Service of Financial Rating Agencies

October 6th, 2011

Categories: Banking, Consistency, Dependability, Economy, Financial Rating Agencies, Lending Money

credit-score

The Standard & Poor’s downgrade of US debt sent shivers down spines. Frank Paine [known previously on this blog as Zachary], a retired Federal Reserve Examiner and international commercial banking officer, describes the world of financial rating agencies. He covers where and how they started, how they are used to analyze other industries and governments and he shares his opinion of how useful their conclusions are. 

He wrote:

An old friend who knows my background, and who is himself a retired international banker, recently asked me: “As a credit guy, what is your take on S & P’s downgrade?” He continued, “My initial reaction was positive, but what does it mean if, in fairness, they have to downgrade everybody else except Switzerland?” 

With a wonderful sense of irony, he followed this question with “Hope all is well.”  [He was referring to something else, but his choice of words and timing was wonderful!]

switzerlandWhat a great question!  There are a lot of interesting angles to this issue.  To start with, I’m not even sure about Switzerland, but doesn’t that raise the question of what use the ratings are if every country is rated the same?  They are useless if we can’t use them to distinguish varying levels of credit risk.

My understanding is that the system for rating publicly issued securities came into being quite some decades ago in large measure as a function of insurance company regulation.  The public policy issue was the companies’ solvency for paying claims (liability companies) or benefits (life companies).  It was thought that citizens buying policies were not capable of understanding the level of risk in insurance company balance sheets, and therefore there should be a way of measuring and communicating that level of risk that would not require “buyers to beware.” A corollary to this notion was that insurance companies should not be risk takers.

insurance1Over the years, regulators (and others) found that these ratings could have other useful applications, such as, for example, measuring the degree of risk in commercial banks’ bond portfolios. And indeed, many “players” in the finance industry found that it was easier and cheaper to measure their risk by depending on the ratings.  Even commercial banks, once places that were expected to do their own credit analysis, found (lazily) that they could outsource their credit risk management.  Instead of duplicating the agencies’ analytical work, they could simply borrow it, saving their own analysis for business that was not publicly traded.  In recent years, the agencies have developed a system for rating securities that are not publicly traded.  I am not an expert on this, but I gather that they have developed statistically based models that they feel are acceptable proxies for the publicly traded situation.   

But how does all this work when considering sovereign risks?  What statistical basis can one find for assessing the credit risk of sovereign states?  We know that they occasionally go into default, but do they go bankrupt?  Bankruptcy is a legal status, not a financial status.  To what court do you take a sovereign defaulter to get it to acknowledge bankruptcy?  None, of course…they don’t declare bankruptcy.  They default perhaps, or terms get adjusted, sometimes “haircuts” get applied, interest rates get reduced, and so forth, but they never declare bankruptcy.

Let’s take this a step further. With corporate business, there is a huge database of financial performance.  Using multiple discriminant analysis, one can even define the probability that specified factors will affect the probability of default and bankruptcy.  Can one duplicate this for sovereign states?  I would say “no,” because the database is simply not big enough.  And I think this is where the agencies slipped, basically because they put too much faith in their own models, and assumed that they could identify the factors leading to default, and then apply relevant probabilities.  The probabilities were highly flawed.

world-mapSo, how should one consider sovereign risk?  Sovereign risks are inherently political, and so the ratings must reflect political analysis, something that financial analysts are notoriously not very good at.  Heaven knows that political factors are what determine whether or how a country will go into default-the present state of things in the EEU provides an excellent example.

I believe that it is an error to think that rating systems designed for the management of corporate risk can be applied to sovereign risk.  Sovereign risks should have their own, separate rating system, based on political factors rather than financial factors.  Whether this can in fact be achieved is questionable, but the attempt might be worth the effort.  It probably should be done by separate agencies, thus avoiding possible conflicts of interest.

So, to summarize, all is not well.  This field needs a lot of work.

If Frank Paine is correct–that a country’s financial strength and stability should be looked at by a rating agency specializing in the analysis of sovereign states, not in financial institutions and corporations–was  the S & P downgrade more of a public relations slap than an accurate analysis? Do you think that most people have an idea that the economy is in deep dish distress without confirmation by a rating agency? Do you fear that we are on the brink of panic? Will the Wall Street protesters have any affect in redressing our problems?

wall-street-protestors

7 Responses to “Service of Financial Rating Agencies”

  1. Jeremiah Said:

    Mr. Paine uses as his “hook” upon which to hang his superb, and in my opinion, accurate discussion about what is wrong with the way we analyze sovereign risk, the question he was asked by a friend: “As a credit guy, what is your take on S & P’s downgrade?”

    His friend asked the wrong question. What he should have asked is: “Was Standard and Poor’s right or wrong to have downgraded the debt of the United States?”

    That question Mr. Paine does not answer, and obviously his questioner had second thoughts about his own answer, or he wouldn’t have raised the issue in the first place. The funny thing is that a few months after the deed was done, the answer, whether it be “yes” or “no,” has become irrelevant. That some private sector rating agency owned up to the obvious: the quality of America’s debt “ain’t what she used to be,” only confirmed what we all knew anyway. Nothing has changed.

    Like the writer, I spent many years trying to figure out whether it was safe to lend money to sovereign countries. And, if you did, would you get it — all of it, that is — back? I’ll give two specific examples of decisions I made, and how I made them:

    During what was known as the “Latin American Debt Crisis,” a good personal friend who was
    in charge of the international business of an old line Wall Street investment banking house with which I had no relationship, personal or otherwise, asked me whether Mexico would default when an issue of publicly held bonds came due for payment in a month. He told me candidly that he had a chance to buy a bunch of them at a deep discount. I said that, while the country might default on its privately held debt, I didn’t think, for reasons of “image,” it would on its public bond issues. It didn’t.

    A few years later, on New Year’s Eve, which happened to be a Thursday, I was sitting with a colleague who ran the money position of the bank we both worked for. He was asked by one of his traders if he could lend the Bank of China $100,000,000 to be paid back on Monday. If we did the deal, the net, net pure profit we would earn would be in excess of $200,000. Our limit for China was a tenth of that, $10,000,000. I was pretty sure that China wasn’t going to go out of business over the weekend, and said “do it,” breaking every credit risk control in the business, but Mr. Paine’s then colleagues never caught up me, and our boss, the chairman, congratulated us both, saying, “Don’t tell me about it.”

    Rating agencies, computer models, economists and statistics had nothing to do with either decision. Intuition, experience, market knowledge and an intangible understanding of what made both countries tick were what I based my decision upon.

    (True confessions: I also got it wrong a few times. When apartheid was around, I cut off South Africa, because I thought the place would collapse in blood bath. It is still thriving. Then I also lent money more than once to underdeveloped countries that I figured wouldn’t go broke before they paid us back. They did.)

    As one of the most highly regarded specialists in the country in his medical field once said to me, “If you want a good doctor, get one over 60!” I’m all for Mr. Paine’s separate rating agency for sovereign debt, but staff it with old pros.

  2. Jeanne Byington Said:

    Jeremiah,

    I wish I could figure out how to make $200,000 over a weekend! Congrats.

    You are right: A computer model or a set of metrics can’t do what experience and intuition based on information and knowledge can.

    All of this is way over my head, although on a tiny scale, I’ve heard of banks making foolish decisions about lending money to individuals and can see how on a giant scale, when disconnecting brains and depending solely on formulas, the same thing can happen.

    A successful litigator wanted to borrow a small sum [for tax reasons] and he knocked on the doors of commercial banks all of whom refused him because “He had access to too much credit.” If he went on a spending spree and used each credit card to the max, he could have paid it all back with his pocket change. But because he didn’t fit some model, he didn’t get the money from the biggies. A one-horse bank, where he has a weekend home, lent him the money and they continue to do very well, thank you. No crises and no government rescues for that bank.

  3. Lucrezia Said:

    It’s way too frightening to enter this argument without the shield of an advanced degree in finance. From the ingnorant man on the street point of view, I see the Wall Street Warblers as chirping in the wrong field and annoying the wrong people. If they want to make any kind of difference, they should be setting fire under the feet of a Tea Party Congress, and make sure they do not return for a second term. These legislators have done everything in their power to set up roadblocks to progress, and if peace and prosperity is ever to return, it will be because they have been tarred, feathered, and run out of Washington on a rail!

  4. Jeanne Byington Said:

    Lucrezia,

    I have heard a few of what you call the Wall Street Warblers interviewed and get the feeling that some don’t have a clue why they are there or what they are there for.

    There’s lots to do so that the country can readjust and no longer worry about a bad rating–giving the pundits time to figure out how to hone a better system. One: Tighten the loosey-goosey SEC and banking regulations that are far too easy to slip through and take advantage of. Two: I heard Mayor Bloomberg comment after the 2008 semi-crash that many corporate heads had no clue about many of the vehicles they sold because they were so complicated. My solution: If the chairman of a corporation doesn’t understand a financial vehicle then his/her company can’t sell it.

  5. Lucrezia Said:

    A former boss maintained it was the C students who became the CEOs and their brainier counterparts faded into obscurity. From what I have seen of corporations and those in charge, he is probably right. So long as there are people of such low caliber in control, no change can be anticipated. The purse strings win, and they are in the hands of corporate mini-minds.

    As to Wall Street Warblers, many, if not most, have no notion of the issues, and are coaxed into line by those with a political agenda. It’s always been like that, and is not likely to change. Just stop and ask a guy carrying a sign. Chances are you will be rewarded by a blank stare. However, since thousands of zombies show up, their handlers can now proclaim that this is “a popular” or “grass roots” uprising. Yeah, right.

  6. Jeanne Byington Said:

    Lucrezia,

    Your description of stopping a guy carrying a sign and what to expect–nada–was just how I felt when one of the self-proclaimed [I hope not official] spokespeople was interviewed by a morning radio program show host.

    The Warbler mumbled about how people should only have to do the kind of work that gives them pleasure [as I thought, “Nice, but that’s not why it’s called WORK, and what does this have to do with corporate greed on Wall Street?”] and then he went on to say that he was going “across the street to Starbucks when I get off the interview,” as I thought of the money I save by buying my coffee at Sam’s on Third Avenue and 44th Street [for 75 cents a cup] while he was dropping a few bucks for a cup of java at Starbucks….Oh, well. He said he flew in every week from St. Louis. Glad he has the money and the time. My husband wondered if he was using his parents’ corporate jet.

    Hope he doesn’t end up joining the team that revises the approach of financial rating agencies!

  7. Frank Paine Said:

    “Jeremiah’s” comments here are very much to the point, and I do not disagree. I would point out, though, that both decisions (Mexico and China) he discusses were very short term. Things get immeasurably more difficult when you have to take a longer term point of view. Thinking back to the Latin American crisis that Jeremiah talks about, I remember when, in my then incarnation, that my management was enthusiastic about the idea of making medium term loans to the Government of Peru. Lenders at that time were bullish on Peru, in large measure because copper prices were high. They did not consider the moral character of the people then governing the country (“the management”). I distinctly remember pointing out to my management that Peru’s “management” were kleptomaniacs not to be trusted under any circumstances. I don’t remember these forty-odd years later what the final decision was, but sure enough, Peru, at various later dates, became a defaulted borrower.

    Clearly, then, time plays a major role in all this.

    Now, as to what Lucrezia has to say, it seems mostly political, and political arguments are ones I usually avoid–it’s too good a way to lose friends. However, I sense that Lucrezia, and Jeanne as well, are looking for government to solve the problem. My difficulty with that is that the public rating agency concept arose and expanded largely as a result of regulation. I’m not convinced that looking to regulation to correct a regulatory weakness is likely to solve much. What we need is a system that will enable professionals to make accurate credit risk assessments. When I was a Federal Reserve regulator whose job frequently required me to assess banks’ credit risk management processes, I was frequently distressed at the low quality of the guidance we were given, much of which was written as the tail end of a political process (please note that political party or “tea party” had nothing to do with it–all were guilty), not as the result of consideration by a body of professionals. Accordingly, it’s no wonder that the regulatory process missed so much.

    One other thought about Lucrezia’s comments: she (or he) seems to equate grades (high school? college?–I assume the latter) with intelligence and managerial ability (or their opposites). I think that’s a very questionable assumption–I think most studies will support the assertion that there is little connection between grades and managerial ability. Plus, I don’t know who the Wall Street Warblers are. Are they experts in anything? By the way, having advanced degrees in business administration has very little to do with management ability either–even MBAs from Harvard only help people get jobs, and then sit around and wait to be Vice Presidents–those folks don’t actually have any more ability than anyone else.

    And so it goes…

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