If used as geopolitical weapons beware, credit ratings can be more dangerous to your homeland than to your enemies

Sir, FT Alphaville should be commended for bringing up a discussion on what credit ratings can signify and which, even though it could have a fundamental impact on our future, has been so irresponsibly neglected, “Credit ratings warped by geopolitical pressures”, February 4.

Alphaville quotes Guan Jianzhong, the president and CEO of Dagong Global Credit Rating Company of Beijing saying:

“The global credit crisis has shown us that credit rating concerns the safe development of the human society… The current international credit rating system is favourable to the countries behind it, who apply their value and ideologies to the rating standards… It becomes the origin of the crisis and is no longer able to shoulder the credit rating responsibility for the world… However, the human society in the credit economy stage needs fair and just credit rating.”

That puts the finger on a thousand aspects… like for instance what is “fair and just credit rating”?

And it is completely in line with what I argued in a letter published by you in January 2003, namely: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”… and all this made so much worse in June 2004 when Basel II’s credit-risk weighted equity requirements for banks, exponentially leveraged the dangers of credit ratings.

But let me here just focus on “credit rating concerns the safe development of the human society” in order to repeat to FT, for the umpteenth time, the following warning:

Risk-taking is the oxygen of any development, and so there is nothing as contrarian to a safe development of the human society, as an excessive risk aversion… such as that one imposed by the Basel Committee on our banks.

Now you may observe “What about all those excessive risks banks took and which caused the crisis?” and to which I would respond, again for the umpteenth time: “This crisis, as all bank crises in the past, have been caused not by excessive exposures to what was considered risky, but by excessive exposures to what was ex ante considered safe but that ex-post turned out to be risky”.

Sir, I have been arguing for years that since the information contained in credit ratings is already cleared for by banks, in interest rates and size of exposure, it is sheer lunacy to reuse that same information when setting capital requirements… something which should have much more to do with the possibility of the credit risks having being wrongly perceived.

And I have also argued that to distort the allocation of bank credit to the real economy, based on perceived credit risk, serves absolutely no social purpose. If regulators absolutely must distort, it would better of they did it with for instance ethic-ratings, sustainability-ratings or potential-of job-creation-ratings.

Alphaville introduces Guan Jianzhong’s comments with “It is no joke the way modern finance is being warped by geopolitical pressures and ambitions”. Indeed, but careful, the use of credit ratings as weapons can easily turn out to be more dangerous to your own homeland than to your enemies.

PS. The article is a consequence of Fitch Ratings placing a BBB minus, barely investable rating on [Russian] Gazprom. Beware, good ratings can also take some down, ask Greece.

The riskiness of country risk

And citizens could sue agencies for too good credit ratings of sovereigns, which caused governments to borrow too much.

Sir, I refer to Stephen Foley’s and Guy Dinmore’s “Italy eyes €234bn suit after ratings groups failed to value la dolce vita” February 5. It reminded me of an Op-Ed of September 2002 titled “The riskiness of country risk”.

In it I wrote: “What a nightmare it must be to be risk evaluator! Imagine trying to get some shuteye while lying awake in bed thinking that any moment one of those judges, those with the global reach that have a say in anything and everything, determinates that a country has become essentially bankrupt due to your mistake, and then drags you kicking and screaming before an International Court, accused of violating human rights.

What a difficult job to be a rater of sovereign creditworthiness! If they overdo it and underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. Any which way, either extreme will cause hunger and human misery.”

And so what’s more to say. If the Italian Government sues the credit rating agencies for having given Italy too bad ratings, an Italian citizen might equally sue these for having given Italy too good ratings

And after that, what about suing the regulator who with their risk-weighted capital requirements for banks multiplied immensely any signal emitted by the credit ratings?

Regulators, stop the credit rating agencies from telling banks where it is safe to go. They haven’t a clue, as neither have you

Sir, Christopher Thompson quotes Bridget Gandy, managing director of Fitch “If you compel banks only to use a leverage ratio, the only way to be more profitable is to take more risks on the assets you have. You need to have balance between capital coverage of risk-weighted assets and leverage, risk is not just about size”, “Banks ‘need’ to cut €3.2tn of assets” August 12.

And that is precisely the type of mentality, which completely aligned with the mentality of the bank regulators in the Basel Committee, and which if allowed to prevail would guarantee that the €3.2tn of assets expected to be cut in Europe, would not be cut in the most economic efficient way, but only in accordance to its perceived riskiness.

And, as a direct consequence, Europe would end up with its banks stuffed with “absolutely safe” assets, which could be financed by other means, while it’s medium and small businesses, entrepreneurs and start-ups, those “risky” borrowers which might hold the best chances for Europe to return to sturdy economic growth, will be completely starved for access to bank credit.

A credit rating agency, incapable of looking around the corner to what might happen down the line, might be an extremely good agency for rating the creditworthiness of banks and borrowers this and the next quarter, but is extremely useless for rating the credit worthiness of anything some years ahead.

“The only way [for banks] to be more profitable is to take more risks on the assets you have” Yes Fitch, indeed… and what is wrong with that? The latest decades the way banks have become more profitable has only been by convincing the regulators they need to hold less and less capital on assets perceived as absolutely safe. And look what damages that has caused us.

No Fitch! I appreciate very much your credit ratings, and these will be used, but it is high time for regulators to stop you from telling the banks where it is safe to go, because, sincerely, you have not the faintest idea about it... as of course, neither have they.

More important than how accurate credit ratings are, is how these are used.

Sir, Brooke Master’s reported “Regulators exposes big three rating agencies’ shortcomings”, March 19, referring to the European Securities Markets Authority’s (Esma) year-long examination of Moody’s, Standard and Poor’s and Fitch. Two comments:

First, when they hold that one agency was not giving the markets sufficient notice that it was reconsidering the ratings of a large group of banks, they should never forget that the credit ratings, when predicting the bettering or worsening of credit ratings, can also help to catalyze these.

In this respect I would suggest reading the US GAO Report in 2003, subtitled “Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises” It stated: “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.”

From that report it is easy to understand that one of IMF’s problems is that what it opines, becomes a political and an economic risk too. And the same goes for the credit rating agencies.

And please, let us also never forget that it would be just as wrong of a credit rating agency to underrate the creditworthiness, of for instance a bank, than to overrate it.

Second, worse than a badly awarded credit rating, is a badly used credit rating. And of that bank regulators are guilty. Let me explain, again.

Banks normally cleared for perceived (ex-ante) risk, that which for instance is given by the credit ratings, by means of interest rate (risk-premiums), size of exposure and other term; let us call that “in the numerator”.

But our current bank regulators, those in the Basel Committee and the Financial Stability Board told the banks they needed also to clear, I would call it re-clear, for exactly the same perceived (ex-ante risk) risk, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital.

That was, and is, loony, and only guarantees the banks did and will overdose on perceived (ex-ante) risks.

And that only guarantees that when bank crises will finally occur, as they always only result from excessive exposures to what is believed “absolutely safe” but that ex-post turned out risky, we will find the banks standing their naked with too little capital to cover up with.

And that only guarantees that those perceived as “risky”, and which could in fact be those our real economy most need to keep it moving forward, and create jobs for our young, will have their access to bank credit made more scarce and expensive than ordinary.

And so much more important than having Esma examining credit rating agencies would be having Esma, and all others too, examining first how the bank regulators use the credit ratings.

Please, never forget, that even the most accurate credit rating is made wrong, when excessively considered.

In January 2003 in a letter published by the Financial Times I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”. Where was Esma then?

FT, it was there, right in front of your nose, in 2004, and you still don’t want to see it. Why?

Sir, on November 2, 2004 Charles Batchelor wrote in FT a short piece titled “Basel II favours high quality borrowers”. In it Batchelor describes how the new capital requirements for banks will be very much based on credit ratings, and quotes Kim Olson, the managing director of Fitch saying “banks have an incentive to sell poor quality debt and buy high quality”.

And, as a saying in my country goes, “the child that cries and the mother who pinches him”, of course the banks sold too much poor quality debt, like loans to unrated or not so good rated borrowers, like medium and small businesses and entrepreneurs; and of course bought too much of what has always been most dangerous for banks, namely what was perceived as “absolutely safe”.

And now, soon 5 years after the crisis detonated, precisely because of excessive exposures to those perceived as “The Infallible”, and when now regulators in Basel III, with their liquidity requirements based on perceived risk, are set on giving even more incentives to banks “to sell poor quality debt and buy high quality”, the Financial times stubbornly, I can’t figure out why, remains silent on how the Basel regulations distort the markets and odiously discriminate against “The Risky”.

In June 2004, there was an unwitting but de facto terrorist act against the good corporate governance of the credit rating agencies.

Sir, of course we fully agree with John Gapper in that “Credit rating agencies must beware of the law” February 7. But!

Let us say you had a credit rating agency and which with some mistakes here, and some there, some worse than others, had been able to reasonably prosper over the years. And then suddenly, in June 2004, with Basel II, bank regulators decided that if a security was rated AAA or AA by your company, banks could hold these against only 1.6 percent in capital, meaning banks could leverage their capital with the expected risk-adjusted returns of that instrument an amazing 62.5 times to 1.

Anyone who does not understand what a de facto tsunami sized terrorist act against good corporate governance that meant, does not know what he is talking about, or is just out selling himself on a holier than thou basis.

Let the credit rating agencies rate, and us learn, again, just to take the credit ratings for what they are.

Sir with respect to your “Holding the rating agencies to account” November 6, there are only two alternatives: 

One is the caveat emptor route of taking the credit ratings for what they are, always subject to the possibility of human fallibility, of one or any sort, and always subject to some uncertainness which is very hard or even impossible to measure, and all for which the ratings should be handled with care. In this case, the best regulators can do, is to append a label stating: “Warning: excessive reliance on credit ratings can be extremely dangerous to the health of your portfolio.” And, the worst thing what regulators can do, is precisely to give the ratings the credibility and importance these were given in Basel II. 

The other route is that of “we must make them work” no matter what. Yes, if a credit rater had just gone out of his office for one single day to see how the mortgages that formed part of the securities he was rating, these would not have been AAA rated, and that I swear. But, since the rater preferred the comfort of his office to the subprime suburbs¸ just as you and I do, he did not go there. And so should he now be sued? Perhaps, but if you hope to get something remotely substantial out of him, you must hope he is able o enlist the support of Bernanke and Draghi. 

And here is the “sophisticated” Financial Times going for the second option and writing “Things will only change once ratings are regulated more rigorously and paid for by investors rather than issuers”. I am amazed that FT has descended into such primitive naiveté… just for starter what would a credit rating cost if the raters needed to insure themselves against any sort of malpractice. 

Really, if anyone should be held accountable in this case that should be the bank regulators, they must have known the risks. In a letter that you yourself published in FT in January 2003 I told them that “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds” 

No! Let the credit rating agencies rate, and us learn, again, just to take the credit ratings for what they are.

PS. The current S&P and Kroll duet “Anything you can rate, I can rate better I can rate anything better than you No, you can’t Yes, I can” 

Greece would be nothing compared to the big AAA-bomb already dropped!

Sir, of course Goldman Sachs´ Erik Nielsen is correct saying that “ECB must re-examine its dependence on rating agencies”, March 25, since “no country would hand the controls of a nuclear device to a third party”.

But this has really very little to do with Greece as that would be just a minor tactical puff! The real big AAA-bomb already exploded in the subprime heart of the Empire, causing a couple of trillions of dollars in damages and radiating many harmful after-effects that we are just beginning to tally and comprehend.

The AAA-bomb

There should be limits on how much you can make your opinions heard.

Sir in “Fitch eager to make headlines” September 17, Adam Jones quotes Mr de Lacharriére the owner of Fitch Ratings saying with respect to the possibility of buying Les Echos “that a ratings agency and a financial news provider are complementary since both strive to deliver impeccable information: ‘There is no conflict of interest, we have truly the same objective” May I ask has he ever heard about the reason for separation of powers in any government even though their different branches have the same objectives. On the contrary if I was a bank regulator of those who have empowered the credit rating agency to dictate so much within the financial markets one rule I would make sure of is that these credit rating agencies should have no access to other additional means of imposing what they consider to be their First Amendment protected opinions.

Is the coverage in Business Week influenced by the fact that its parent company, McGraw-Hill, also owns Standard & Poors?

Most probably not but given the real power that has been given to the credit rating agencies that should not even have to be a question we consumers would have to ask ourselves since the regulators should know that it is in their best interest to keep incest as far away as it can?

Is there anything else with sufficient power to stand up to the credit rating agencies going crazy than a free media with the voice to criticize it? Will the criticism be the same if they have the same father? I do not think so and so I would gladly suggest that McGraw-Hill makes up its mind about which part of the business it wants to keep.

Where is everyone?

Sir, Roger Merritt the Managing Director of Credit Policy of Fitch Ratings, one of the three and only credit rating agencies, now tells us that “Hedge fund behaviour in credit markets is untested” June 6, even though he knows that when you for instance rate the adequacy and safety of a boat you must do that in reference to the waters where it is suppose to navigate. Merritt, in response to a report in FT, now mumbles about some new paradigms in the global credit markets and then goes on to explain some century old facts that we all know and that he should have known. Where are the regulators willing to regulate when we need them?

What is new though, perhaps only because it is so shocking we did not even want to think about it, is that this diversify-your-risk driven market and that I prefer to call the hide-the-risk market has now developed some financial products, formally traded among formal participants, that create a vested interest (which means they profit) in the default of mortgages. What is this? A financial coliseum? Although I do no profess to understand it all (who can) I am no stranger to the fact that this type of derivatives could help people to get easier access to mortgages but now try to explain to someone being evicted that you cannot help him because someone has a legitimate profit motive that stops you from doing so. Where are our leaders when we need them?

Investing in people losing their homes?

Sir, June 1 Saskia Scholtes reported of hedge funds' "Fear over a helping hand for home loan defaulters¨ and June 5 Richard Beales says that Fitch ratings could downgrade bonds backed by subprime mortgages if the loan's terms are changed to help borrowers keep their homes. It takes some time for the implications of such news to set in but when it does it really knocks you down. Do they mean that in all the risk diversification (or risk hiding) that has been occurring through derivatives we have now actually created a group of investors with a vested interest in people losing their homes? Sorry, something sounds wrong and this surely must be something more than your regular moral hazard. Can I go long on a nuclear missile index?