Moody’s view of sovereign ratings
I’m very late to Adam Ozimek’s interview with David Levey,Â Â the former Director of Sovereign Ratings for Moodyâ€™s. Levey makes a couple excellent points about sovereign ratings, starting with this one:
On methodology, things changed in the mid-2000s. Under pressure from regulators and issuers, the agencies were forced to â€śopen the black boxâ€ť and become much more explicit about their criteria, scorings, weights attached to various factors, etc. There was a tendency to move to a â€śscientisticâ€ť, quantitative, formulaic approach. I tended to resist that (being a great admirer of Hayek). I saw risk assessment as a multidisciplinary, highly qualitative, judgment process involving a varied weighting of factors.
I fear that this is exactly the reason why S&P started coming out with weirdly precise deficit-cutting targets — the “chop $4 trillion over ten years, or we’ll downgrade” phenomenon. Sovereign ratings are always more of an art than a science, and the pressure to become quantitative and formulaic has been deleterious at both major ratings agencies.
Levey also explains how ability and willingness to pay are inextricably intertwined:
Neither willingness nor ability can be defined independent of the other. â€śWillingnessâ€ť depends on political calculations of the degree of sacrifice that would be required to make payment, which in turn depends on the financial resources available or easily raised. â€śAbilityâ€ť depends on how much additional resources for debt payment the government can â€śsqueeze outâ€ť through reductions in spending or increases in taxation â€” a political consideration. So the relation between them is -to use an old phrase-â€ťdialecticalâ€ť and the analysis is based on what Adam Smith called â€śpolitical economyâ€ť. This may sound like â€śscholasticâ€ť nit-picking, but the point is vital for guiding the rating decision process.
It is reasonable, therefore, for S&P to keep one eye on debt ratios when it’s judging the US willingness to pay: the higher the amount of debt a country (or any debtor, for that matter) has, the lower that debtor’s willingness to pay becomes. If I only have $5,000 outstanding on the mortgage on my $300,000 home, I’m going to be extremely willing to pay that debt. If I have $500,000 outstanding, then, not so much. But as Levey says, these things aren’t scientific. And it’s silly to try to move from a general principle — the higher your debts, the lower your willingness to pay them — to something spuriously quantitative, like putting a dollar amount on the point at which your willingness to pay will fall.
Levey also says that I’m wrong about the difference between S&P and Moody’s. He’s much more of an expert on this subject than I am, so it’s worth taking his views seriously. But his stated reasons for disagreeing with me are pretty weak. He gives three:
First, S&P â€śnotchesâ€ť for subordinated debt, meaning that they are taking into account that a default on that debt is likely to have a greater severity than on senior debt.
No, it doesn’t mean that at all. Subordinated debt is more likely to default — that’s what subordinated means.* And because it’s more likely to default, it has a lower credit rating. You don’t need to look at severity in order to give a different credit rating to subordinated debt than to senior debt.
Second, market participants would find ratings almost impossible to use without comparability of meaning. So â€” in a sense â€” the markets more or less force equivalence of meaning on the agencies.
Essentially, Levey is saying here that S&P has to do what Moody’s does, since the markets think the two agencies are doing the same thing. I don’t buy it.
Third, if the meanings were that different, there would be a lot more â€śsplit ratingsâ€ť (situations where the agencies rate differently) than there are.
This isn’t really true. The main case in which the difference in methodologies would result in a split rating is a case where there’s a significant risk of default, but where the likely loss given default is zero, and the likely recovery rate is 100 cents on the dollar. This is exactly what we’re looking at in the case of the US sovereign rating, and it applies to entities with US sovereign guarantees as well. But beyond that, it’s rare elsewhere. In general, if an issuer defaults, they’re not likely to pay off their debts in full. And as a result, S&P and Moody’s are likely to have similar ratings.
The ratings could diverge at the other end of the spectrum, too — Moody’s might have a lower rating than S&P, if the default probability were low but the loss given default was likely to be enormous. When does that happen? Mostly in the world of structured credit, where Moody’s had a vested interest in ignoring the fact that recovery values in the event of default were generally zero.
All that said, I suspect that what Levey’s saying here does have some truth to it: S&P is well aware of how its ratings are interpreted by the markets, and does little to disabuse the markets of that impression. I do think that the difference between S&P and Moody’s explains why S&P downgraded the US and Moody’s didn’t. But I don’t think the difference is all that big in their general day-to-day operations.
*Update: Greycap points out, in the comments, that really the meaning of the term “subordinated” is what happens to the debt in bankruptcy: that the claims are junior to other claims after the company has defaulted. This is true. But by the same token, everybody knows this, and lots of companies restructure or otherwise work out their debts “in the shadow of bankruptcy” — essentially trying to replicate the likely outcome of a bankruptcy case without all its myriad associated costs. It’s very easy, in that situation, for subordinated debt to suffer a haircut or become converted to equity while senior debt remains whole.
Update 2: Greycap seems to think that a default on subordinated debt while the senior debt remains whole “arguably has never existed in the history of the world and will never exist until the end of time”. Just off the top of my head, isn’t that exactly what we saw at Anglo Irish Bank?