capable of realizing revenue from a given amount of economic activity than a Scandinavian sovereign. Widespread tax evasion (as in Greece) or political barriers to tax increases (as in the US) can limit a government’s ability to raise revenue. Thus, government revenue may be a better metric than GDP for gauging a sovereign’s ability to service its debt.

Finally, the stock of debt is not the best measure of its burden. Countries that face comparatively low interest rates can sustain higher levels of debt. The United Kingdom avoided default despite a debt/GDP ratio of roughly 250% at the end of World War II. The amount of interest a sovereign must pay on its debt each year may thus be a better indicator of debt burden.

Our new database attempts to address these concerns by layering central government revenue, expenditure and interest data on top of the statistics Reinhart and Rogoff previously published.

A Public Resource Requiring Public Input

Unlike many financial data sets, this compilation is being offered free of charge and without a registration requirement. It is offered in the hope that it, too, will advance our understanding of sovereign credit risk.

The database contains a large number of data points and we have made efforts to quality control the information. That said, there are substantial gaps, inconsistencies and inaccuracies in the data we are publishing.

Our goal in releasing the database is to encourage a mass collaboration process directed at enhancing the data. Just as Wikipedia articles asymptotically approach perfection through participation by the crowd, we hope that this database can be cleansed by its user community. There are tens of thousands of economists, historians, fiscal researchers and concerned citizens around the world that are capable of improving this data, and we hope that they will find us.  To encourage participation, we have supplied a comments feature and plan to add more participatory functionality in late January.

Sources and Acknowledgements

Aside from the data set provided by Reinhart and Rogoff, we also relied heavily upon the Center for Financial Stability’s Historical Financial Statistics. The goal of HFS is “to be a source of comprehensive, authoritative, easy-to-use macroeconomic data stretching back several centuries.” This ambitious effort includes data on exchange rates, prices, interest rates, national income accounts and population in addition to government finance statistics. Kurt Schuler, the project leader for HFS, generously offered numerous suggestions about data sources as well as connections to other researchers who gave us advice.

Other key international data sources used in compiling the database were:

• International Monetary Fund’s Government Finance Statistics
• Eurostat
• UN Statistical Yearbook
• League of Nation’s Statistical Yearbook
• B. R. Mitchell’s International Historical Statistics, Various Editions, London: Palgrave Macmillan.
• Almanach de Gotha
• The Statesman’s Year Book
• Corporation of Foreign Bondholders Annual Reports
• Statistical Abstract for the Principal and Other Foreign Countries
  
  

For several countries, we were able to obtain nation-specific time series from finance ministry or national statistical service websites.

We would also like to thank Dr. John Gerring of Boston University and Co-Director of the CLIO World Tables project, for sharing data and providing further leads as well as Dr. Joshua Greene, author of Public Finance: An International Perspective, for alerting us to the IMF Library in Washington, DC.

A number of researchers and developers played valuable roles in compiling the data and placing it on line. We would especially like to thank Charles Tian, T. Wayne Pugh, Amir Muhammed and Anshul Gupta, as well as Karthick Palaniappan and his colleagues at H-Garb Informatix in Chennai, India for their contributions.

Finally, we would like to thank the National University of Singapore’s Risk Management Institute for the generous grant that made this work possible.

Sovereign Debt Ratings - How High is High?

The ratings agencies' country debt ratings have received a double blow from Bloomberg News in the last 10 days.

First, Bloomberg unleashed a piece entitled "Moody’s Gets No Respect as Bonds Shun 56% of Country Ratings" that argued that movements in bond yields more often disagreed (versus agreed) with a ratings change. If the argument is true, the result would then be that, in trying to predict future market movements, flipping a coin might be more constructive than basing your decision on a ratings action.

Less than a week later, Bloomberg released "BlackRock Sees Distortions in Country Ratings Seeking Revamp" which claims upfront that "Credit rating companies are distorting capital markets by assigning the same debt ranking to countries from Italy to Thailand and Kazakhstan, according to BlackRock Inc. (BLK), the world’s biggest money manager."

These are both punishing blows, but they also force us to reconsider what a rating is, what a rating means. Unfortunately, if we cannot ascertain what the rating describes, we cannot reasonably judge a rating agency's performance.

How High is High?

On a fundamental level, imagine we rank restaurants differently. One ranking may take only the quality of the meal into account. Another may consider the peripherals to the meal, or ambience - the relative comfort of the seats; the temperature; the noise level; the view etc. Can we really compare two ratings provided under different measures?

Unfortunately, is not only that investors are failing to assess what the rating depicts, but the rating agencies are choosing to keep the question open. Why box themselves in?

When things go wrong, rating agencies advertise that they actually got it right - their ratings are only RELATIVE measures of risk. They are trying to predict which countries or companies will be more likely than others to default or suffer impairment. But if you look at their actual ratings actions, and their action definitions, there is often little evidence of relative measurement.

Let's suppose one downgrades the UK. A relative action might read something like this "the UK has grown its debt-to-income ratio more than other countries." But one seldom sees this - they're almost always cardinal (i.e., absolute) and seldom ordinal (i.e., relative rankings).

One does well to ask, if ratings are relative, why when times are rough are we seeing more downgrades than upgrades? Are they all getting relatively worse than each other? In a relative system, one would hope they would roughly equate.

An Example

When Chinese rating agency Dagong put the USA on negative watch on Christmas, we looked a little deeper into the reasons. Their actual release is a little more detailed, but the Financial Times breaks it down for us as follows:

In placing the US rating on negative watch, Dagong cited five factors: 

1. The US is at an impasse in budget negotiations 

2. With no plan for maintaining solvency, the US is monetising its debt 

3. US government debt is growing much faster than fiscal revenue 

4. The fiscal cliff could lead to a US recession in 2013 

5. Frequent emergencies such as the fiscal cliff and debt ceiling deadlines add to the risks

Nothing relative there, so we went to Dagong's website to look at their definitions.

See the following excerpts:

AAA denotes the "lowest expectation of default risk"

AA "ratings denote expectations of very low default risk"

BB "ratings indicate that the issuer faces major ongoing uncertainties..."

B "ratings indicate that expectations of default risk are relatively high but a limited margin of safety remains." (emphasis added by us)

What does "very low" mean - very low relative to others, or to some absolute standard? To borrow from Arturo Cifuentes, what would it mean to restrict a company from building a "very high" building in New York? Would it be relative to the other buildings or relative to a specific measurement of "high"?

"Lowest" sounds absolute.  "Very low" could go either way.  "Faces major ongoing uncertainties" sounds cardinal, or absolute.  And "Relatively high" is certainly ordinal.  So, we're still not sure - relative or absolute, or a little of each? Does anybody know?

Monitoring Ratings Monitoring

Today's "Administrative Action" announced against Standard & Poor’s Ratings Japan K.K. hones in on just the sorts of problems our transparent ratings "drive" would protect against. 

For those of you who haven't been following, PF2 consultant Marc Joffe's open-source PSCF model has been gaining widespread attention, with Marc being recently commissioned by the California State Treasurer's office to further develop the PSCF default probability model for municipal bonds. 

Japan's FSA makes a strong case for promoting ratings transparency.  Having a transparent model allows others to catch ratings errors before they become too problematic - a positive feedback loop that lends to market stability and to investor confidence. 

It also encourages (or forces) rating agencies to keep current their ratings, minimizing the possibilities for larger rating changes (mostly downgrades) if and when raters notice their ratings are out of sync. 

An excerpt from the Japanese FSA's Administrative Release reads as follows (emphasis added):

"[S&P failed] to properly confirm important information that affects Synthetic CDO ("SCDO") credit ratings
 ...

[S&P] did not properly take stock of the cumulative loss amount pertaining to the reference obligations that affects the credit rating of SCDOs. The Company did not take measures such as confirming with arrangers of SCDOs whether there had been any credit events relating to the reference obligations.

Therefore, some cases were identified where incorrect credit ratings had been assigned to certain SCDO products for a significant period of time until just before the withdrawal of the credit ratings due to the redemption of those SCDO products.
 ...

The Company has continued publishing the credit ratings of the relevant SCDOs without confirming whether there were any credit events.
... 

The Company incorrectly maintained until October 2010 a credit rating of a SCDO product that should have been downgraded in January and further in February of that year. This is due to input to the Company’s system of incorrect notional amount data in relation to the reference obligations in the monitoring process of the SCDO credit rating.

The Company has not implemented a verification process whereby a second person checks the accuracy of the data input."

The Real Fiscal Cliff

Recent developments in the fiscal cliff negotiations should put to rest any hope that this process will produce a meaningful solution to the nation’s long term fiscal imbalance. For advocates of fiscal sustainability, the negotiation suffers from two serious flaws:

(1)    The fact that the party leaders are still playing to their respective bases, rather than having serious, closed door discussions. Since real long term reform would be very complex and politically painful, it requires time to run the numbers and build support for the sacrifices required on both sides. If these activities are telescoped into the last two weeks of December, they cannot be accomplished effectively. What we are likely to see then is a deal lacking in specifics with numbers that don’t add up.

(2)    Attention is mostly focused on avoiding the immediate emergency posed by the fiscal cliff and on the top two income tax brackets (the adjustment of which can only generate a small part of the solution). To the extent that attention focuses on the Armageddon that awaits us on 1/1/2013 or the morality of tax rates, less space is available to educate the public about the need to address long term sustainability issues.

To the extent that budget impacts are being considered, the discussion has focused on how to achieve $4 trillion of deficit reduction in the next ten years. The debate typically obscures the question of what “base” the $4 trillion in savings will come from. This base scenario is most certainly not current law – since that would include all the spending reductions and tax increases that compose the fiscal cliff. In fact any fiscal cliff compromise is likely to entail higher ten year aggregate deficits than those that would occur under current law.

Moreover, ten year scoring of budget proposals takes attention away from the most important fact. Under current policies or anything approximating them, the US will probably run deficits of several trillion dollars each year during the late 2020s and early 2030s. This is precisely when the greatest burdens will be placed on Social Security and Medicare because the maximum number of baby boomers will be both alive and retired. Since these big deficits will be piled onto an already large stock of debt, they are likely to trigger some form of sovereign debt crisis. Such a crisis would have devastating effects on taxpayers, government employees, beneficiaries and bondholders – as it would be manifest in some combination of sharp tax increases, deep spending cuts, inflation, and possibly an outright default on Treasury obligations. Some of these effects would probably trigger widespread civil unrest similar to the violence we have been seeing in Greece. Unlike today’s fiscal cliff, which can be avoided through simple legislation, this future crisis would be far steeper and far more difficult to side-step:  revenue and expenditure would be forced to immediately converge due to the unaffordability of deficit financing.

Since I am a financial analyst and not a politician, the preceding narrative contains two serious flaws. I have told you that any crisis is 15 to 20 years away and that it is likely rather than certain. I would better command your attention by claiming that there will be an immediate crisis if nothing is done, but that isn’t credible. Since I am writing for a thoughtful audience, I am confident that you will read on.

Due to the existing low interest rate environment, debt service cannot become an unbearable burden anytime soon. Given the amount of global liquidity and the fact that US debt contains a substantial component of long dated bonds, there is no reasonable scenario under which rising interest rates will trigger a crisis in the near term. To say otherwise might make for a great rhetorical flourish on a talk show, but it just has no economic or mathematical basis.

In the longer term, a crisis is only likely rather than certain for a number of reasons. In general, it is fair to say that any long term prediction has to be qualified just because of the sheer weight of accumulated uncertainties. In this specific case, it is possible that we will be saved by some new innovation that sharply increases productivity thereby generating enough incremental revenue to get us over the hump. Another possibility is that interest rates won’t revert to post-World War II historical averages. Perhaps we have entered a new normal in which massive global savings will continue to compete for an insufficient supply of fixed income investments, or one in which large portions of the federal debt can be monetized without price inflation (due to declining monetary velocity).

On the other hand, there are also extreme scenarios that could exacerbate any future fiscal crisis. A medical breakthrough that significantly extends life spans under the current fixed retirement age system would greatly increase dependency ratios. A major war or series of large natural disasters could sharply increase deficits at any time.

Putting all these tail scenarios aside and focusing on outcomes nearer the median, the fact remains that population aging will probably cause a long term fiscal crisis in the absence of major reform. Failure to plan for this eventuality seems to me to be the height of irresponsibility.

Given the size of America’s fiscal gap and the division of power, the only politically feasible plan is one that increases revenues and reduces spending growth in multiple areas, including discretionary spending, Social Security and health care entitlements. Unless the plan distributes the pain across all areas, it will probably be either too small or unable to become law.

If voters demand government services that roughly approximate those now available, it will not be possible to hold spending to 18% of GDP – a limit suggested by Republican leaders in the 111^th Congress. As more and more people draw Social Security and use Medicare services, spending will rise sharply, even if these entitlements are adjusted somewhat. Simply taxing the rich won’t be sufficient to fill the fiscal gap. Higher income taxes at all levels and/or new consumption taxes will be required. As a libertarian, I personally oppose taxes and believe that it would be both morally preferable and economically more efficient to cut spending enough to achieve a primary budget balance without increasing revenues.  But since my party received 1% of the vote in the Presidential election, this plan will not be enacted. Instead, we will either have a plan that includes considerable, broad-based tax increases or one that doesn’t solve the problem.

Prevailing wisdom suggests that domestic, non-discretionary spending programs are individually too small and have too much political support to contribute much to closing the fiscal gap. Cutting them across the board may have adverse unintended negative consequences.  Earlier decades have bequeathed us two ideas that can be used to achieve significant savings in these programs. Zero based budgeting, properly understood, involves a complete reappraisal of all spending items. It is designed to address the question of whether each program remains cost effective or is just continuing due to inertia. Because Congress is too politically conflicted to successfully implement zero based budgeting, it should delegate this responsibility to a bi-partisan commission as it did when base closings were required at the end of the Cold War. A politically neutral zero based budgeting commission could wring substantial savings out of domestic discretionary spending without disrupting truly valued services.

Advocates of military spending often remind us that defense is not a driver of the impending problem because it represents a stable or declining share of GDP – depending upon the base year used. However, if that base year was during the Cold War, the comparison isn’t meaningful. The country no longer needs to stare down the Soviet Union and its network of clients. Rather than exaggerate the threats posed by China, North Korea, Iran and al Qaeda, defense advocates should be supporting the elimination of Cold War oriented weapons programs that are not designed for today’s lesser security issues. Also, since the US represents a far diminished share of world GDP, its relative responsibility for funding alliances like NATO needs to be reconsidered. While it is true that entitlement spending will be the driver of future budget imbalances, there is no reason that offsetting savings cannot be found elsewhere in the budget. A dollar spent on defense has the same budgetary impact as a dollar spent on Medicare. The budget can and should shift away from defense and toward entitlements.

Social security proponents take a similar tack to the defense hawks: “our favorite program is not really the problem so let’s look elsewhere for savings.” Often the argument revolves around the fact that the Social Security trust fund is not expected to be drained for a couple of decades. But since the trust fund is simply money that the government owes to itself, it is not fiscally significant. More important is the annual gap between social security tax revenues and benefits. Until recently, this difference was positive, now it is near zero and by 2030, it will be negative to the tune of half a trillion dollars annually. While incremental reforms cannot eliminate this annual social security deficit, they can reduce it to the extent that added revenue and other budgetary savings can offset it. The most obvious reforms include making the retirement age a factor of life expectancy – as Italy has recently done – and making downward adjustments to benefit formulae.

While everyone agrees that Medicare is a huge budget problem, the solutions offered often fail to miss the fundamental issue this system poses – an issue that also applies in part to Medicaid and future Affordable Care Act benefits. The US health care system is unique in that it largely fails to use either of the two proven methods known to control costs. In a totally free market system under which patients are fully responsible for their own medical bills or insurance, cost growth is limited by the fact that many people will be unwilling or unable to pay for certain medical services. Since this results in richer people getting better care – an outcome that most people find offensive – all advanced countries have some form of government-sponsored third party payment. However, most countries that have government controlled health systems use non-price rationing to control costs. These rationing tools include waiting lists and “death panels” that deny certain types of care. A meaningful solution to Medicare and other health entitlements is going to require some form of rationing – either through greater patient responsibility as advocated in the Ryan budget or through a strengthened version of the Independent Payment Advisory Board (IPAB) included in the Affordable Care Act. A compromise approach might involve some sort of bimodal system in which beneficiaries could choose between a government -managed HMO (akin to the public option discussed during the health reform debate) and a market based option under which patients receive limited premium support.

Reforms of the type discussed here cannot be formulated and sold to the American people during a couple of weeks in the holiday season. They need to be well designed in order to limit adverse unintended consequences and carefully balanced to ensure that enough House and Senate votes can be cobbled together from those closest to the political center. In the absence of evidence that these planning processes are occurring, I am left with the assumption that any end of year package won’t avert the long term fiscal crisis we now face.

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.

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?

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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.

Canadian Provincial Debt

Marc's recent research on the financial strength of the Canadian provinces was (finally) published yesterday and is getting some good attention today. 

If interested, have a look at the Wall Street Journal's coverage here.

- PF2