The Art of Pricing (and the Heart of the War)

The fight for transparency in the financial markets is gaining traction.

Even maverick Judge Rakoff, in his SEC v. Citi settlement ruling, got in on the act with commentary that resonates: “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.”

The recent media coverage on the transparency issue is particularly acute as it pertains to asset pricing transparency, which is becoming ever more important as the market seeks alternatives to ratings-based capital allocations, per the requirements of Dodd-Frank.

The problem is that while each asset has only one rating (from each rating agency), there’s no consistency of pricing from one bank to the next. We fear that absent a centralized or standardized solution, any mark-to-market pricing will continue to cause headaches in markets where assets aren’t actually traded (there’s no ready or visible price).

Floyd Norris explains in a recent piece that “[under] the [accounting] rules, banks have a choice of three ways to report the value of identical securities. Even if two banks are using the same valuation method for the same security, they can come up with different values, and it is very difficult for an investor to get any feel at all for just how optimistic, or pessimistic, a bank’s estimates might be.”

He also brings in a quote from former FASB member Ed Trott, explaining that “’we are moving back to the past’ by increasing the ability of banks to massage their numbers as they wish.”

This revelation (unfortunately) jibes well with Gretchen Morgenson’s commentary in her piece entitled Slipping Backward on Transparency for Swaps. Gretchen explains that “[right] now, many swaps are traded one-on-one, over the telephone. The price is usually whatever the dealer says it is.” (Recall in Michael Lewis’ The Big Short, when Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”)

And the problem isn’t limited to the comparability of asset valuations at the Big Banks. The Big Auditors are also coming a cropper in their audits of banks. Norris explains in a separate piece that analyzes the PCAOB’s oversight reports of KPMG and PricewaterhouseCoopers: “[one] virtually identical criticism of the two firms could be a sign of the way all the firms have been auditing how banks value hard-to-measure financial assets.”

“In three of these audits,” the board wrote in its report on KPMG’s audits done in 2010, “for certain financial instruments the firm obtained multiple prices and used the price closest to the issuer’s recorded price in testing its fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices.”

With the banks being able to extract greater margins from opaque markets, the war over asset price transparency is currently being won by the might-makes-right team.

But a more simple solution that levels the playing field for investors big and small, and reduces the burden (and cost) of each auditor having constantly to reinvent the wheel, is to create a central platform for pricing.

Confidence will increase in the adequacy, verifiability, and consistency of financial statements. Regulators would have a field day and investors would be better able to spot when they’re being fooled. Of course the Banks wouldn't be too happy.

Here’s an analysis we put together of the material benefits afforded by a centralized (and perhaps standardized) pricing solution.

Update Dec. 2: According to a Bloomberg article by Jesse Hamilton that came out this morning (SEC’s Data Crunchers Find Red Flags Leading to Hedge-Fund Cases), the SEC through a prorietary tool, has been increasingly been taking action against hedge funds for misconduct including "fraudulent valuations and misrepresenting fund investors."

Hamilton brings in a relevant quote from Bruce Karpati, co-chief of the SEC's asset management enforcement unit:

“Hedge-fund managers depend on valuation and performance for both their compensation and marketing,” ... “These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”

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For a updated list of disputes around asset prices provided, click here.

Cross-Border Collateral Complexities

by PF2 consultant Rick Michalek

It's 11:59pm. Do you know where your collateral is?

The question of how to locate and ensure the realization of security is often asked, but rarely definitively answered, particularly in international complex derivative transactions. In an ever increasing number of cases, lenders - and counterparties and their insurers - have been forced to ask exactly this question.

The question is becoming increasingly relevant. Consider the following from a recent Press Release from the Office of the Trustee for the Liquidation of MF Global Inc. (published 11/21/2011)

"Further complicating matters, assets located in foreign depositories for customers that traded in foreign futures are now under the control of foreign bankruptcy trustees, and while the Trustee will pursue them vigorously, it has been his experience that recovery of these foreign assets may take more time. The Trustee's counsel has also stated in open court that the Trustee has only relatively nominal proprietary - that is non-customer - assets in his immediate control."

The "recovery of foreign assets may take more time...." is the key issue, and one that remains despite the wholehearted attempts by the regulatory bodies both in the US, the UK and elsewhere, to address the long standing challenge of rationalizing international and inter- jurisdictional processes for the realization of posted and pledged collateral.

Those experienced with derivative structured finance transactions will recall the litany of "assumptions" contained in the typical security interest opinion delivered by deal counsel and relied upon by the transacting parties. The utility and reliability of that legal opinion was conditioned on every single one of those assumptions being true at the time of delivery. The diligence required in verifying those assumptions was often "delegated down", and whether that diligence was fully and accurately performed - often under the pressure of a closing deadline - is critical to the ultimate outcome when pursuing collateral.

Mirroring those assumptions, the deal's legal opinions will also include critical "qualifications", including those related to the location of the collateral. Exceptions would inevitably be made to cover the possibility of collateral being moved out of relevant jurisdictions after the date of closing (particularly relevant to those secured by physical notes or other forms of indebtedness).

In multi-jurisdictional transactions, involving collateral originated in legal jurisdictions lacking well-developed protocols for settling competing interests of creditors residing in different jurisdictions, a trustee may be faced deciding which of the mutually inconsistent judgments it will recognize and honor. Creditors thinking of suing might want to delve deeply into the documentation - a decision that may make the difference between covering the costs of litigation or suffering the sting of a pyrrhic victory of having paid to prevail.

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To get in touch with the author of this piece, email Rick at rm@pf2se.com

Return of the TruPS CDO

The good news, for investors in TruPS CDOs, is that at least one rating agency has responded to our calls for upgrades.

Moody’s, in two separate actions over the last two weeks, upgraded three tranches of Trapeza CDO VI and two tranches of Alesco Preferred Funding CDO I.

All five of the upgraded Alesco and Trapeza bonds were previously downgraded on July 13, 2010.

When you analyze ratings migrations, you notice raters have a tendency to inflate the initial ratings on new structures (the “Type I” error). When things go wrong, rating agencies then tend to exaggerate their downgrades to avoid being caught looking foolish when AAA or AA securities default. But they then run the second risk, which is seldom monitored or advertised, of the “Type II” error – the rating too low of a security that pays off in full. Both of these errors have the potential to be damaging to investors: investors get insufficient coupon reward for taking outsized risks at the beginning, and then they pay too much, in ratings-based margin, for holding under-rated bonds after the magnified downgrades.

We felt we had noticed the exaggeration of downgrades for at least some TruPS CDO bonds. We expect certain of the bonds that have been downgraded, to as low as CCC, to pay off in full. We therefore called for upgrades, of at least certain of these bonds, after noticing a growing disconnect between the actual asset-level performance of TruPS CDOs and the ratings performance of the asset class.

Upgrading bonds is a good thing for TruPS CDO investors: it may provide the support needed to mark them up, or to reduce capital reserves (or margin) held against them. In the best case, for bonds expected to ultimately pay out in full, the upgrade provides “leverage” for small bank managers to justify holding these securities at par in hold-to-maturity accounts; or to combat regulatory pressure to mark them to fair value based on an OTTI write-down.

While Moody’s upgrading intentions are a healthy sign, they do not always precipitate a similar response from the other rating agencies in the short term:

- The upgrades are due, in no small part, to the generation of excess spread by the underlying assets. Fitch, for one, does not model these structures and so by definition cannot adequately capture, in their ratings, the effects of this excess spread. It may thus be reasonable to expect Fitch’s TruPS CDO ratings to linger in this regard, until they ultimately follow the direction of the other rating agencies. (To be fair to Fitch, Fitch did in its September review retroactively upgrade a single tranche when Fitch saw the tranche was being paid down – but it also downgraded seven tranches and affirmed the ratings of 488 tranches. The A2 tranche of PreTSL 8 was upgraded, wait for it, from CC to B, less than one year after it was downgraded from B to CC. The bond was originally rated AAA by Fitch.)

- Rating agencies also, understandably, have a natural tendency to want to avoid flip-flopping on their ratings. The CLO downgrade-turn-upgrades within a year have caused the raters significant embarrassment. How will they look if, so soon after downgrading these 30 year TruPS CDOS, they then re-upgrade them? The market may be led to believe that the raters’ economic models hold little predictive content.

Trading in TruPS CDOs presents serious money-making opportunities, heightened somewhat by the ratings arbitrage available: for example, the recently upgraded A1A tranche of Trapeza VI is now rated Aa3 by Moody's, A by Fitch, while rated CCC+ by S&P. This dynamic should also provide holders with all the encouragement they need to examine the “true” flow of funds of their TruPS CDOs, rather than relying purely on their ratings (and succumbing to associated regulatory pressure to boost reserves).

What Value the Rating?

I often ask myself how valuable any sell-side research can be, given the obvious conflicts being suffered through by a banks’ research team. The attributes that undermine the effectiveness of a banks’ research analysis are numerous – here are some:

1. the bank typically has many more buy recommendations than sell recommendations (The Big Short’s Vincent "Vinny" Daniel neatly captures the conflict when he says “You can be positive and wrong on the sell side,”… “[but] if you’re negative and wrong you get fired.”)

2. similar to the prior point, the uneven distribution of ratings renders the “buy” rating less meaningful

3. the accuracy of a rating isn’t easy to test, as its term and range isn’t always well-defined

4. the rating changes with regularity, and so never adjusts or converges to a final number, so the same analyst may appear right then wrong then right again. Were they right, overall? (see for example “S&P upgrades Google stock days after "sell" view”)


I remember chatting, a while back, to a former sell-side research analyst from a so-called Yankee Bank about what it was like rating stocks during the heat of the financial downturn (2007-2008).

He commented on the futility of his position: his predictions may just as easily be right as wrong, given the heavy influence of emotions, or market technicals, rather than any reliance on company fundamentals – which he was being asked to judge.

But he also described his position as awkward: in a market in which he truly expected almost everything to keep going down, he wasn't in a position to issue sell ratings on all his stocks. Why maintain a buy rating, or a hold, if you really think the client out to sell? But what effect would be produced if you put a sell rating on everything? Putting a sell rating is bad for business, and by way of the influence banks wield in providing ratings, serves only to increase the likelihood of a further decline, or to exacerbate that decline.

So in a down market, we have an influential bank analyst, who otherwise provides useful market color, feeling his position to be both awkward and futile.

I remember his remarks from time to time, especially when people ask me what I think of the US downgrade by S&P or the downgrading of other sovereigns like Italy or Spain.

While the downgrade may or may not be the right action, from a legal perspective based on the code of NRSRO ratings, one has to wonder what the benefit may be. If the downgrade action reflects the rater's perception that a sovereign entity may struggle to raise funds – as was the case in the Italy downgrade action – the actual downgrade itself only serves to heighten the sovereignty's difficulties in raising such funds. Economists often call this a self-fulfilling prophecy or a self-effectuating phenomenon.

As opposed to the threat of downgrade hanging like Damocles' sword above a finance minister, encouraging him/her to get the country's finances in order, the downgrade action serves little purpose - only making it harder to get one's finances in order.

And thus the duality of the position: can one credibly support an action that only serves to exacerbate a difficult situation, while helping nobody (aside, perhaps, from short sellers and political opponents to controlling regimes or parties).

The bank analyst felt his position to be futile and awkward. The rating analyst may struggle to sleep: his or her option is to defy the company's code, or to be destructive.

Will S&P's Wells Notice Change Their Behavior?

The role of the credit rating agencies in the recent financial crisis has been highlighted by numerous investigations including the Financial Crisis Commission and the Senate Permanent Subcommittee on Investigations (PSI). It therefore comes as no surprise that Standard & Poor’s receipt of a Wells Notice, indicating the SEC’s intention to sue, has garnered its fair share of attention. Challenges presented by the issuance of the so-called Wells Notice, and the circumstances surrounding it, will likely culminate in rating agencies and issuing entities having to adjust their approaches to the ratings process.

The various forms of media speculation have focused on Delphinus CDO, a crisis-era structure backed by subprime mortgage bonds, as the focal point of the SEC’s investigation. This transaction was highlighted by Senator Levin’s PSI report as a “striking example” of how banks and ratings firms branded mortgage-linked products safe even as the housing market worsened in 2007.

The implications of S&P’s internal emails, made public through the Senate’s investigative process, are that the rater may have known, at the time it was issuing its ratings on Delphinus, that the ratings being provided were inconsistent with its then-current methodology. In essence, S&P’s model and ratings were contingent on certain preliminary information made available to them by the underwriting bank. When that information changed at a late stage of the deal’s construction, S&P’s model was no longer able to produce results consistent with the desired rating.

That S&P nevertheless issued the originally-requested rating, despite its being incompatible with the new information, opens a line of questioning into whether S&P’s ultimate rating adequately reflected its own analysis. In issuing the Wells Notice, the SEC may at this juncture reasonably suspect S&P of committing a Rule 10b-5 violation.

The SEC would be pressed to show that S&P knew, at the time it was providing the rating, that the rating was ill-deserved (and thus misleading to investors). If the SEC is able to show that S&P intentionally provided a misleading rating, they would distinguish this case from several of the other rating agency complaints that have been dismissed.

Importantly, the SEC’s case would almost certainly survive the rating agency’s preferred defense motion that invokes their First Amendment rights to express an opinion. Floyd Abrams, S&P’s external counsel on First Amendment issues, himself confesses in his September 2009 testimony before the House that “[the] First Amendment provides no defense against sufficiently pled allegations that a rating agency intentionally misled or defrauded investors,” … “nor does it protect a rating agency if it issues a rating that does not reflect its actual opinion.” (emphasis added)

Aside from the abovementioned Wells Notice, the SEC is showing a keen focus on each rater’s application of its own public methodology: their annual rating agency examination report, released late last week, cites as an “essential finding” that “[one] of the larger NRSROs reported that it had failed to follow its methodology for rating certain asset-backed securities.”

The result of the Delphinus investigation notwithstanding, the mere threat of legal action alters a rater’s approach to issuing ratings and maintaining current ratings. We have already seen the fruits borne of pressure instilled by the new regulatory landscape. In late July of this year, S&P stunned the market by pulling away from rating a commercial mortgage-backed securities (CMBS) transaction, led by Goldman Sachs and Citigroup, on the evening prior to the deal’s closing. S&P reportedly needed to adjust its model to reflect “multiple technical changes,” ultimately leading to the deal being shelved.

The manner in which S&P dealt with a controversial and costly methodological change suggests a new-found sensitivity towards violating the 10b-5 legal standard. Such a drastic action, bringing significant embarrassment to S&P in addition to the loss of market share, would have been inconceivable in the prior, revenue-centric, competitive landscape.

With raters seeking at all costs to avoid a 10b-5 violation, we foresee them increasingly turning away bankers who pressure them with “last-minute” demands. Bankers, risking their deals falling through, will be driven to accommodate the rater’s requirements in providing their supporting data in a more timely fashion, well in advance of a deal’s closing. Perhaps we’ll have fewer deals done as a result; but perhaps those deals will be safer, supported by less-hurried analyses.

As we have seen before, it continues to be legal risk, and not reputational risk, that has encouraged oligopolistic rating agencies to re-focus their attentions on the quality of the product being provided. With Damocles’ sword swinging over-head, we can only hope for more objective ratings going forward – and fewer stale ones.

Complexity is a Cash Cow (but not for you)

“Fortuna's wheel had turned on humanity, crushing its collarbone, smashing its skull, twisting its torso, puncturing its pelvis, sorrowing its soul. Having once been so high, humanity fell so low. What had once been dedicated to the soul was now dedicated to the sale.” – from John Kennedy Toole’s A Confederacy of Dunces

Frank Partnoy, in his recent Financial Times commentary, makes the bold point that while “[most] for-profit companies are run for the benefit of shareholders … banks have been run more for the benefit of employees.”

Partnoy doesn’t delve too deeply into the basis for his claim, but he may well be alluding to the fact that traders were being financially rewarded for executing trades that brought short-term profits at the expense of long-term pain.

We have all heard about the Abacus case, where the bank was accused of siding with one client at the expense of others. (Goldman settled with the SEC for $550mm). In other cases it is argued that banks actually positioned themselves in direct opposition to their clients. Needless to say it doesn’t augur well from a long-term, shareholder value perspective for a bank to be adverse to its clients. Either the bank will suffer or its client will suffer.

From a corporate governance perspective one might argue that senior management failed to the extent its traders were not being compensated based on the long-term quality of their decisions, but rather on their short-term profits. In such a scenario, the traders would not have been incentivized, or forced, to consider the long-term benefits of strong client relationships. They would simply want to execute high margin, million dollar trades.

And hence the layering on of complexity, and the disappearance of transparency.

Complexity

Complex, opaque, private trades afford broker-dealing banks numerous short-term money-making opportunities.

First up, the lack of asset transparency (inability to see through to the asset’s support) and trading transparency (inability, due to the private nature of certain markets, to follow the money or the trading levels) makes it easier for banks to get away with manufacturing prices to their advantage, or taking advantage of comparatively unsophisticated (trusting) clients.

Jim Grant (founder of Grant’s Interest Rate Observer) posited in a recent Bloomberg interview that the world we live in “is a world of fake prices and of manipulated prices.” For liquid, traded securities like municipal bonds or US Treasuries, it is understandably quite difficult to massage the numbers; but for lesser-traded, or illiquid, assets price discovery can be cumbersome if not impossible, making price manipulation all the more feasible.

In Michael Lewis’ The Big Short, Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”

The lack of transparency, too, is entirely convenient to banks in the know: it creates numerous opportunities to profit at the expense of those with less information. We call this imbalance an "informational asymmetry." It may be very difficult to sell Apple stock at an above-market price to even the least sophisticated of investors: they can readily tell that the security ought to be valued lower. But when the security is complex and privately traded, and when the comparatively unsophisticated investors do not have the market know-how or savvy to model the deals, it can be much easier for a bank to "pull one over" on them. The Fed ponders the severity of this very advantage in its aptly titled report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

Complexity also undermines the potential for investigative journalism (they cannot get access to the data or make a complex deal sound too interesting) and, more importantly, the ability for regulators to oversee the markets they regulate. The IMF in 2006 warned that “[while] structured credit products provide a wealth of market information, there remains a paucity of data available for public authorities to more quantitatively assess the degree of risk reduction among banks and to monitor where credit risk has gone.”

Investors would do well to acknowledge the incongruent incentives banks may have to add their complexity to their products. But as buyers, complex deals can be difficult – and expensive – to analyze, and cumbersome if not impossible to trade (out of) during times of heightened volatility.

Investors can push back when offered complex deals that don’t meet their interests – and they can strive to ensure that their rights to high quality information and transparent disclosures are upheld.

Complexity allows for high margin trades that elicit high profits, but sometimes on terms that are not commercially reasonable. And in times of high volatility, they tend to be accompanied by high bid-offer spreads. As always, it’s buyer beware.

The Downgrade Cometh

The concept of conflicted opinions is dear to us. When a conflict is more than a conflict it has the power to put the conflicted party in a false position; the conflict doesn’t act simply as a distracting factor which may throw doubt upon the opinions rendered – but it brings with it an uncanny ability to intrude on the precision of the supporting analysis, and the delicacy with which it is handled.

We have written before of potential conflicts inherent in the ratings model; today our guest author Marc Joffe brings the conflicts question closer to home in the context of S&P’s much debated US downgrade. While at PF2 we’re agnostic on the value added by the downgrade at this late stage, we are happy to host his views to encourage meaningful debate around the importance and implementation of sovereign ratings – and we welcome your comments.


The Downgrade Cometh

By Marc Joffe*

S&P took the right action last Friday. The timing may have been unfortunate. And while Treasury’s announcement of a calculation error was embarrassing, the fact is that $2 trillion is little more than a rounding error in relation to the $211 trillion overall fiscal gap calculated by Lawrence Kotlikoff. But rather than crucifying S&P, the media should be asking other rating agencies what numerical analysis they have done – if any – to justify their decision to maintain status quo.

The persistence of the US AAA rating in the face of high debt ratios and political paralysis was becoming an embarrassment for the rating industry. The ratings disconnect reminded one of the Enron saga, or the subprime misratings, which were sorely lacking in any intellectual basis. Let’s hope that the S&P downgrade begins the long march back to credibility.

Faulty ratings should be viewed in a much larger context of biased equity research during the internet bubble (Who is Jack Grubman?), Arthur Anderson’s failure to effectively audit Enron and more recently the phony appraisals and poor underwriting practices that triggered the foreclosure crisis.

Credit evaluation (whether by lenders or rating agencies), equity analysis, auditing and appraising are intimately related. All four of these disciplines affect the flow of capital, and professionals working in these fields are torn between cutting corners and ignoring professional protocol when conducting their analysis. Those of us who work in these professions face a stark choice: either (1) submit to management, public or client pressure to do a lousy job, or (2) perform thorough, unimpeded analyses that produces the most objective answer. If too many take the first option, funds are mismanaged, investors lose money and savings are curtailed. After all, if you can’t trust financial statements or credit analyses, what confidence can one have in her investment? A society in which the first choice dominates rapidly degenerates from a transparent advanced economy to a corrupt banana republic. This is the risk faced by the US today.

I see in the S&P Sovereign Group’s rating announcement that they had the courage to say what many of us already knew, and were willing to face public criticism when no money was on the line in the name of professional integrity. S&P’s action should remind all of us who assess debt, assets and financial reports to summon up the courage to speak the truth on a regular basis. The short term consequences may be difficult, but the benefits of an appropriate analysis include a clear conscience and a good night’s sleep. If all of us maintain our standards, we can create stronger financial markets and a healthier society.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

A New Approach to Sovereign Ratings

The debt ceiling debacle has rejuvenated the discussion about the adequacy and effectiveness of sovereign credit ratings, as they're currently being provided.

We remain agnostic on the value added of a US downgrade today – does anybody really benefit from a downgrade at this stage? The objective of a downgrade watch notification, or a downgrade itself, is to encourage governmental concern, which precipitates action. We already have international concern. A downgrade at this stage seems only to cause further turmoil.

We are additionally skeptical of the adequacy of sovereign ratings being provided today: we wonder at the raters' ability to determine what they refer to as “willingness to pay.” Are they any better than anybody else at estimating this highly subjective measure? And if so, why is it they cannot provide to users the separate outcomes of each of these two components of the credit rating - the ability to pay and the willingness?** (Note also distinguished researcher Arturo Cifuentes’ timely suggestion of a third component: permission to pay.)

Sadly it seems a crisis has to occur before we resolve flawed systems. Since we believe sovereign ratings ought to be more consistently applied and more transparent, if worthwhile at all, we are happy to host guest author Marc Joffe's posts. We hope his views continue to encourage meaningful debate around the importance and implementation of sovereign ratings, and we welcome your comments.

A New Approach to Sovereign Ratings

By Marc Joffe*

A couple of my friends in the Moody’s diaspora have argued that rating agencies should not assign sovereign ratings due to difficulties in managing conflicts. I disagree for a couple of reasons. First, to the best of my knowledge, sovereign ratings have performed fairly well over the past few decades. While rating changes could have been faster, I have not seen evidence of systematic bias – except perhaps in the maintenance of the home country AAA rating.

Second, sovereign ratings provide a type of government accountability not unlike that offered by an independent press. For this reason, I am actually sympathetic to the idea that ratings warrant First Amendment protection. The best sovereign rating analysis is politically aware without being politically opinionated. As S&P and Moody’s have repeatedly stated during the current debt ceiling debate, they have no view about which fiscal measures should be employed to adjust the nation’s fiscal trajectory, they just believe that inaction or minimal action is no longer consistent with the highest rating.

Although the prevailing sovereign rating methodology may not actually display bias, it is certainly being subjected to accusations of bias, especially in Europe. Also, the present qualitative approach necessitates delays in rating changes unless the rating group is heavily staffed. In last week’s Congressional testimony, S&P President Deven Sharma said that his agency’s sovereign group consists of roughly 100 analysts rating 126 countries – less than 1 full time equivalent per issuer.

Thus, the biggest opportunity for improvement in sovereign rating performance is the application of transparent, quantitative modeling technology fueled by frequently updated data for exogenous variables. Model driven ratings can be calculated daily, weekly or monthly and then reviewed by analysts prior to release. And models don’t worry about being criticized for a lack of patriotism or for affecting interest rates.

Quantitative credit assessment techniques have been successfully applied to consumers, public firms and private firms. Bloomberg and Morningstar have already implemented ratings based on Merton-style public firm models first popularized by KMV Corporation, while RapidRatings uses financial statement data to automatically rate both public and private firms.[1]

Sovereign risk modeling is newer and less developed. The most interesting work I have seen in this area has come from Nouriel Roubini and colleagues, from Dale Gray and colleagues, and from Kamakura Corporation (full disclosure: Kamakura is a client and also has a public firm model). These efforts are generally focused on emerging market issuers, since that is where just about all recent default observations are available. Data for advanced economy sovereign defaults (or, more precisely, defaults by nations that went on to become advanced economies) is older, hard to gather and may require restatement to be meaningful in modern terms. Reinhart and Rogoff have assembled this data for their book and related IMF papers, lowering the data collection barrier.

I propose a different modeling approach for advanced economies that focuses on their primary risk factor: the impact of population aging on social insurance spending. The approach leverages the wealth of budget, economic and demographic data and forecasts available for these countries. While the remainder of the discussion focuses on the US, it should be equally applicable to major European economies.

In the US, the Congressional Budget Office and other government agencies (including OMB and GAO), periodically issue long term budget forecasts. Typical lengths of these forecasts are 10 and 75 years. For Treasury investors, the longest relevant time horizon is 30 years, which also happens to be the length of the longest term macroeconomic forecasts provided by IHS Global Insight and Moody’s Analytics.

The CBO forecasts include projected Debt-to-GDP ratios. It is also possible to derive Interest Expense to Revenue ratios from the CBO outlooks. This latter ratio may be more predictive of default than Debt-to-GDP because it embeds information about the government’s ability to tax economic activity and the level of its Treasury interest rates. (This ratio effectively ignores principal repayment schedules – an exclusion that could be justified by the assumption of continued liquidity and absence of rollover risk for advanced economy sovereign debt.)

Consequently, the CBO data provides expectations for key ratios at the maturity date of long term Treasuries. These expectations are based on policy and macroeconomic forecasts. If different policy and macroeconomic parameters are used, different projected ratios can be generated. If we provide a range of possible scenarios to a Monte Carlo simulation engine, we could generate a distribution of ratio outcomes.

Next, we can use historical data to identify ratios that are associated with default. A nice property of interest expense to government revenue is that, with rare and extremely idiosyncratic exceptions, it is always in the range of zero (absolute certainty of non-default) to 100% (absolute certainty of default). This relationship prevails across all countries and through time. For purposes of this discussion, let’s assume that an interest expense to revenue ratio of 30% is determined to be a reasonable default point. This would mean that a government would be unwilling to pay interest beyond this threshold, because the political pain associated with further crowding out other kinds of spending exceeds that stemming from a default. Admittedly limited post-Reconstruction experience in the US suggests that the critical value of this ratio, i.e. the default point, is 30% (see my earlier blog post entitled Correction: The US Has Defaulted Before and it Can Default Again).

With a distribution of ratio realizations and critical point both in hand, rating the issuer is then simply a matter of calculating the proportion of the distribution beyond the default point. If this proportion is very low (perhaps 0.25% for a thirty year Treasury), the issuer is AAA. If the proportion of “default-indicative” realizations is higher, then a lower rating is appropriate.

What would such a model conclude about the US? Since the model only exists in the form of the rough outline above, I can’t be certain – but I have a pretty good idea. In April, I calculated a projected interest expense to revenue ratio based on an adjusted version of the June 2010 CBO Long Term outlook. The adjustments mostly reflected some inputs from CBO’s more recent March 2011 10-year forecast. This calculation yielded a ratio of 37.82% in FY 2041. (Although the debt ceiling deal lowers this figure somewhat, CBO may also have to make an offsetting adjustment due to the disappointing GDP numbers published last week). Assuming that the 30% ratio is indeed the default point, the implied default probability is quite substantial.

This rough calculation is based on a number of assumptions, most important of which is that the CBO forecast provides a reasonable expected value. While CBO’s economic forecasts are well within the mainstream, CBO more controversially assumes no substantive policy change. If major tax increases or entitlement reforms are implemented, the expected ratio could be far lower. But the recent debt ceiling debate has shown just how difficult major policy change is in an environment of divided government and party polarization (the concept of Congressional polarization can be quantified as Political Scientist Keith Poole regularly does at VoteView).

Contrary to what we hear from politicians and the media, I do not see much reason to expect this situation to be resolved by the 2012 election. The likelihood that divided government will continue can be estimated by consulting political markets, such as InTrade, which reflects the expectation that Obama will be President and that the Republicans will control the House and Senate in 2013. Also, the further we get into the cycle of baby boomer retirements, which started in 2008, the more difficult entitlement changes will become given the economic inflexibility and heightened voting participation of seniors.

One assumption in the CBO projections that could be questioned is the reversion of interest rates to modern historical averages over the next few years. If, instead, the US has entered a period of sustained low interest rates a la Japan, the terminal interest expense to revenue ratio would be far lower.

Regardless of which interest rate, policy or growth assumptions are used, the simulation model outlined above provides a formal way of evaluating the implications of a range of political and economic scenarios for sovereign creditors. Further, if rating agencies make the simulation model and their assumptions publicly available, investors could substitute their own exogenous variables and form their own conclusions. The benefit is that evaluations of US and other advanced sovereign credits become more rigorous and more transparent. Quantitative approaches do not guarantee objectivity because the choice of assumptions can itself be biased, but any bias and its effect on the rating becomes more apparent and much easier to address.

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[1] Application of models to structured products has proven more controversial, but I would argue that the problems of 2007-2008 are not an indictment of quantitative assessment in general. Instead, the crisis is an indictment of the specific modeling procedures and assumptions employed. Just because models based on Gaussian Copulas failed to adequately weight tail risk does not mean that models relying on more empirically appropriate distributions will not work. And just because RMBS models failed to consider negative Housing Price Appreciation in 2006 is not evidence that models that included a proper set of HPA scenarios would not have been effective.

* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

** It is worthwhile to note that rating agency BMI, though not an SEC-licenced NRSRO, divulges each of the two components separately in its rating analysis.

Correction: The US Has Defaulted Before and It Can Default Again

This is a second piece on the topic of sovereign debt and ratings, by guest author Marc Joffe*. You can access his prior piece here: US Debt Ceiling Crisis: Rating the Rating Agencies.


One troubling aspect of the political debate over the debt ceiling is the constant repetition of the statement that “the US has never defaulted on its debt”. On the grounds that those who fail to learn from history are due to repeat it, I would like to set the record straight. I welcome readers to share this with colleagues with or without attribution. Fellow risk professionals and the general public deserve to know the facts. During its 235 years as a sovereign entity the United States has defaulted on three separate occasions - two of which are reported by Rinehart & Rogoff (2009) - and has also intentionally liquidated debt via inflation.

In 1782, the Treasury failed to pay interest on Revolutionary War debt. Following ratification of the Constitution, Treasury Secretary Alexander Hamilton resumed regular debt service in 1790, but deferred some interest payments for ten years (Riley, 1978).

For several decades prior to 1933, holders of Treasury securities were contractually entitled to receive interest and principal payments in either dollars or gold. At the time, many contracts contained a “gold clause”, which enabled payees to receive proceeds in the form of gold. During the 1933 banking holiday declared by President Franklin Roosevelt immediately after his March 4 inauguration, the federal government refused requests for interest payments in gold, remitting only currency instead. Congress later ratified this action by formally invalidating gold clauses in a "Joint Resolution to Assure Uniform Value to the Coins and Currencies of the United States," passed on June 5, 1933. In 1934, President Roosevelt officially devalued the dollar by increasing the price of gold from $20.67 to $35.00. Although contemporary press accounts characterized the government’s actions as an abrogation (Wall Street Journal, 1933, May 4), Treasury securities issued in June and August of 1933 were oversubscribed and a February 1935 Supreme Court decision upheld the government’s actions. While these actions were generally portrayed today as an attempt to halt gold hoarding or end price deflation, they also appear to have had a fiscal motivation. In FY 1933, the ratio of interest expense to federal revenues reached 33.15%, the only time this ratio has exceeded 30% since the post-Civil War era. The Roosevelt administration needed more funds to implement New Deal programs and wanted the flexibility to issue new Treasury securities unimpeded by gold convertibility (Wall Street Journal, 1933, May 27). On a cautionary note, Moody’s Municipal and Government Bond Manuals from 1933 and 1934, show that all US Treasury bonds carried Aaa ratings both before and after this default (Mergent, 1933-1934).

The United States Debt-to-GDP ratio reached its modern peak of 112.7% in 1945, primarily due to war-time borrowing. Interest rates at the time were relatively low, while tax rates were relatively high. Thus interest expense accounted for only 7.79% FY 1945 federal revenues – compared to a proportion of 9.88% in FY 2010 – suggesting that this high level of debt could be serviced without great difficulty. The Debt-to-GDP ratio fell rapidly after the end of World War II, largely as a result of high inflation that followed the relaxation of wartime price controls and Federal Reserve purchases of Liberty Bonds. Thornton (1984) reports that the Federal Reserve tripled its holdings of government debt between 1943 and 1946 by agreement with the Treasury. Consumer prices rose 18.1% in calendar year 1946 and 8.8% in 1947 (Bureau of Labor Statistics, 2011). By FY 1948, the Debt-to-GDP ratio had dropped to 79.9%. The ratio continued to fall through the early 1970s as economic growth outpaced the accumulation of debt. The ratio stabilized in the mid-1970s and then – after being temporarily suppressed by another round of inflation – climbed through the 1980s and early 1990s. This period was also characterized by high interest rates, increasing the Treasury’s debt service costs.

Meanwhile, as reported in The Economist (2011, June 23), the US Treasury failed to redeem $122 million of Treasury bills on time after another debt ceiling debate in 1979. This episode was purely a technical default, arising from systems issues.

The ratio of interest expense to revenues achieved a recent peak of 18.43% in FY 1991. Tax increases and spending cuts in the early 1990s, followed by rapid economic growth in the late 1990s substantially improved US debt ratios. By FY 2002, interest expense had dropped below 10% of federal revenues, while publicly held debt fell to less than 35% of GDP. Persistent large deficits over the last nine years have substantially increased the nations’ Debt-to-GDP ratio, while interest payments as a proportion of revenues have remained relatively stable due to low interest rates.

In 1933, an interest to revenue ratio exceeding 30% preceded a change in the terms of Treasury securities widely regarded as a default. After World War II, the record high Debt-to-GDP ratio of 112.7% was reduced in large measure through price inflation. Budget projections from various sources suggest that these two ratios will return to their historic highs during the late 2020s and 2030s in the absence of major policy changes. If these projections are realized, history suggests that holders of Treasury instruments will be subject to substantial risk.

While inflation would undoubtedly be the politically preferred method of restoring debt ratios to sustainable levels, outright default is also possible. Since the Federal Reserve chair’s term is not aligned with that of the President or Congress, it is possible that a chair politically disconnected from elected leadership may not succumb to pressure to monetize the debt. Further, regardless of political alignment, a Federal Reserve chair may decide that the price inflationary consequences of monetizing debt are worse than the consequences of a forced restructuring of Treasury debt. Jeff Hummel (2009), the first economist to predict a Treasury default, makes some more elaborate arguments as to why the federal government might choose default over inflation.

Conclusion: The US Treasury has defaulted in the past and it has a material risk of doing so again. Absent substantive budget reforms in the current debate, it is hard to see any justification for leaving the US at AAA.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

References

Bureau of Labor Statistics (2011). Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes From 1913 to Present. ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.

Economist (2011, June 23). The mother of all tail risks. http://www.economist.com/node/18866851.

Hummel, J. R. (2009). Why default on U.S. Treasuries is likely. Library of Economics and Liberty. Retrieved from http://www.econlib.org/library/Columns/y2009/Hummeltbills.html.

Mergent Corporation (1933, 1934). Moody’s Manual of Municipal and Government Bonds. Available online by subscription from Mergent Corporation, Fort Mill, SC.

Riley, J. C. (1978). Foreign Credit and Fiscal Stability: Dutch Investment in the United States, 1781-1794. The Journal of American History (65), 654-678.

Reinhart, C. M. & Rogoff, K. S. (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press. Pages 112-113.

Thornton, D. L. (1984). Monetizing the Debt. The Federal Reserve Bank of St. Louis Review, 66(12), 30-43. Retrieved from http://research.stlouisfed.org/publications/review/84/12/Monetizing_Dec1984.pdf.

Wall Street Journal (1933, May 4). Editorial: No Payment in Gold. Page 6.

Wall Street Journal (1933, May 27). Acts to Cancel Gold Clause: Administration Bill in Both Houses Seen as Move Toward Long Term Bond Issue. Page 1.

US Debt Ceiling Crisis: Rating the Rating Agencies

By guest author Marc Joffe*

News reports and punditry reveal a shocking ignorance of the role played by rating agencies in the US deficit debate. Depending on the commentator’s bias, rating agency actions have been either lionized or demonized, often inappropriately. After dispelling some unfortunate myths about rating agencies, I will offer the reader a more informed assessment of how the three dominant rating agencies are handling the debt ceiling crisis.

Commentators often confuse a credit downgrade with a prediction of default. If a rating agency downgrades an issuer from AAA to AA+, it is not predicting that the issuer will default. The rating change simply expresses the view that a default or a loss of principal/interest is more likely. Since rating scales typically have about 18 different grades, a transition from the highest rating to the second highest rating does not reflect an enormous change in risk. A downgrade from AAA to AA+ simply reflects a rating agency’s view that the credit risk of the US has gone from de minimis to very low. Thus, if a rating agency were to downgrade the Treasury to AA+ and a US bond default did not immediately follow, it would not be appropriate to say that the rating agency made an error. On the other hand, if rating agencies leave the US at AAA and it does default, that would be indicative of an error – similar to assigning AAA ratings to structured instruments that later missed payments.

While it is true that the rating agencies commenting on US creditworthiness are the same firms that assigned inaccurate ratings to mortgage backed securities a few years ago, this fact is not especially meaningful. The analysts who assign ratings to structured finance instruments and those that assess sovereign bonds are different people, working in different groups, using different methodologies. More importantly, the commercial considerations that might bias sovereign ratings are totally different from those that impact assessments of structured assets.

Ratings for mortgage backed securities, collateralized debt obligations and other asset backed instruments are purchased by a relatively small number of issuers. If a rating agency provides an “unsatisfactory” rating for a deal structured by a given issuer, the agency risks losing a sizable fee for the deal in question as well as revenue from all future deals marketed by that issuer. Thus, in the structured finance area, the reactions of a few issuers can materially affect the rating agency’s revenue.

This is not the case with sovereign ratings. Advanced economy sovereigns, such as the United States, pay little if anything for their ratings. Thus, all the concerns about the so-called issuer pays model do not apply to sovereign ratings. At the same time, other commercial considerations might impact them. For example, since rating agencies are regulated by the United States, European Union and other sovereign authorities, they may have reason to fear retaliation from their regulators. While such fears appear to have a basis in Europe where official criticism of the agencies has been frequent, we have yet to see a similar problem in the United States.

Second, sovereign rating changes may impact other ratings in ways that create commercial challenges for rating agencies and investors. Given the dependence of numerous bond-issuing entities on the US government, a Treasury downgrade may trigger a large number of municipal, corporate and structured finance issuer downgrades as well. This cascade of downgrades would impose challenges on a rating agency’s internal systems, staff research skills and relationships with affected issuers.

To the extent that certain institutional investors are restricted to investing in AAA securities, a Treasury downgrade would result in the forced liquidation of many assets. Institutional investors – who often purchase research, data and analytics from ratings firms – may react negatively to such a scenario. Moreover, such portfolio changes could substantially impact interest rates. If these interest rate changes are blamed on the rating agencies, they may suffer reputational consequences.

Such concerns may unduly retard rating changes that appear justified by the issuer’s credit status. In this connection, I am reminded of the Enron situation in late 2001. Back then, the concern was that downgrading Enron to a speculative grade rating would effectively shut the firm out of the credit market and thereby force it into bankruptcy – which is precisely what happened when the belated downgrades were announced.

I characterize the Enron downgrades as “belated” because they occurred long after the firm was identified as a “junk” issuer by quantitative credit models, like the one marketed by KMV Corporation –now owned by Moody’s. Since computer models do not worry about commercial implications of their calculations, they promise to provide more instantaneous and less biased credit assessments than human rating analysts can. While quantitative models for corporate and structured instruments are quite common, relatively little progress has been made in modeling municipal and sovereign risk. (One notable exception is Kamakura Corporation’s sovereign model, released in 2008.)

As with Enron, major rating agency admonitions about US Treasury creditworthiness have been late. Official warnings about the long term sustainability of the federal budget due to population aging date back to the early 1990s. In 2006, Boston University economist Laurence J. Kotlikoff warned that the US was headed toward bankruptcy. In 2009, SR Rating, a Brazilian rating agency assigned the US a rating of AA. This was followed in 2010 by Dagong, a Chinese rating agency, which downgraded the US from AA to A+ last November. Earlier this month, Egan Jones, a small US-based rating agency that employs an investor pays model downgraded the US from AAA to AA+.

Within the last few years, US debt ratios have clearly diverged from comparable AAA sovereigns such as Canada and Australia. For example, the CIA World Fact book shows that in 2010 the ratio of publicly held debt to GDP was 59% in the US, compared to 34% in Canada and 22% in Australia. These other two countries are also less exposed to the consequences of population aging issues and they shoulder a smaller military burden than the United States, so it is difficult to see why all three countries merit the same rating in systems that have 18 distinct credit grades.

Finally, the parliamentary system employed by other Western democracies is better equipped to address fiscal stress than the divided government we have in the US. In a parliamentary system like that of the UK, a single party or a coalition can more readily obtain full control of all the levers of power and use them to implement unpopular changes at the beginning of its term (this is less true in parliamentary democracies that have large numbers of significant parties and thus weaker governing coalitions). In the US, with its more frequent elections, division of responsibility between two houses of Congress and an Executive branch often held by opposing parties and the risk of Senate filibusters, fiscal consolidation is far more difficult. This disadvantage has been exacerbated in recent decades as bipartisanship on many issues has given way to party polarization. These issues of governmental effectiveness should be a part of any comprehensive credit assessment of US Treasury securities.

One justification for maintaining the US AAA rating in spite of these concerns has been refuted by the current crisis. The argument is that since the US manages the world’s reserve currency it is somehow insulated from default. Unfortunately, the US dollar’s reserve status has been under attack for several years, and is not guaranteed to persist over the 30-year term of the longest dated Treasury instruments. Further, the reserve currency argument implicitly assumes that the Federal Reserve would monetize Treasury debts should default risk appear. This argument ignores Fed independence, as well as the fact that the CPI indexing of many Federal benefits would impede the government’s ability to liquidate debt by printing money. Finally, I have not heard any responsible commentator suggest that the government address a failure to raise the debt ceiling by paying creditors with newly created money, so clearly reserve currency status provides no refuge in the current scenario.

While all three major rating agencies have been late to the downgrade party, there are notable differences among them in their handling of recent events. In my view, S&P has performed the best. They were first to take any action, assigning a negative outlook to US Treasury securities on April 18, 2011. Further, S&P has correctly maintained that a debt ceiling increase without meaningful budget reforms would still merit a downgrade. As suggested earlier, the long term US fiscal imbalance has been known to policymakers for 20 years. If a political crisis like the one we are currently experiencing is unable to motivate elected officials to substantially reduce the gap between out-year revenues and expenditures, it is hard to see what will, thus leaving a future default as a significant risk.

Moody’s recent pronouncements have also been largely on target, but the agency was slower off the mark. On February 24, 2011, Moody’s predicted that the debt limit would be raised before the ceiling was reached - on May 16. On June 2, the agency observed that the risk of default due to a failure to raise the debt limit was a rising but still very small risk. Finally, on July 13, Moody’s placed the US credit rating on watch for possible downgrade and also noted that it would assign a negative outlook if substantive deficit reductions were not implemented together with a debt ceiling increase. Although welcome, Moody’s stance is not as strong as that taken by S&P. While Moody’s is threatening to maintain a negative outlook in the absence of substantive action, S&P has warned of an outright downgrade.

Another worry about Moody’s position is that the firm is frequently represented in the media by economists from Moody’s Analytics, such as Mark Zandi. Moody’s Analytics is a distinct subsidiary within Moody’s Corporation from the rating issuing entity, Moody’s Investors Service. Consequently, Zandi and others at Moody’s Analytics are not involved in the sovereign ratings process, a fact often lost on interviewers. Further, Moody’s Analytics economists have previously been on record as supporting fiscal stimulus measures including the recent temporary reduction in the Social Security tax rate. While Keynesian policies may be justified on other grounds, they are not consistent with maximizing a sovereign issuer’s creditworthiness at least in the short run. It is thus unfortunate when the public gets the impression that Moody’s Analytics economists are somehow representing the views of the rating agency.

Finally, it has been disappointing to see the third rating agency joining the discussion so late. In a report dated June 8, 2011, Fitch stated that it would place the US on negative watch on August 2nd if the debt ceiling was not raised and suggested that outright downgrades would occur only in the event of an actual failure to pay scheduled interest or principal. The idea that a default would be needed to trigger a downgrade negates the value of credit ratings. If credit ratings are not supposed to hold predictive content, it is hard to see why investors would need them.

In short, the leading credit rating agencies are belatedly awakening to the fact that a dysfunctional political system and long term fiscal imbalances have created significant risks for Treasury investors. Now these agencies, led by S&P, are beginning to provide investors with insight into the unfolding situation, largely free of the biases that affected them during the 2007-2008 credit crisis. That said, investors would ultimately be better served by measures of advanced economy sovereign risk that react more quickly and are less burdened by potential conflicts.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.