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.

The EU Downgrades

This will be quite a short post. It has been impossible to miss the news from last Friday about the downgrades of several EU countries by Standard and Poor's (S&P):

Ratings agency Standard & Poor's downgraded the government debt of France, Austria, Italy and Spain on Friday. But it kept Germany's at the coveted AAA level.

The downgrades deal a blow to the eurozone's ability to fight off a worsening debt crisis. All told, S&P cut its ratings on nine eurozone countries.

The rating agency ended France and Austria's triple-A status. It also lowered Italy's and Spain's by two notches and did the same for Portugal and Cyprus. S&P also cut ratings on Malta, Slovakia and Slovenia.

"In our view, the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone," S&P said in a statement.
France's downgrade to AA+ lowers it to the level of U.S. long-term debt, which S&P downgraded last summer.

S&P had warned 15 European nations in December that they were at risk for a downgrade.

The way that the press have reacted is as if this is some kind of shock, even though the potential for a downgrade has been been trailed, as is mentioned in the quote above. S&P's statement about why they made the downgrade can be found here. It has also had an impact on the rather dubious Euro bailout fund, with this from the WSJ:

Standard & Poor's Ratings Services on Friday said it had stripped triple-A ratings from France and Austria and downgraded seven others, including Spain, Italy and Portugal. It retained the triple-A rating on Europe's No. 1 economy, Germany.

The downgrade to France, the bloc's second-largest economy, will make it harder—and potentially more expensive—for the euro zone's bailout fund to help troubled states, because the fund's own triple-A rating depends on those of its constituents. The downgrades also speak to how deeply the concerns over countries on the euro zone's periphery have penetrated its core. Worst-case fears weren't borne out: France avoided the two-notch downgrade S&P had warned of last month.

So, is this really news? In some senses 'yes', and in some senses 'no'. The most interesting thing about the ratings agencies is that they are supposed to look into the future and make assessment of asset risk, but they nearly always seem to play 'catch up' with the reality on the ground. Even the most casual browse of the financial news would have told anyone that the problems of the Euro were spreading from the so-called periphery into the so-called core. The S&P downgrade is, as always seems to be the case, just playing catch-up.

However, it is news in the sense that it has real impacts. The first impact is on the bailout mechanism, as mentioned in the WSJ article. However, another impact is upon European banks. I expected to find a raft of headlines to this effect, but a search of Google News did not turn up what I expected (perhaps my keywords were not right, and I missed the articles). In particular, those banks that hold the sovereign debt of the downgraded countries will see further erosion of their already (in many cases) strained balance sheets. The only example I found discussing this point was curiously in reference to Japanese banks:

France’s loss of its AAA rating probably won’t have any immediate effect in Japan as domestic banks’ holdings of French bonds aren’t large, Azumi said in Tokyo yesterday, according to Kyodo News.

It is now an open secret that the ECB has been bailing out European banks in the hope that they will in turn use the money to purchase European sovereign debt. This from Wolfgang Münchau in the FT:

And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.

Regular readers will know that I do not agree that the bailout was a 'good thing', but I quote this as it as it makes the point about the indirect purpose of the bailouts. I have mentioned before that there are large chunks of debt coming due in the next couple of months, and funding these chunks of debt may be a severe problem. I used this chart from the Economist before, as it paints the picture well:



When bank balance sheets are already under strain, the question is what they might do with all of the money that the ECB is pouring into their balance sheets. The new Basel accords are demanding higher levels of capital, and the ratings of assets will impact upon their compliance. The question is this; with their balance sheets already strained, when the periphery debt looks ever more dangerous, and the core debt is now being recognised as high risk, why on earth would any bank actually purchase high risk European sovereign debt?

The problem is this, that in the topsy-turvy world of banking regulation the ratings agencies really matter. They are, of course, completely hopeless in their assessment of risk, but they nevertheless have major impacts. However, it does occur to me that there is the possibility that the bailout of the banks by the ECB might come with strings attached, in backroom deals, that as a quid pro quo, the banks agree to continue to purchase dubious Euro sovereign debt. I can only speculate on this but, if such an agreement has taken place, it is a great way to increase the contagion. It really is kicking the can down the road.

Furthermore, as many (including myself) argued, the establishment of the Euro bailout fund would spread the problems into the Euro core, as countries such as France were already in a position of having too high levels of debt. A long time ago, I discussed the problem of who would be left to do the bailing out when every country was racking up too much debt. The context of the discussion was the US, if I remember correctly, but the same applies here. It has long been the case that any bailout is being funded by countries borrowing more money to enact the bailout. They are not using a net credit position to bailout, they are just borrowing more on the basis of having a better credit position than the bailee. However, when they are in a position of having too much debt themselves, they start to tip their own creditworthiness into the danger zone. Again, using your own fragile creditworthiness to support the less creditworthy is another case of kicking the can down the road.


The problem with such can-kicking is that it ratchets up the final consequences of the crisis. I have argued against the idea of contagion before, as the problem was not one that might be compared with a contagious disease, but more like a cancer that is destroying from within each country. However, the actions of trying to avert a major crisis are genuinely creating contagion. It was in the early points of the crisis that I suggested that contagion was the wrong metaphor for the problem, but it now seems appropriate. I am genuinely puzzled at what is going on. It just seems that policy-makers must actually see that they are in a hole, but they continue to keep digging it deeper.


It is not as if I am alone in questioning the endless successions of bailouts. Again, it does not take long to find voices expressing concern. What on earth do those who are enacting the policies think the end of the game might look like? Do they really believe that, for example, that one year from now that the Euro crisis will have ended, that sovereign debt problems will have disappeared, and that Europe will be on the road to economic recovery? They must, surely, have some kind of belief that this will be the case, and this must be why they continue to try to 'solve' the crisis? However, if they were to stop digging their hole for just a moment, the absurdity of this idea becomes apparent.

The crisis is getting ever larger, not diminishing. The fact that the ratings agencies are downgrading is just a belated indication of the reality of the situation, and just highlights exactly how bad things have become. When such clueless organisations have finally accepted the depth of the crisis, then it must be very, very bad indeed.


Note: A longer post than intended...

Update: 

Just after I completed the post, I found this in the Telegraph:

Use of the European Central Bank's three-year funding programme is expected to exceed €500bn in February when lenders are offered their second chance to access its new long-term refinancing operation (LTRO), according to Credit Suisse.

Last month, banks borrowed a total of €489bn using the LTRO, which has effectively seen the ECB take on the role of providing a large part of the funding required by several eurozone banks.

Analysts at Credit Suisse point out the ECB's willingness to provide an increasing proportion of the short and longer-term funding required by eurozone banks has led to a widening gap in the size of its balance sheet versus those of the Bank of England and the US Federal Reserve.

The ECB's balance sheet has risen in size to close to 30pc of eurozone GDP from just over 20pc before it launched the LTRO. By comparison, the Bank and Fed's balance sheets are both worth just under 20pc of domestic GDP.

And later:

The ECB's decision to increase its exposure to banks has effectively seen it provide the "bazooka" markets had been urging it to use to help stem the debt crisis.

Spanish banks that borrowed money using the LTRO are thought to have used most of it to buy Spanish government debt, leading to a lowering in yields.

Interesting, is it not? It still does not discuss the problem of the downgrades for the bank balance sheets, but it is there in the subtext. I still suspect my Google News search was looking for the wrong key words, so if anyone has seen an article on the effect of the downgrades on bank balance sheets, a link would be welcome.