January 2012 Archives

Comparing the Incomparable- Credit Ratings Agencies Revisited

January 17, 2012
Comparing the Incomparable- Credit Ratings Agencies Revisited


By R. Tamara de Silva
January 17, 2011

Yesterday, Standard & Poor's relieved the Eurozone's bail-out fund, the European Financial Stability Facility ("EFSF") of its AAA credit rating, possibly hampering the fund's ability to contain the European debt crisis. This comes on the heel's of the S&P stripping both France and Austria of their triple-A rating in favor of a rating of AA+.[1] The effect of the S&P downgrade may be negative. Ratings agencies exist to level asymmetries in information and evaluate risk but one of their inherent oddities is that they seek to compare things whose differences in scale make them incomparable. Ratings agencies also have conflicts of interests, they often evaluate financial products (like collateralized debt obligations) that they do not understand, they seem to lack fixed ways to measure absolute risk, and they are at times, catastrophically wrong.

Elephants and aardvarks

Downgrades should not be considered in a vacuum. When the ratings agencies equate economies based upon ability to repay debt, they artificially equate countries disregarding factors such as size, geo-political risk and political infrastructure that make their comparisons odd.

S&P announced on August 5, 2011 that it would downgrade the credit rating of the United States. Interestingly it announced during the last day of this same month that while the world's only superpower and largest economy would now get only a AA+ rating, securities backed by sub-prime home loans, the same type of investments that led to the worst financial debacle since the Depression (and one from which we have not yet arguably recovered) would receive its once coveted triple AAA rating...unlike the United States.

There is no question that the United States will be able to repay its debts, we will continue to print more money-the larger issue is the continual erosion in the Dollar over time. Although a currency cannot be devalued ad infinitum without catastrophic results, at least for the time being, there is no credible replacement for the Dollar continuing to be the world's reserve currency. No other nation has the assets to back up being the world's reserve currency.

Looking at the S&P's downgrade of the United States in a vacuum, one would think that it is more prudent (according to all three ratings agencies), to prefer Austria, Denmark, Norway, France, Germany, Singapore, Luxemburg, the Swiss or even Finland. There is no consensus by all three agencies on countries like Hong Kong, Australia and the Isle of Mann. Yet other than ratings, the similarity ends there. Comparing the United States, the largest and most analyzed economy in the world with relatively petite nations like Luxemburg and Finland are like comparing the teeth of an otter and an elephant-one is so remarkably larger than the other that a comparison seems problematic. Admittedly both animals have teeth. Or like comparing the speed of an elephant and an aardvark.

To put the utility of comparison between the United States, which has a GDP of $14.657 trillion, in perspective, here are the GDPs of some of the remaining triple AAA rated countries in 2010 according to the IMF [2] :

• Luxemburg has a GDP of $52.43 billion,
• Germany's GDP is $3.314 trillion (largest in the EU)
• France $ 2.582 trillion,
• United Kingdom $2.172 trillion
• Lichtenstein $4.83 billion
• China $10 trillion (largest behind United States)


Comparing the largest most innovate, most scrutinized economy in the world to a nation like China is humorous because in terms of actual accounting standards, any meaningful transparency, the complete absence of a stable democracy or political freedoms-China is a peasant country. When the United States is downgraded, there is no other United States to compare it to, so to some extent, the rating downgrade may not be absolutely everything the media proclaims it to be.

Effect of downgrade on United States so far

When the markets opened on the first Monday after S&P's downgrade of the United States, the benchmark 10-year Treasury bond's yield dropped to 2.5%. Price, which is inverse to yield in bonds, has continued to increase even approaching all-time historic levels. This past August, the 10-year yield dropped almost 60 basis points, piercing below 2% (lower than their historic all-time low in 2008 when Lehman Brothers collapsed). The demand for United States' Treasuries has increased dramatically immediately following the S&P downgrade.

If the United States were deemed less credit worthy (less likely to pay its creditors), then investors and bond holders would demand higher returns for buying any U.S. debt/bonds. The very ability of the United States to borrow money by issuing bonds would be jeopardized. The market has ruled against this logic and to a large extent against S&P-justifiably so.

Remember a government bond is a debt instrument issued by a national government denominated in that government's currency. United States Treasury securities are valued in US dollars-their price is in United States Dollars.

A risk-free interest rate is the nominal rate of return for an investment with no risk (no credit risk) [3] of financial loss. The risk-free rate of return for almost all this century was the yield of United States Treasuries.

graph.pdf

Why would the market seemingly disregard the opinion of S&P? Perhaps because many people remembered that during the housing bubble, sketchy loans (once again I proffer this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. S&P's granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused $2 trillion in losses to everyone that relied on them-basically, everyone. No one else seemed to find it ironic that this same agency told the United States by how much it thought its debt should be lowered.

Conflicts of interest and fraud

But back to the credit ratings agencies... Not that long ago, in August 2010 and again in July of 2010, the SEC threatened to charge all three ratings agencies with fraud. Some would say better late than never. During the housing bubble, sketchy loans (I use this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. The agencies' granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused billions if not trillions of dollars in losses to everyone that relied on them-basically, everyone. The credit ratings agencies are paid by the issuers (their clients) of the securities they were supposed to evaluate, creating an inherent conflict of interest. They were the game's referee and one of its players at the same time.

The SEC report on Credit Ratings Agencies from June 2007 identified another problem other than having the referee in a match being paid by one of the sides, (not the investors or the public's side mind you), that prevented the agencies from giving accurate ratings. The agencies could not give accurate ratings of many of the instruments involved in the housing bubble and credit crisis because of the complexity of the transactions involved and the inability of agencies to understand what they were analyzing.

One could argue that the agencies were not engaging in a deliberate (alright not a horribly deliberate) fraud, that is having a public position of trust, being paid and knowing they cannot do what they are assigned to do but pretending to do it anyway. Mind you, if anyone else had engaged in this behavior, they would have likely been indicted for fraud and possibly RICO.

What may let the agencies off the hook is that they relied on the issuers' (the clients again, usually investment banks) audit committees. Audit committees cannot seem to be comprised of Chia Pets in human dimension. The fact that these committees represented having signed off on the financial instruments in question should mean something-if not, why have these corporate committees?!

Furthermore, one could argue that the credit ratings agencies must not be held responsible for their ratings because they did not and could not have understood the trading transactions taking place at the investment banks because they had to rely on the information they were given which was not itself transparent.

A possible longer term solution to the conflict of interest driven nature of the credit ratings agencies is to take away the compensation structure of the credit ratings agencies and deregulate them completely in-order to discourage inherent conflict of interest or use the Credit Spread Market-problem solved! Take away what is essentially a government-sponsored monopoly of credit ratings agencies and allow investor paid credit ratings agencies, which could open up the market and privatize the ratings industry. Without credit ratings agencies, the market will determine value more efficiently than the analysts at the agencies. A problem with this approach is that there might be variance between the ratings of twenty agencies as opposed to just three, causing the rating on any one agency to mean less and to make more work for risk managers.

No liability

S&P has somehow avoided to this very day, all criminal and civil liability for its part in the most recent financial crisis. If the agencies had some liability for their ratings, they may have a better incentive for assuring that they got them right. Neither the Justice Department nor the SEC (which has itself managed to miss all the major financial debacles of the past five years) has ever charged S&P with criminal conflict of interest (as they in practice do and would do to any number of much smaller economic participants with a much smaller fields of damage). Neither the Justice Department nor the SEC has gone after S&P for admitting before Congress in 2008 and 2009, that their being paid by the issuers (their clients) of the securities they were supposed to evaluate, created an inherent conflict of interest and did in fact wrongly influence their ratings.

Nobody has charged the S&P with criminal fraud or fraud on the marketplace for taking money from issuers in simple bad faith (playing the part of the referee and judge in a boxing match after being paid by one of the boxers) for rating securities, they admitted in sworn testimony they did not understand!

This sordid tale has no end. According to Bloomberg, S&P is giving its self-coveted triple AAA rating to junk,

"Standard & Poor's is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government.
S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties."
[4]


A spokesperson for S&P when asked about why it would give its higher rating of triple AAA yet again to subprime securities repackaged by many of the scions of AIG and Goldman that participated in causing the Credit Crisis and profited from its bailout simply stated, "We believe our ultimate success will be driven by the value investors derive from our ratings and analysis."
However, it is not honest, however much one is paid, to issue a triple AAA rating to what Bloomberg calls,

"More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg,"

and not the United States of America.

Relatively speaking

Size matters. Pension funds and many of the largest institutional investors have rules about what investments they may invest in and these rules are based on the ratings given to investments by the credit ratings agencies. Consider that Australia, Andorra, Bermuda, Canada, Cook Islands, Denmark, Estonia, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom retain their triple-A ratings.[5] These countries represent less than 21% of the world's collective GDP...my math may be slightly off. If investment funds were limited to investing in triple-A products, it would be preposterous to think that less than 21% of the economy of the world would fund the remaining 79%.

Another weakness of the credit ratings agencies is that there is no set standard employed for measuring absolute risk. What I mean by absolute risk is the measure in gambling parlance, of the risk of ruin. Wall Street and regulators have, in the example of a bank lets say, no better way other than asking for capital ratios to ascertain a bank's risk or ruin. Other factors, like the value of assets and counterparty transactions lack still, even in 2012, transparency.

Because the credit ratings agencies share this problem of being unable to objectively ascertain absolute risk, they lag the markets' own detections of absolute and relative risk. For example, the agencies did not foresee the Latin American debt crises, the European debt crisis, AIG, the Credit Crisis, Enron, Worldcom, or even MF Global. In this sense, credit ratings agencies look backwards better than they can look ahead. Arguably, there are extremely few economists or market participants that can look ahead-this may be a wholly unfair criticism...except this is part of the reason for having the ratings agencies.

The most obvious problems with the existing regulatorily instituted regime of three credit ratings agencies is that they have no competition, no real accountability because they have to be utilized even when wrong, and no liability. This oligopoly ought to be dismantled and the private sector should be allowed to get into the ratings game in the same way that analysts exists in the financial markets for every other type of investment. Doing so would eliminate the existing conflicts of interests within the credit ratings agencies and allow investors to pay the private ratings agencies for their research. Competition will have to drive the caliber of research and ratings upward.

Sadly, nothing in the gargantuan 2,300 page Dodd-Frank Act or that has been discussed in the Senate Committee on Banking, Housing and Urban Affairs addresses the problems with the credit ratings agencies...the same ones that contributed to our recent financial crisis.@

R. Tamara de Silva

Chicago, Illinois
January 17, 2012

R. Tamara de Silva is an independent trader and securities lawyer

Footnotes:
1. The EFSF's ratings are derived from its backers and France and Austria were two of the largest guarantors behind Germany. S&P's downgrade of the EFSF will mean the fund has 440 billion less in Euros than before the downgrade.
2. These numbers are adjusted by PPP (purchasing power parity), basis-this takes into account, relative cost of living and inflation rates, rather than just exchange rates.
3. There are other risks like inflation risk (the principal returned on a debt instrument upon maturity would have less purchasing power) and currency risk (the Dollar could as it has, decline in value relative to other currencies).
4. http://www.bloomberg.com/news/2011-08-31/subprime-mortgage-bonds-getting-aaa-rating-s-p-denies-to-u-s-treasuries.html
5. http://www.standardandpoors.com/ratings/sovereigns/ratings-list/en/us?sectorName=null&subSectorCode=39&filter=E

In Defense of Private Capital and Capitalism

January 14, 2012


In Defense of Private Capital and Capitalism

By R. Tamara de Silva
January 14, 2012


Is Mitt Romney guilty of capitalism? His opponents in the race for presidential nominee of the Republican Party have converged in their rhetoric and ideology with the Democratic Party and President Obama to decry that Romney's actions at Bain Capital and the private equity model in particular, are wrong, so extremely wrong that they make him wholly unworthy of consideration of President of the United States. Whether or not the latter conclusion is true or false, their argument is not evidence of either conclusion. I have read that a majority of Americans tune out politicians unless they stand to benefit from a specific government program or benefit-this would be a rational instance of when to tune them out.[1 ] The Democrats and accusing Republicans are in error about private equity and capitalism. What is worse they are placing populism above this country's core principles.

"If someone who is very wealthy comes in and takes over your company and takes out all the cash and leaves behind the unemployment? I don't think any conservative wants to get caught defending that kind of model." This quotation, which could have been from David Axelrod or President Obama, was actually from Newt Gingrich. In other words, conservatives cannot defend capitalism if it means that people will lose jobs.

Some history is helpful. Job creation and job retention are not the primary motivations for innovation and industry in the United States, they have never been. Job creation gained traction in the public discourse when it used as a justification for the government spending TARP funds-the rationale being that the government's spending would create a soft landing for the economy, lessen the economic impact of the recession and Credit Crisis and create (albeit often temporary and expensive) jobs. Yet it is not job creation that has motivated this country's most celebrated capitalists but profit motive or sometimes the pursuit of excellence expressed as an idea. Henry Ford did not start building his own self-propelled vehicles that ran on gasoline in order to create jobs any more than Steve Jobs began building personal computers to create jobs.

Hard Edges

We may not be in an economic crisis but a period of economic change. Capitalism has hard edges, especially in periods of extremely rapid economic change. Failure and obsolescence are the sina qua non of capitalism. What Mr. Gingrich's statement is missing is the possibility that America and the rest of the developed world are in the midst of period of rapid flux.

Almost without exception, most neo-classical economic theory holds that crises do not persist indefinitely, because economic systems revert to some equilibrium or balance. Perhaps, America and Western Europe as seen by the possible collapse of the European monetary union, may by in as much a period of economic change as it is in crisis. The distinction is important because if we are in a period of rapid economic change, things may not get better exactly as we expect them to-they will change.[ 2 ]

We may be in the midst of another economic revolution akin to that of the Industrial Revolution. Alternatively, we may be seeing disruptive technologies change the world and create economic upheaval (the hard edges) in the form of extreme wealth and extreme poverty as we saw in the close aftermath of the steam engine, the internal combustion engine, the railway and the utilization of electricity.

The world has never been, not at any time since mastery of the seas meant dominance in trade-not even during the silk trade--as interconnected as it is now. Technologies like the Internet and information technology have been both disruptive and creative at once, and at a breathtaking pace. The face of manufacturing, as we have recognized it for most of the twentieth century has itself changed, so has its importance as a percentage and engine of economic growth. It has been replaced by other sectors including and perhaps infamously, the financial services sector described by the term financialization. Just as what happened one hundred years ago, politicians lobbied for groups that were nearing obsolescence, but were unable to stop change itself. We see changes in the countless examples of relatively lower skilled, high paying jobs that have been erased and may never return. In periods of rapid economic change, settled patterns of work are upended. Another factor is the creation of disparate wealth between wealthy superclasses (robber barons) and everyone else, including the newly displaced.

Bain Capital, Private Equity and Venture Capital

It is easiest to extol the virtues of free markets and capitalism when able to toss in Steve Jobs, Bill Gates, Thomas Edison or Henry Ford as stunning examples of its success- but to be fair, these people are eight sigma events. Most capitalists are hardly this glamorous, they never make magazine covers, and their stories and personages are decidedly more bland if not just boring-fitting very well into the fat middle of a normal bell curve. Mitt Romney has been roundly accused of being unpardonably bland but this is not an economic transgression. Attacks on his career at Bain Capital are misplaced because both the private and venture capital business models provide extremely important social and economic functions.

Romney and Bain Capital are charged with making too much money, having businesses fail and alternatively, causing some of the most sympathetic people in North America to lose their jobs. The fallacy of these arguments are legion.

Bain Capital is primarily a private equity firm that also has a venture capital arm. Private equity firms invest by buying ownership of companies where they see the potential for a return for themselves, a return they capture by later selling the company at a profit to another party or parties either in the private or public markets (they sometimes retain acquired companies). Private equity investors can be more sophisticated than other corporate governors and in theory be better managers- thereby using their unique vantage point and experience to create wealth for investors.

Venture capitalists take a lot of risk, often investing their own money in start-ups and the new companies of entrepreneurs in the hopes of finding the next Google, or Apple. Both private equity and venture capitalists are rewarded for being able to recognize the best entrepreneurs, the best ideas, and helping to bring them to market by financing them, so that the world profits from the next iPhone, the next life-saving technology or Google.

No one in either industry risks their own or their investors' money expecting to fail. They would not stay in business if they did.

Sometimes, as the bi-partisan critics point out, people in companies acquired by private equity lose their jobs. One of the reasons for this is that private equity turns companies around by making them more efficient. This is often accomplished by getting rid of excess layers of management, unnecessary employees and generally, "bloat." It is important to remember that what is considered "excessive" in layers of management or how "bloated" a company may look-is largely subjective. Profit motive is the engine of capitalism, not job retention.[3 ]

When we introduce terms like "looting" which is a loaded term it is important to keep in mind that this is also a subjective term. Romney's critics are looking at Bain in hindsight...with some not insubstantial measure of bias. Also consider, that the world may be changing at a rapid place and some degree of job displacement may be the norm.

Investing in companies and trying to turn them around is not as easy it is sounds. It also involves an appetite for risk that most people do not have. A majority of businesses fail within two years of sooner after their inception (even if they are not distressed to start before being acquired by a Bain Capital).

Taking risk is nonetheless commendable. Taking huge risks can lead to catastrophic failure or success. I read somewhere that Thomas Edison failed well over 1,000 times before successfully creating the lightbulb. But he made in well in excess of 1,000 attempts and had the stomach to endure that much defeat-this is not common. Facebook, and Google were not guaranteed to successes. There is only one Mark Zuckerberg and only one Steve Jobs. If a high failure rate did not come with taking significant risks, there would be a 100,000 Bill Gates as opposed to just one. Looking at Bain's record, I am reminded of the Pareto Principle or 80/20 rule--that 80 percent of the effects are the result of 20 percent of the causes.

Overall, venture capitalists do well and their importance to the economy cannot be disputed. Venture capital is responsible for 12.1 million private sector jobs or about 11% of total private sector jobs that collectively generate $2.9 trillion in revenue.[4 ] Private and venture capital firms are responsible for most jobs in the software, telecom and semiconductor industries.[ 5]

Slavery and Principles in Opposition

The Founders has a very odd notion for their time, the idea that people were born with natural rights-not granted by a monarch or a government but actually born with rights, rights inherent to all individuals. This was a radical idea!

While there is no pure form or capitalism, capitalism is more conducive to individual freedom and human rights than any other system.[6 ] It simply trumps all alternatives. Capitalism promotes the opposite of slavery and is conducive a core principle deeply held by the Founding Fathers - that human beings have human rights. Self-ownership, the opposite of slavery is one of them.

This also comes with the harsh reality that some people will not succeed and must fail in a capitalist system. Because in a larger sense, it really makes no difference whether capitalism works perfectly or not-it is the legally instituted economic system most opposite of slavery.

Candidates for the Presidency, including the incumbent, like all politicians crave power so much that they must feed populist tendencies which, are based on emotion regardless of whether they cannibalize this country's core principles. All of the arguments against Bain Capital are populist ones designed to enrage, and excite anger and envy. They seek to alter the capitalist system by selectively identifying what parts of a free market are acceptable at a moment in time and what are not--and to suggest improper conduct where there is no evidence of any illegality (other than profit) by imposing the same arbitrary values-envy not being a great value by the way.

Some principles have to be above populist tendencies or we will have no principles standing. Steve Jobs and Henry Ford are good examples against these populist arguments-their motivations were never job creation or job retention but their economic enrichment-in pursuing these narrow goals they changed the world. Insisting that job creation or retention trump the motive of wealth creation, is something entirely other than capitalism.

Adam Smith's first great work before The Wealth of Nations was The Theory of Moral Sentiments, which made the case for sympathy as a foundation for human relationships in a civil society. Politics plays a large role in human relationships especially when it is used as lever to ignite class warfare and to institutionalize envy. Populism must never be used as a political campaign, however convenient or effective, because it ultimately enrages and divides a nation at its core, and sometimes these divisions cannot be healed.

Instead of attacking Bain Capital, all the candidates from both parties ought to address what harms capitalism (other than themselves obviously). If it were just Adam Smith's animal spirits competing and the fiercest winning, we would not have government subsidies, tax breaks and bailouts--all selectively doled out for a few-not all. Not even a Fed giving free money to some (a preferred very few)-not all. Or maybe we would because many of those that succeeded the most would always use their resources to create cartels, monopolies and buy political influence. Bribery and policy for vote getting- have no place in a purely capitalist system and their presence has...at least this is my guess-given capitalism a bad name.@
R. Tamara de Silva
Chicago, Illinois
January 14, 2012

R. Tamara de Silva is an independent trader and securities lawyer

Footnotes:
1. Class War? What Americans Really Think About Economic Inequality, Lawrence Jacobs.
2. Of course economists that guess correctly and point out a plausible causal variable will appear brilliant but there again, only in hindsight. We cannot really know if we are in a crisis or in a period of dramatic change but it cannot hurt to be aware of the possibility of the latter.
3. The profit motive cannot be selectively excised from capitalism in favor of job retention, as many of Romney's critics suggest. It was not that long ago that the USSR boasted of full-employment but could never match the sheer volume of innovation produced by its arch rival.
4. http://uvc.org/why-private-capital-backed-companies/#jobGenerators
5. Id.
6. There is no purely capitalist system and may have never been-in the sense of a laissez-faire system because the State is always and in some manner involved.