Of Credit Ratings, Sovereign Risk and Semi-Sovereign Risk

This post was prompted by Barry’s article Credit Rating Firms: Worthless in a Bull market, Damaging in a Bear Markets.

When I was a bond manager, we had a rule for our analysts — ignore the rating, but read the write-up.  The analysts at the rating agencies would give their true opinion in the write-up.  The buy side analysts usually found themselves in agreement with what was written, and would tell us what they thought the rating really should be.

After that, the portfolio managers were encouraged to ignore the rating, except to calculate the yield haircut for the incremental capital employed.  Those doing structured products developed their own models for benchmarking the risks of deals, ignoring the ratings, but reading the reports, because there was often really good information on the weak points of deals, including things not mentioned in the prospectus.

As managers, we knew we could always find seemingly cheap bonds for a given rating, but they were “cheap for a reason.”  We would avoid them.  Who would buy them?  Collateralized Debt Obligations [CDOs].  In CDOs were run by mechanical rules that relied on the ratings of the debts, among other things.

As such, they tended to fail.  After seeing the debacle 1999-2002 in CDOs, most insurers swore off CDOs — aside from AIG.  They were structurally weak securities with lousy collateral.

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The rating agencies have a hard task.  In the old days, they said that ratings were good for a full credit cycle.  Bond managers wanted stable ratings, and didn’t want to be bothered with ratings that were higher in the boom, and lower in the bust.

In 2001, after Enron, the rating agencies took several actions to be more proactive about ratings.  Result: a lot of ratings moved down rapidly, led to a collective screech from bond managers.  Result 2: the rating agencies stopped being proactive.

Barry is mostly right that in a bull market, ratings are worthless, and in a bear market, you don’t need them.  But they do have uses:

1)  Many bonds have no one analyzing them — particularly small deals.  A rating helps create a buyer base.

2)  The bread-and-butter corporate ratings are usually pretty accurate.

3) They summarize a lot of useful data in a small space.

4) What the analysts write is usually pretty good.  They are reasonably good at ranking credits within a given class against one another.

The corruption occurred higher up in the firms, because they mis-set the ratings for categories as a whole.  CDOs too high, subprime CDOs way too high, Munis too low, CPDOs ridiculous etc.  Part of the problem is inadequate thinking and risk aversion about new asset classes, because they don’t have loss data for assets that have been bought to securitize.

I’ve written too much, but I will give you one more key lesson of the period 1990-2008 regarding ratings, and this applies to sovereign issues today: Ratings that must be maintained in order to avoid a given result are dangerous, and good bond managers avoid investing in such bonds.

Examples:

1)  Insurers that made their Guaranteed Investment Contracts [GICs] putable on ratings downgrades.  (Fixed rate failure early 90s [Mutual Benefit], floating rate late 90s.  [General American / ARM Financial])

2) Enron-like structures that would force issuance of preferred stock on a downgrade (and some other triggers)

3) Reinsurance treaties callable on a downgrade.

4) Swap counterparty agreements requiring more capital on a downgrade.

5) Step-up bonds, where more interest is paid after a downgrade — not worth it…

It is perverse to want more out of a company when they are downgraded — often it leads to a collapse.  As a bondholder, it does not pay to stand near cliffs where a downgrade can change the creditworthiness of a company.

Sovereign governments are the same way.  You can’t make them pay; the only big penalty is getting shut out of the bond market — which means that in the future, their budget would have to be balanced on a cash basis.  So, I offer one simple insight on sovereign risk — I suspect that sovereigns default when the interest payments are more than structural budget deficit.  At that point, it would pay for a government to default.  Of course, this would have to be a situation where the structural budget deficit is high, and there is little hope of bringing it down politically.

Now one could just print their way out of the situation, and hand fresh currency to creditors — but at a cost of high interest rates and inflation, which could crush economic activity in real terms.  Partially inflating to do it, and borrowing to make interest payments would face a similar hurdle, because the borrowing would likely be at higher rates due to inflation.

But States of the US, municipalities whose States don’t allow them to file for Chapter 9, members of the EU, and other Semi-Sovereign credits that don’t have access to a printing press have it tougher, but I think the same test applies.  If the structural budget deficit is high, but less than interest payments, the odds of a default rise considerably, because if they cease paying the interest, the budget is balanced.  Being shut out of the bond market does not matter at that point.

Now, there are still costs to defaulting.  Rare would it be for a government to stop being profligate after a default.  They would need the bond market back at some point, and then the negotiation over past debts would begin.  There would also be seizures of assets abroad.  There might even be economic sanctions.  If the defaulting nation is big enough, it could cause some bank failures, leading to a broader set of crises.  At some level of crisis, war is not impossible, improbable as that may be.

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Coming back full circle, I am reminded that corporate credits don’t typically default because they can’t refinance, they typically default because they can’t make the interest payment.  My opinion is that it is the same for sovereign debts, except that is more sturm und drang around it because of currency, political, and solvency of financial institutions issues.

So, what would be a good next step?  Create a table of Sovereign and Semi-sovereign debtors, estimate their structural budget deficits and their interest payments.  My question: has anyone done this already?  Is there a good place to look where the data is summarized?  Let me know any ideas in the comments, and thanks.

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