The Rating Agencies

There is a fascinating piece of news that I have just stumbled upon in Bloomberg, regarding the EU and the ratings agencies:

Credit rating companies face curbs on when they can assess government debt and restrictions on their ownership under draft plans agreed upon by the European Union to limit the industry’s influence and tackle conflicts of interest.

Investors will also get the right to sue ratings companies if they lose money because of malpractice or gross negligence in the plans agreed upon yesterday by lawmakers from the European Parliament and Cyprus, which holds the rotating presidency of the EU.

The interesting point here is that the Basel banking regulations entrenched the ratings agencies within the financial system. Essentially, the ratings agencies became the key to the level of capitalisation of the banking system. The small detail that the ratings agencies were paid by said same banks to undertake the ratings did not cause concern in the bizarre world of banking regulation. No doubt there will be many who will applaud the EU for taking action against the agencies; they really are, in some respects, the guys with the black hats. However, we must also remember that their power in the market was underpinned by a regulatory framework; the Frankenstein that created this monster was the regulators.

The problems with this latest move from the EU is that it does not seem to be founded in a genuine motivation for reform, but rather to de-fang the major ratings agencies, which are coincidentally downgrading sovereign debt. One suspects that the motives here are not entirely about the aim stated in the article, which is about 'financial stability'. The reason I am doubtful about the intentions is that the stated aim is to address conflicts of interest. This is the most simple problem to fix, and does not require this rather odd approach. It is so absurdly simple to fix the conflict of interest that the solution given absolutely must have different motivations; the absurdly simple answer to resolve conflicts of interest would be to ban any rating of any financial product that is paid for by the issuer of the product. It does not matter whether the product is a personal pension, or a complex derivative product.

Also, with regards to sovereign ratings, this is one of the few areas where (relatively) there is little conflict of interest. How curious is it that this is the focus of the attention of the EU? The following passage from Bloomberg tells the story:

On sovereign debt ratings, lawmakers and officials agreed that each credit rating firm must pick three days a year when they would be allowed to give so-called unsolicited assessments of governments’ creditworthiness, according to Jean-Paul Gauzes, a lawmaker involved in the talks. Ratings firms may get a chance to issue unsolicited ratings -- those that haven’t been requested and paid for by a client -- outside those dates if they can justify it to regulators.

“Credit rating agencies will have to be more transparent when rating sovereign states, respect timing rules on sovereign ratings and justify the timing of publication of unsolicited ratings,” Barnier said. “They will have to follow stricter rules which will make them more accountable for mistakes.”

Here we have the distinctly curious situation of the lawmakers seeking to restrict the access to the ratings when the ratings are paid for by entities that need an independent rating; it is the very opposite of the absurdly simple solution to conflict of interest. Just as the rating of a derivative should be paid for by the potential purchaser, the same with bonds. In this case, this is exactly what the ratings agencies are doing. They may be useless at their job, which is not the point of this post, but they are in this case presumably acting in the interest of the purchasers, not the issuer. This is how the system should work, but that is what is being attacked. In summary, this is simply an attempt for the EU to try to bury the crisis that is threatening the EU and the Euro project.

The news should be greeted with outrage, but the visceral ant-ratings agency feeling will probably see applause from many quarters. Whilst I would like to see the agencies de-throned, this is not the solution, and it tells us more about the terror being felt in the upper echelons of the EU than it does anything substantive to fix the agencies.

France Downgraded

For regular readers, they will know that I do not have much (any?) respect for the ratings agencies, but will also recognise that their pronouncements have impact. When they pronounce, the world listens, and in the case of the banks, they must listen due to capital adequacy regulations. This is from Reuters:

France lost its prized triple-A badge from the Standard & Poor's in January and so Monday's move by Moody's was not surprising but it underlined doubts about Socialist President Francois Hollande's ability to fix France's public finances.

This is a commentary from the same article:

"I don't expect it (the downgrade) to have an immediate knock-on impact today on access to and cost of funding," said Espirito Santo analyst Andrew Lim of the possible impact on the banking sector. "But it's symptomatic of the wider concerns of a plain-vanilla negative impact on the economy being suffered in the next few months and quarters. Spain, Italy and peripheral Europe are weakening and France's exposure to them is something to be aware of."

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

Whilst the Euro sank a little, it is not seen as a harbinger of crisis, or at least not yet. Another article notes some of the upcoming risks:

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

It is a very good point. When those doing the bailouts look less creditworthy, there are the makings of a future crisis. This from the Wall Street Journal:

The European Financial Stability Facility is widely expected to receive a credit rating downgrade within the week, allowing it to resurrect plans to issue bonds after the rescue fund's second-biggest backer--France--saw its rating trimmed.

A downgrade could marginally curb demand for EFSF debt. It would normally make it harder for borrowers to raise funds. But for the EFSF, it would help resume plans to finish its 2012 funding program after it was forced to shelve a three-year bond sale Tuesday due to the rating discrepancy between the EFSF and France.

The EFSF--Europe's short-term bailout fund that has helped raise cash for Greece, Ireland and Portugal--said Monday that it planned to sell three-year bonds denominated in euros.But the decision later in the day from Moody's Investors Service Inc. to strip France of its triple-A rating complicated the proposed EFSF deal, as it left the rescue fund's rating standing above that of one of its key backers. The EFSF described the decision to shelve the deal as "technical." Under its so-called Deeds of Guarantee rules, it was forced to pull it despite having attracted more than 3 billion euros ($3.8 billion) in investor demand.

A piece in the Australian is highly critical of the (relatively) new French President, Francois Hollande (in some respects, a rather silly piece describing how he is enjoying the perks of power, but also with some more serious material):

Unfortunately, economic indicators suggest otherwise: unless it acts fast, "la belle France", for all its fine talk could become the latest and most significant victim of the eurozone debt crisis.

Economist Nicolas Baverez was one of the first to predict France's downfall a decade ago. He argued last week that the President, whose popularity has plummeted faster than that of any of his predecessors since his election in May, is in denial of the financial tsunami that could batter his palace walls by next year.

"He has missed at least three opportunities to begin a recovery," said Mr Baverez, warning that unless Mr Hollande quickly implemented reforms, the country would face the humiliation of being forced to go cap in hand to the eurozone and the International Monetary Fund for a bailout.

"In 2013 our country will be the world's biggest borrower of euros, bringing recession, soaring unemployment and an inevitable financial crisis," said Mr Baverez. "Germany will make France pay dearly for its backing."

[and later]

As thousands of people marched through the streets of Paris last week as part of a pan-European protest against austerity, student Laurent Botti, 21, handed out leaflets accusing Mr Hollande of being a "clone" of the conservative Mr Sarkozy.

"He has betrayed us," Mr Botti said, complaining that Mr Hollande had presented himself in the election as Europe's anti-austerity champion but had ended up siding with "big business".

Whatever the case, something has to be done, quickly: public spending accounts for more than half of French GDP, the highest share in the eurozone. No government has balanced the budget since 1981, thus public debt has risen from 22 per cent in those days to more than 90 per cent. The economy is stagnant and will hardly grow next year. More than 10 per cent of the workforce - and close to a quarter of the young - are without work.

This story has a particularly interesting aspect. Hollande campaigned on an anti-austerity ticket, and is now confronted with the power of the bond markets to discipline perceived high risk states. I found this an interesting story in light of a very thoughtful piece in Spiegel recently (I have growing respect for this publication, as one of the few outlets that offers real depth of analysis). This particular point came to mind when seeing the French downgrade:

The attempt by countries to bolster the faltering financial system has in fact increased their dependency on the financial markets to such an extent that their policies are now shaped by two sovereigns: the people and creditors. Creditors and investors demand debt reduction and the prospect of growth, while the people, who want work and prosperity, are noticing that their politicians are now paying more attention to creditors. The power of the street is no match for the power of interest. As a result, the financial crisis has turned into a crisis of democracy, one that can become much more existential than any financial crisis.

I have long railed against government debt, and continue to wonder why governments in mature economies need to borrow at all. The Spiegel analysis is quite correct. Democracy, and the belief in democracy is now on the chopping block. We can see this most clearly in the countries that are already going through the most severe crises, such as Greece.

The problem that we, meaning all of the electorates of the Western democracies (to varying degrees) face, is our own immaturity. Whilst some of the democracies are very mature in terms of age, the behaviour of the electorate remains immature. When we see protesters on the streets of Europe, protesting against austerity, we have a picture that is analogous to the teenager having a tantrum and demanding a new iPad. The fact that his parents are already in debt, and cannot afford the iPad is entirely absent from his thoughts.

In the case of Francois Hollande, he promised the goods and the French electorate duly elected him. However, when coming to power and facing the reality of France's economic situation, he is now being forced to backtrack. The result is that his popularity is plummeting (sorry, cannot find the link for this). The problem faced by Francois Hollande is the problem faced in so many countries. The electorate demand a standard of living that is higher than can be funded from the output of the economy. To return to the article in the Australian:

The figures tell only part of the story. A report commissioned by Mr Hollande from Louis Gallois, a respected business leader, blamed the eurozone's heaviest social charges on payrolls, over-regulation and exceptionally high taxes for undermining France's competitiveness.

Genevieve Forestier, who abandoned her dream to set up a fashion label last year to take a job in a lawyer's office instead, could not agree more. "All the social charges and taxes are enough to put off even the most enthusiastic of entrepreneurs," she said. "The worst thing, though, about running your own business in France is that once you've hired someone it is virtually impossible to fire them. I've heard of a case where an employer had to continue paying a worker's salary even though he was in prison."

Not surprisingly, new firms seldom get off the ground and France has fewer small and medium-sized companies than Germany, Italy or Britain. At the same time the government continues living beyond its means. Mr Hollande agrees that the state should spend less, but some of the cuts thus far seem cosmetic.

The prospect of France losing market confidence terrifies European Union officials. It might need a bailout on such a scale that the mechanism to preserve the euro would be overwhelmed.

It is a crude piece of commentary, but nevertheless captures some of the problems being faced by France. As France has lost competitiveness, the debt has been increasing. This is the story that sits underneath the economic crisis. The immaturity of demanding 'x' standard of living in economies that can only really afford 'x-' standard of living. Even as the emerging economies were rising in competition with the mature economies, the demands for ever higher standards of living increased. It was the role of governments, whatever it might take, to deliver these ever higher standards. This from the Spiegel article:

When the debts of companies and private households are added to the public debt, the sum of all debt has grown at twice the rate of economic output since 1985, and it is now three times the size of the gross world product. Economies in the developed world would appear to require credit-financed demand in order to continue growing -- they need consumers, companies and governments to go into debt and to put off paying for their demand until some unspecified point in the future. Of its own accord, this economic system produces the compulsion to drive up the debt of public and private households.

Governments delegate power and creative force to the markets, in the hope of reaping growth and employment, thereby expanding the financial latitude of policymakers. Government budgets that were built on debt continued to create the illusion of power, until the markets exerted their power through interest.

Interest spending is now the third-largest item in Germany's federal budget, and one in three German municipalities is no longer able to amortize its debt on its own. In the United States, the national debt has grown in the last four years from $10 trillion to more than $16 trillion, as more and more municipalities file for bankruptcy. In Greece, Spain and Italy, the bond markets now indirectly affect pensions, positions provided for in budgets and wages.

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

One of the notable points is about household debt. We can see the mentality that is driving the electorate, which is in turn driving the politicians, by visiting an electrical store. Why pay now when you can pay later? We know that the people who enter the store, with a tight household budget already, deep down know that the purchase of the latest shiny good is going to put their overall budget at risk. However, they still buy. They just want that shiny new good. This is the mentality of the electorate, and it is no surprise that we get politicians who pander to this immaturity. There is a fundamental lack of maturity, and self-justification is given for poor budget choices.

As such, when the politicians, economists, and policy makers seek to justify yet further increases in debt, they are pushing at open doors of an immature electorate. We, the electorate grasp at their justifications willingly, as they are telling us that they can 'magic' into existence the shiny goods that we desire. And, as if by magic, they seem to keep on making them appear. However, it is just another variant of the electrical store offering 'buy now, pay later'. The Spiegel article understands the point. It subtitles the article 'betting with trillions'. The principle is this; increase the borrowing to solve the problem of previous borrowing. It is perhaps the greatest wager ever made. It is a wager that might collapse the global economy. We, the electorate, are collectively urging them to raise the stakes.

GDP And 'Economic Growth'

It seems a long while since I discussed the Economist article in which Hurricane Katrina was given a positive slant due to its potential to add to GDP growth (so long ago the I do not have a link). I was therefore fascinated to see this account:

Paul Ashworth, chief US economist at Capital Economics, said in a note that while the initial impact of the storm on the economy could be quite large" when the clean-up is taken into consideration the "overall impact on GDP growth could even be positive."

He said, assuming all output was lost in the two regions for two days, it could mean a 0.7pc loss for the quarter as a whole.The economy expanded 2pc in the last quarter.

However, he cautioned that this was an extreme assumption: "These back of the envelope calculations undoubtedly overstate the loss of output. Not all output has been lost, particularly not across the whole East Coast region. Some people will be working as normal, others will be working from home."

Regular readers know that I have long railed against the use of GDP, which I see a being close to useless, if not positively dangerous. This analysis just highlights the point. It was therefore extremely encouraging to find an article by Bob McTeer, a former Dallas Fed President, who recognises the danger in the use of GDP:

Generally and loosely speaking, a higher GDP, reflecting both higher spending and higher incomes, is a good thing. However, if the higher GDP is boosted by hurricane clean-up and repair, that’s not so good. The problem is we don’t get a subtraction for the destruction of existing assets; just an addition for replacing them. At least one might think of the clean-up as “shovel ready” projects. Wars are similar in that they generate GDP without bringing with them a higher standard of living.

My favorite example in school of the short-comings of GDP (GNP then) was provided by the question what happens if a man marries his maid. If she keeps doing the household chores as a wife, they are taken out of the market place and GDP shrinks. Getting hair cuts at home or eating at home more and eating out less would have a similar impact on GDP without necessarily reducing standards of living. Just remember that GDP was designed to measure output in the marketplace, not to measure economic well-being.

The article seems to imply that the faults of GDP are well recognised, but this is not apparent when considering the almost fetishistic focus that is made on the GDP measure. One of my biggest bugbears is the government debt to GDP ratio. It is now a commonplace, and frequently replaces the hard number of the actual cumulative total of debt and GDP growth is used as a signal that an economy is capable of servicing debt. In the case of our earlier commentator, we can see quite how dangerous GDP actually is.

In the case of Hurricane Sandy, hurrcane damage will apparently be able to improve the governments capability to service debt. Never mind that the government will be borrowing a bucket load of money to pay for the clean up of the devastation and destruction of assets; this will better allow the government to pay back its debt because, you see, GDP will grow from the fallout of a hurricane. I can see no better illustration of the fallacious thinking of those who worry about GDP slipping when governments cut back on borrow and spend. Borrowing to create activity in an economy, as I have argued previously is seen as a perpetual growth machine which is 'lossless'. In this case, the loss and replacement of perfectly good assets apparently creates economic growth.

No doubt some commentators will claim that government 'investment' is different; it creates long term growth. For example, many such people will propose project 'x' or 'y' as an investment. What they do not discuss is that these projects will come on top of borrowing for consumption. Also, as I discussed in a recent post, in one case I found a proposal to 'invest' in new rail infrastructure for the UK, even though rail is heavily subsidised such that this is not an investment with a positive return, but an investment to increase expenditure into the future (not withstanding that it might have quality of life benefits). 'Yes', there are some genuine investments that might be made, but these should not be made on top of borrowing for consumption. However, the term 'investment', as used by government, is often highly malleable, and is often nothing to do with investment but is rather concerned with expenditure for consumption.

The case of the US is interesting, as I have seen arguments made that the US has under-invested in infrastructure, and then present the idea that investment now is the solution. Again, why was the US government borrowing during the 'good times' and not investing in these apparently neglected projects? Why were they borrowing for consumption rather than for investment? Why is it that these economists were not railing against the government borrowing and consuming in the good times, when they could have been borrowing to invest in these projects? The answer is simple; they do not want to make the hard choices. Every element of government spending can be found to have a justification, but that justification does not include confronting the hard choices of either raising taxes or choosing between priorities within the constraints of the actual tax revenue available.

It is much easier to just borrow the money and leave the problem of paying until later. As I have long argued, at least in developed economies, there is no real reason why governments should be borrowing at all, barring major natural disaster or events like World War II. They have a strong base of income to draw upon, and can pay for both expenditure and investment from that income. Even if taking a Keynesian position, governments are not supposed to be borrowing and spending for consumption during the good times, but are supposed to only do this during the bad times.

I reiterate the point; those who support government borrowing and spending have never wanted to make the hard choices - either persuade the taxpayers that they really need to pay more taxes, or confront the difficult problem of priorities for expenditure. Instead, they propose borrowing and spending, during both the good and bad times. As they do so, they hide behind fig leaves such as GDP, which hides the long term damage that they are inflicting upon the economy; they persuade people that the economy is 'growing', even whilst the debts mount, and the activities which are developed through borrow and spend boost GDP. The real problem is cowardice; they cannot persuade people to pay for the expenditure of the government, so they pass on the problem of paying to the future. They believe that all of those government expenditures are 'good', but do not have the guts to make their case honestly and openly and subject the real cost to the scrutiny of voters. It is a tragedy, and I can only wish that voters would start to punish this cowardice.