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Thursday, August 16, 2007

Ratings Agencies and Sovereign Debt

The Financial Times this morning informs us that the European Commission seems less than pleased with the recent performance of the ratings agencies:

The European Commission is to investigate credit ratings agencies amid growing dismay over their slow response to the subprime mortgage crisis.

Officials in Brussels, and many other critics, believe the ratings agencies failed to act quickly enough to warn investors about the risks of investing in securities backed by US subprime mortgages – the sector whose troubles triggered the recent global market volatility.

In the United States we are also informed that Barney Frank, Democrat chairman of the House financial services committee, plans to hold hearings on the agencies’ performance next month. I just wonder, especially from a European perspective, if this isn't a problem - and a response from the Commission - that will come back and haunt us all.

Not that the agencies are themselves entirely free of blame in the present situation, obviously there are issues which arise, but my point would be that these were all evident before the current crisis came upon us, so maybe we could have an EU Commission and US House of Representatives investigation into why the people who are being so vociferous now were so silent then.

Obviously there are issues of professional coherency involved here since the agencies are, of course, businesses in their own right, and they are not simply giving an opinion. They are in fact consultants to a lot of the companies that have issued the sort of debt instruments that are now under the hammer. They have rated these companies, and that's one of the ways they make their money.

Equally obviously this will all need to be scrutinized after the storm settles again, but since almost everyone knew - or should have known - what was going on, it is rather unjust, and unnecessarily destabilising, to simply point the finger at the agencies themselves. It is important at some level that their credibility be maintained.

The reason I say this is because the real problem I am thinking about in writing all this is not so much the corporate or hedge fund debt one, but looming sovereign debt and emerging market risk ones.

Essentially we have two major economic players - Italy and Japan - with levels of debt to GDP which are way beyond what might be considered prudent, especially in the light of the ongoing weaknesses in their economies, and the dynamics which may be associated with the rapid ageing of their populations. At the same time within the frontiers of the EU we have a collection of countries - effectively the old Eastern bloc countries, the EU10 - which could be classified as "emerging economies". Among this latter group there are several - Latvia, Lithuania, Estonia, Hungary - who have recently been having "issues" with the ratings agencies.

Effectively the European problem arises from weaknesses in the EU's own institutional structure - the ECB, the Commission - and in the political and monetary framework within which these institutions work. We have had a process - known as the Stability and Growth Pact - which has signally failed to work to contain the debt dynamics of some significant eurozone participant economies - Italy and Greece would immediately come to mind here - and since the ECB is effectively seen as offering some kind of guarantee, the problem has to some extent been allowed to grow unchecked despite persistent efforts from the Commission to browbeat the governments concerned.

So, and I think more out of frustration than clear thinking, the ratings agencies were brought into the act as "guarantors of last resort" with the ECB declaring back in 2005 that they would not in the future accept government paper (bonds) from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies.

Now this is to put one hell of a lot of responsibility into the laps of these same assessment agencies, since who would really like to be the person with responsibility for pulling the plug on Italy's sovereign debt, or for that matter for deciding that Latvia is rapidly headed for a hard landing and the euro-Lat peg is going to break?

In general terms the "sobriety" of these institutions, coupled with the fact that many of the states and affiliates involved are important clients at one level or another, would normally be thought to operate as an effective brake on any such "upping the anti" type process. But if you then start chiding and castigating these very same people for not being forceful and vigilant enough, what sort of results result do you really expect next time they have to carry out a review on - say - Italy's creditworthiness, or the steps Estonia is taking to correct its imbalances and overheating issue. This becomes doubly important since the most recent data from Italy suggest that she will have difficulty again in 2007 meeting the criteria for the debt dynamic that were agreed upon last year.

The difficulty is, as Buttonwood recently observed in the Economist, that the response of these agencies to developing problems is often neither linear nor consistent. During the "good times" they tend to understate the problems, whilst during the bad ones they may well err on the side of overstating them.

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.

The sub prime situation is in fact a good "case in point" example of this process at work. And after the agencies themselves admit the problems were worse than previously anticipated, then the markets, predictably, also over-react. So the question I am asking is, would we all now really like to see this situation replicated in the case of the Italian debt problem, or the Baltic overheating issue? Would we, or the EU Commission, be happy with the outcome?

I think in this kind of area it is better not to tempt fate, or call on others to do what you are not prepared to do yourself. In the event that the Italian government is one day forced to default on its sovereign debt, will we be holding the European Commission itself responsible in the way that they would now try to point the finger at Standard and Poor's or Moody's? The root of the problem here is that the EU itself needs to be able to make accurate and clear assessments of the underlying issues involved on its own account, and to develop the capacity to face up to difficult decisions, take them, and then make them stick, rather than simply fudging everything in an ongoing process of political "deals" and horse trading. Nor is it a solution, when the going gets really tough, to outsource responsibility to agencies which really are neither designed for, or adequate to, the task in hand.

Bloomberg also has a timely piece on the background to the whole constant proportion debt obligations situation. And note this:

The legacy built by John Moody and Henry Varnum Poor a century or more ago is being tarnished by losses on securities linked to everything from subprime mortgages that the firms failed to downgrade before it was too late to high-yield, high- risk loans. Bonds backed by mortgages to people with poor credit fell by more than 50 cents on the dollar in June before the companies started to slash their ratings.

Ratings firms ``used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,'' said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. ``But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.''

I think this is the point. Too much importance and pressure has been placed on these agencies, can they really be blamed to such an extent when it turns out they can't hack it? We need to think carefully about the sovereign debt issue in the context of steadily ageing populations. Other mechanisms have to be found.

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