Monday, January 16, 2012

Eternal existential ratings questions

Or playing the downgrade game…
What is a rating? Is it a statement about the credit quality of a country or security RIGHT NOW, or is it about what it will become?

What does it mean to give a rating and put the country or security on downgrade alert?

Does a negative outlook mean you did not have the guts to take the rating down to where it belongs, to a level that would make it stable? I think so. Fourteen EMU counties now have negative outlooks. So why would any investor buy any of these sovereign debt securities priced at their current rating level, perched on the verge of another downgrade? Is this a fool’s game?

Think of this as you might a baseball player’s contract. Albert Pujols is a good example. He has been a great player. But in snatching him away from the Cardinals, the Angels are going to pay him a very hefty fare. As players get old their statistics deteriorate- you can take that to the bank. Pujols is no Spring Chicken. That is very clear, yet Albert now has a 10-year deal worth $254mln. So evaluating someone or something at its past performance is not simply a problem that resides with credit rating agencies. It is hard to see how the Pujols deal will make sense as it ages. How would you rate this deal as far and money spent? Could you help your team more by spending $245mln a different way?  

So too with the ratings in EMU… Italy has just been cut by two notches and is put on a negative outlook – overnight! What happened? Bad pasta? Food poisoning?

Is that action of a TWO-NOTCH cut and a NEGATIVE OUTLOOK S&Ps way of saying, hey, we blew it, we should have downgraded them a long time ago but now it would be too embarrassing to take them down by THREE notches in one fell swoop?

Is there something systemic about downgrading all these EMU countries together (but then in not downgrading all of them… and not downgrading all of them equally…)? There is something to that but in the Zone, indeed one of its fallings, is that there are still so many individual responsibilities and so little to centralization other than currency- and monetary policy- sharing.

To settle this once and for all, I think ratings should not be allowed to have an outlook bias. If investors are going to buy sovereign debt instrument they need to know how you view it now and for ‘the foreseeable future.’ If the current rating does not seem to be sustainable then it should be downgraded now, it is the wrong rating.

I want to see ratings constructed in such a way that the probably of upgrade is equal to the probability of downgrade. Then I will admit to ratings being fair. But as long as credit rating agencies are waiting for huge downgrades and giving a downgrade with a bias I don’t see the ratings as having any veracity.

In the case of EMU the rating game is more difficult since ratings depend on what the e-Zone will agree to and it is not agreeing to do much of anything. But as long as this is reality it seems that a harsher near term down grade makes all the more sense! It just might be the stuff to get reluctant countries to the bargaining table to make the tough choices they are refusing to make now.

One intrinsic problem with setting current ratings levels, and this is true with all financial variables in fact, is that they are nothing more than the present value of a discounted stream of expectations. Still, it would be wrong to think that ratings are anything more special or different than the securities that they rate, since securities prices (stocks, bonds, etc.) have that same property.  If a rating agency cannot handily compress a vector into a scalar-rating maybe it should seek a new profession?

For now the ratings game is muddled. The agencies seem to be quite unsure how to proceed. I would make it easy. Anytime a true question arises about whether a rating is justified, it isn’t. Any serious question about a security or a country keeping its rating in the near future means it longer owns its current status; it is borrowing it from its past reputation, like an over-the-hill sports hero.

This approach would also lead to quicker decisions on downgrades and more downgrades and presumably more upgrades too. Right now the system is too rigid, too-ossified. Ratings agencies are too worried about making changes and they procrastinate, thereby putting themselves behind the eight-ball when changes are needed. What has just happened to Italy is somewhere between a farce and joke- but it is no shock. It’s no wonder that the Europeans want to move away from using any of the findings of the credit rating agencies.

I can understand a sports team overpaying for a baseball player as the Angels have done for Pujols. In baseball there is emotion and an assessment that involves the human factor. Some players will underperform on the field and yet may be worth more than their mere numbers suggest at the box office - fan loyalty and infatuation. But the ratings game in markets is a numbers and letters game and we need for those who play it, to play it fairly, squarely and with a sharp pencil. I don’t suggest an algorithm to be used without any personal judgment since ratings do require some judgment.

I would suggest rating contracts to trade on the CBOT or some other exchange. That would put speculators at an equal risk of upgrade or downgrade risk and would assure that ratings changes are not delayed. I do not refer to betting on any agency’s rating but on a separate set of market determined ratings where investors could go long for short the contract and where financial gain or loss would accrue to a change in the markets assessment of the rating.  There might still be events that would precipitate two-notch changes, but far fewer of them. There might also be a greater danger of overshooting as we see in times of financial crisis.

Of course someone might note that CDSs are already sort of like this…except they are part of the game not separate from it. Greece (so far) has been able to engineer a default without triggering CDS payments. That’s a nice thing if you are writing them, not so nice if you have purchased them. Moreover, CDSs are about an event called ‘default’ whereas ratings are a broader concept. Maybe markets should step in and do something where the ratings agencies seem to be failing. Dollars to doughnuts Italy would have been seeing the pain much sooner had this practice been in play. We can blame the ratings agencies for their abruptness but we cannot be too critical of where they have currently set most of their markers. But then there is that issue of negative outlooks…


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More downgrades are coming. Credit ratings downgrades of cities towns and states are the next shoe to drop.


Ratings can be flawed.

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