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Usefulness and competence of rating agencies

This is not electoral populism to only criticize rating agencies, rather than question their economic utility and try to ask questions about their actual skills, in other words their ability to analyze the creditworthiness of issuers they rate.

Article also available in : English EN | français FR

All observers and financial market specialists have written a lot about rating agencies in recent months. Here’s what I think

1/ First of all, they are dangerous for macroeconomics and public finance of the most fragile issu. One of the best illustrations of this danger is the well-known phenomenon of self-fulfilling prophesies and their too pro-cyclical role. By downgrading and warning such issuer or by considering the possibility of default of a sovereign, rising credit spreads and therefore - other things being equal - higher interest rates on the issuer secondary debt in question increases the probability of default

2/ Then the rating agencies are not very useful to investors because they are not always involved with an appropriate timing.. Either degradation of some signatures are too late and follows the breakdown of credit spreads (telcos degraded in 2002-2003 should have been at the height of the tech bubble in 2000 or so at worst in 2001, the fragile countries in the Euro zone, including France, should have been downgraded in the first phase of the financial crisis in 2007-2008) ; or on the contrary these degradations occur too "early" in the middle of consolidation plan regarding the issuer finances, This, as we have seen above, has the effect of being self-fulfilling by damaging the creditworthiness of the entity downgraded by higher interest rates induced.

3/ Finally, the agencies do not always shine for their competence and irreproachability when it came to complex structured note programs. Do not forget the complacency of the rating agencies given their position as judge and jury in the rating of complex issues: the better they noted, the more they favored the marketing of the issue rated and the more commissions they get

Complex and useless finance is still there

While complex finance should be preferred to improve risk modeling, it continues, in times of market stress, to help designing unmanageable and useless complex structured products

often quote these examples of securitizations rated AAA when issued between September 2006 and April 2007 and considerably downgraded six months later, because these agencies were unable or unwilling to understand the complexity of these dangerous structures. I think especially about the famous CPDO for constant proportion debt obligation, the worst kind of product that the financial markets have imagined: with leverage, the more risky the markets became with an increase in the risk premium on issuers the more you borrow to take the risk and vice versa. Based on the fact that credit spreads always come back to an average. How agencies could they ignore the risk of leverage on this type of product and how have they been content to look only at the credit quality of the SPV (special purpose vehicle) transmitter - credit quality near the AAA through enhancement techniques which role is to secure for senior investors that are traditional institutional the first losses incurred by junior investors. The problem is that the so-called safe enhancement worth nothing considering the market risks contained in these structured products.

Agencies are often misjudged when it comes to rate such issuer and, most often ignored in the general public as more complex to explain, they have demonstrated their incompetence when it comes to structured products such as CDO or CPDO

OFFICIALIZE THE RATING AGENCIES LOSS OF CREDIBILITY

Dangerous, useless, often incompetent and greedy, agencies again have recently speak about themselves by announcing that the world will live without AAA. The best illustration of this was the decision by the S & P to watch carefully 15 of the 17 member states of the Euro in early December (it was impossible to include Cyprus since the country was already monitored and much less than Greece, which given the deterioration of its public accounts had nothing to fear from agencies)

By downgrading or putting everyone under supervision, it is clear that agency decisions are likely to come out more unnoticed and be taken less seriously - like a loss of impact when punishing a child because you punish him for no apparent reason.

Thus, the French paper is monitored for, according to the agencies, taking into account the alleged fragility of the banking system and its key refinancing needs (we will see later, without any chauvinism that French banks are however some of the least fragile in the Euro Zone)

So why announce Friday 09/12, another supervision of three French banks because this time of the observation of their country signature

By downgrading or putting everyone under supervision, it is clear that agency decisions are likely to come out more unnoticed and be taken less seriously.
Mory Doré

- So we will eventually downgrade the French banks because of France or will downgrade France because of its banks? Admit that in terms of credibility, we have seen better. Especially since once again the pro-cyclicality and self-fulfilling prophecies are ever present with the following vicious circle: you downgrade the banks and then you cause an inflation of their refinancing conditions, which may require the state to recapitalize and can lead to deteriorating public finances. What will agencies decide then? Downgrading government papers then banks with high exposure on their balance sheets with securities issued by this country...

- And why stop in such a good position? By warning on the deterioration of the French state, it was necessary for the S & P to notify or downgrade anything related directly or indirectly to French signature and not just to banks. This is going to affect other players bearing high exposure to French government bonds like insurers: negative credit watch for Allianz, Aviva, AXA, CNP, Generali

- And if we want the job to be done completely, issuers guaranteed by the sovereign under surveillance should also be warned - which was done. Consequently signatures still above suspicion and even today all rated AAA are now in the crosshairs: EIB, Cades, CDC, Reseau Ferré de France, Unédic, KfW, Rentenbank, European Union and of course the famous EFSF.

We know that there are systemic risks, but is there any need for extra? And if finally the AAA permanently disappears from the map of investment grade ratings, we can rely on an adaptation of the limits in slices of ratings imposed to institutional investors leading them to retain their positions recently deteriorated.

ABOUT THE RATINGS

There is much talk about agencies ratings and it seems useful to explain the need to finally take a step back from the ratings assigned and especially do not solely base your long-term investment decisions on existing or anticipated ratings

  • Not only for all the reasons we put forward in this paper about the uselessness of the agencies, their dangerousness and in some cases their incompetence
  • But also because the excessive media coverage of the ridiculous rating (who in the general public did know a few months ago about the meaning of AAA?) On various channels should not worry you

We must put all that into perspective. The ratings of a particular issuer are based on the assessment of its creditworthiness (hence its ability to repay and the calculation of its probability of default)

To assess a probability of default of an issuer, the time horizon used is generally one year since we consider that this horizon is sufficient to match the investor in terms of investment strategy and policy risks.

Agencies should seriously reconsider their statistical models and probabilities of default arising as since 2007 the world has changed and therefore displaying a zero probability of default to an issuer rated AAA or AA over a period of 1 year is now considered audacious.
Mory Doré

And when we consider the probabilities of default depending on the level of ratings, we honestly want to laugh about the over-dramatizations relayed here and there on such and such downgrading or surveillance. Based just on historical S&P [1], we can see that

  • the probability of default of a AAA or AA over a period of 1 year is zero
  • this probability is 0.07% for a signature rated A (or a comfortable confidence level of 99.93% for a statistician and a risk more than comfortable for an investor with seven cases of default every ten thousand years !!!! )
  • with the same sources, we have a probability of 0.23% for BBB ratings, from 0.81% for BB signatures and 6.27% for B signatures

All this to say two things

- psychodrama after deterioration from AAA to AA should not prevent an issuer to sleep. The French sovereign had not really understood when you see the ridiculous submission from our government to rating agencies; the same government now seems to consider a downgraded rating would not be catastrophic, not because he have finally realized what is a probability of default associated with a notation, but because his only concerns are political

- agencies should seriously reconsider their statistical models and probabilities of default arising as since 2007 the world has changed and therefore displaying a zero probability of default to an issuer rated AAA or AA over a period of 1 year is now considered audacious.

AND THEN WE ARE STILL REQUIRED TO ASK QUESTIONS ABOUT THE LACK OF IMPARTIALITY AND OBJECTIVITY OF RATING AGENCIES

Even if we do not like too much this type of shortcut, let us ask the question if there is not a conspiracy theory against the Euro via certain agencies as we hear here and there?

A kind of Anglo-Saxon conspiracy against Europe. We really do not think so but what is certain is that the United States are not totally uncomfortable about the turbulence in the Euro zone. Because during that time, the dollar is not in competition with the Euro regarding its status as an international reserve currency

We know, indeed, that the U.S. must attract non-resident investors to keep buying Treasuries and then finance the US budget and trade deficits. It is therefore essential that the dollar remains the reserve currency, and the Euro do not become a credible alternative to the Dollar. We may think that as long as doubts persist about the credibility of the euro, the U.S. will not complain about that. So maybe there is no US conspiracy but do not rely on US to temper criticism of the European monetary integration and the Euro.

In any case, if the rating agencies were objective and impartial, they will affirm a number of things and in this respect, we have two examples

1/ If this is about looking at the macroeconomic fundamentals (debt, growth, deficits), it is hard to understand why the states of the euro zone are punished whereas the signature of a sovereign as the United Kingdom is not worried by the agencies at all. Indeed, the present and anticipated public finances is worse in the UK than in the euro area, as far as that goes the growth prospects are worst in the UK than in the euro zone. Agencies will tell you that the UK has zero default risk, despite the enormity of its debt as the UK banks monetize the Kingdom debt. That’s right at the moment but this means that British banks, including the best bank in the world HSBC, accumulate unsustainable forward processing risk - even if the Bank of England does not raise interest rates before 201 ..

So why such a convenience agencies vis-à-vis the UK economy?

2/ Second example, banks in the euro zone show greater transparency (even if it deserves to be seriously enhanced) than Anglo-Saxon banks. Besides the European Banking Authority (EBA) has just updated the recapitalization needs of European banks

  • Germany : € 13.1 billion
  • Spain : € 26.2 billion
  • Greece : € 30 billion
  • Italy : € 15.4 billion
  • Portugal : € 7 billion
  • France : € 7.3 billion

To date, we have no accurate estimates for the UK and US banks for recapitalization. We notice the small needs of French banks. Maybe the agencies are wrong regarding their targets.

WITH ALL THIS, GOVERNMENTS MUST RETAKE CONTROL OF ECONOMIC POLICY FOR GOOD

Fiscal policy must be intelligent and be rethought (the golden rule about balancing at all costs the public accounts is absurd). This means that we must distinguish between good and bad expenses, provided that the good expenses are those that are profitable and promote growth (because there are cost-effective public investment just as there is unprofitable private investment ).

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We must also distinguish between good and bad taxes, good taxes are those that do not discourage growth. One could also say that we must be able to sort out the good and bad political and economic leaders. But that is another topic that deserves an entire book devoted to the negligence of all political leaders that have led companies or states to the brink of bankruptcy and who now claim to explain the user manual of the crisis solution. No name, but certainly many will recognize themselves. The real problem is it not in this cruel lack of exemplary, competence and efficiency of these people? Unfortunately, I think yes, because when you know you will never be sanctioned and punished, not only you manage poorly but also you make bad decisions called strategic as you will not assume any unfortunate consequences.

To return to our subject, it is therefore to demonstrate to markets and agencies that we establish a real economic policy for growth (supply policy in countries with low potential and demand policy in Northern Europe) and an appropriate taxation (taxation of consumption almost everywhere and zero tax on relocatable production factors)

To save the euro, European governments must understand that trying to always please the markets and take short-term measures in order to calm the stock market indices and tensions on some debt obligations sovereign is not a good solution. Let us remember this hypocrisy form markets and rating agencies : on the one hand, governments are required to follow the budgetary virtue, so that deficits are reduced significantly without saying that such a policy would maintain recession , we know that at the same time if fiscal imbalances of fragile countries were severely reduced, then we should expect more attacks on their public debt due to economic policies breaking growth and therefore preventing budget deficit to decrease.

Growth without budgetary virtue is useless and the budgetary rigour without growth as well
Mory Doré

In fact if we had to please the market, who would it be fun? We know that markets are not an abstract creature, an omniscient engine custodian of the optimal allocation of resources and the objective evaluation of financial asset prices. Markets consist of a variety of actors with constraints, objectives, time horizons and different regulations: trader, market-maker, investor, institutional investor, bank treasurer, Manager ALM, central bank, hedge fund manager, asset structurer

After all, what do the markets need simply (at least the markets represented by the long-term investors)? Simply return on financial assets managed

  • To achieve a positive net margin of the resource (borrowing from a client, or a bank loan market) used to refinance these assets
  • To ensure income and capital gains on recurring cash entrusted by long-term savings for different needs (additional income, retirement, accidents of life ...)

It will be understood, markets need economic growth for the so-called risky assets to perform : equities, high yield corporate bonds and investment grade, commodities. But they also require careful management of public funds in order to secure the assets backed on the creditworthiness of issuers: government bonds, bank bonds and to a lesser extent corporate investment grade bonds

Growth without fiscal virtue is useless and fiscal discipline without growth as well.

Mory Doré , December 2011

Article also available in : English EN | français FR

Footnotes

[1] Source : Cumulative average default rates by rating modifier, 1981-2007, Standard’s and Poor’s

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