Standard & Poor’s and the ratings game
The decision by Standard & Poor‚Äôs to downgrade the U.S. credit rating illustrates a number of areas of weakness in the world of ratings.¬† While S&P,¬† Moody‚Äôs and the other mainstream ratings agencies have done a pretty good job on corporate and municipal debt ratings over the past century and more, when it comes to sovereigns and other highly politicized situations, their records are rather poor, if you‚Äôll forgive the pun.
Most observers now know that S&P, Moody‚Äôs and other ratings agencies prostituted themselves and their special position of trust with respect to mortgage-backed securities and exotic derivatives on same.¬† But in the world of sovereign debt, S&P is forced to evaluate many more subjective facts than are involved in a simple analysis of the probability of default of, say, General Electric or IBM.
Recall the financial and economic crises in Europe following WWII, the era when the U.S. was proclaimed the new Rome and the dollar was equated with gold at the Bretton Woods conference.¬† The broken nations of Europe and Asia were rebuilt with American credit and prosperity reigned, but most credit ratings for European nations remained unchanged under ‚ÄúPax Americana.‚ÄĚ
By the 1970s and 1980s, oil shocks and trade deficit combined to send many Latin American nations into default.¬† And in almost every case, the major ratings agencies were late in downgrading these obligors because of political pressure from Washington and the creditor banks in New York.¬† In the world of S&P and Moody‚Äôs, people decide when to issue or change a rating — usually for consideration. ¬†This entirely subjective, conflicted process is very exposed to political manipulation.
Roll the film forward to the late 1990s, when the collapse of Enron was delayed for weeks as rating agencies like S&P delayed their decision to downgrade the fraudulent Ponzi scheme created by Ken Lay.¬† Robert Rubin, who resigned as treasury secretary in July 1999 and several months later became chairman of Citigroup’s executive committee, called Peter R. Fisher, the Under Secretary of the Treasury for Domestic Finance, on Nov. 8, 2001, after learning that Enron was close to losing its investment-grade rating. ¬†A political uproar followed.
While Rubin was later cleared of any criminal wrong doing, the effort by Washington to delay the change in Enron‚Äôs credit rating prevented many investors from fleeing Enron exposures and thus caused them billions in losses.¬† Likewise in the case of WorldCom, another highly political corporate bankruptcy, the visible probability of default for the obligor was headed toward junk status more than a year before S&P actually downgraded the company‚Äôs debt rating.
The experience with past debt crises us several things about the decision last week by S&P to drop the US credit rating.¬† First, the decision to change a rating on a sovereign borrower is usually months late.¬† In the case of the downgrade of the US, S&P and other agencies arguably should have acted many years ago.
As I wrote for¬†Reuters last week, “Basel III in the age of sovereign default,” that if credit default swaps (CDS) for the U.S. are trading over 50bp per year, then it sure looks like the marketplace is voting for a “BBB” bond ratings equivalent for Uncle Sam. A bond equivalent “AAA” rating equals 1bp of default probability, by comparison.¬† Like WorldCom, the US has been trading over 50bp in five-year CDS for many months now.
The second aspect of the S&P action Friday is that the actual decision of the timing of a ratings change remains entirely opaque.¬† Based on the criteria in the S&P report, the agency arguably should have downgraded the U.S. when the central bank began ‚Äúquantitative easing‚ÄĚ several years ago.¬† The uproar regarding the S&P decision is due in large part to the fact that nobody understands the timing of the decision.
But the most striking aspect of the S&P decision, especially speaking as the owner of a bank ratings firm, is the lack of a mechanistic framework to help investors and political leaders understand the rules of the ratings game.¬† Whereas at my firm we use computers to rate all U.S. banks and publish a new rating for every banks at the same time each quarter, the process used by S&P — if you can call it that — has virtually no hard debt service or economic benchmarks to tell when a rating must change.
At the end of the day, the challenge facing S&P and the other traditional providers of ratings is to migrate their decision-making process to a more transparent and less easily manipulated model. ¬†Needless to say, we at IRA are feeling pretty good about our decision of almost a decade ago to allow machines to determine ratings changes using hard rules defined by mathematics, the underlying data and the calendar — not the whim and caprice of humans.
Delay in changing a rating means a delay in a change in valuation and adjusting asset allocation, with big ramifications for investors and markets. ¬†As my friend Sylvain Raynes, who formerly worked for Moody‚Äôs rating structure products, said at a meeting of PRMIA in 2007:
Valuation is not the most important problem in finance; valuation is not the most interesting problem in finance; valuation is the only problem for finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If you do not recognize the difference, the fundamental difference between price and value, then you are doomed.