Credit Where Credit's Due?
It’s a few weeks now since I compared long suffering US Treasury Secretary Tim Geithner to a transvestite athlete but it seems to have caused quite a stir so for anyone who missed it, here’s what I said to Money Channel’s Banphot Thanapermsuk when he asked me about the recent performance of credit ratings agencies:
Quite apart from just looking at the individual actions that the credit rating agencies are taking, which are very interesting in themselves, I think there's also a bigger picture here that's to do with the whole investment market, the whole economy and even everything to do with human behaviour.
When you play golf, if you take one shot more than you're supposed to take, they call that a bogey and the reason for that is that centuries ago in Scotland, people used to imagine that they were playing against an imaginary opponent, a bogey man, and if they got one shot less than the bogey man, they won the hole, so they had someone to blame, basically, if they lost, and I think one of the questions about the ratings agencies is do they just exist so that there's somebody there who can quantify things that really are measurable? That's how credit rating agencies really started out in life. At that stage, they were working for investors. Investors used to ask credit agencies to assess individual securities and the agencies would come back with reports saying “yes it appears their credit is good and their business model is good” but they were paid by investors to do that work. The other thing is maybe we're expecting these guys to go and measure things that really aren't quantifiable at all. We're asking them to give ratings on things that you can't measure.
Nassim Taleb has written a couple of books about the fact that we all want to create order when actually things are completely random. Both ‘Black Swan’ and ‘Fooled by Randomness’ explain this concept that we all try to arrange things into patterns when patterns maybe don't really exist at all. I think one difficulty for ratings agencies is that in 2011/12, we don't really know what they are. We don't really know exactly what job we're expecting them to do. They're no longer just working for investors. If investors want to get information about a particular stock or bond, they don't really base it on what a particular credit rating agency says, and they don't really have that direct relationship any more. The credit agencies aren't really working for them. In 2008, we became very uncomfortable with the fact that the credit rating agencies had been working for the companies whose sub-prime securities they had been rating. That made us very worried about conflicts of interest. We're not really sure what credit rating agencies do and who they do it for.
If I can use another sporting story perhaps - when we saw Secretary Tim Geithner famously go on TV to say it was a terrible decision for S&P to cut the US credit rating from AAA, we were reminded of a couple of female athletes in the 1930s, Stella Walsh and Helen Stephens. In the 1936 Olympics in Berlin, Helen Stephens beat Stella Walsh to the gold medal. Stella Walsh and all her fans were so upset that they accused Helen Stephens of being a man. As a result, Helen Stephens had to undergo a lot of testing, and it turned out she really was a woman. She may have been bigger and stronger than most but she really was a woman. The allegations were completely unfounded.
About 50 years later, when Stella Walsh died, it actually turned out that Stella Walsh, the woman who had accused Helen Stephens of being a man, who had been making all these unfounded accusations, really was a man. There seems to be an eerie echo of this when Secretary Geithner turned around and said the downgrade was a bad decision by the S&P. After all, the main reason why the US rating was downgraded was because of what Tim Geithner’s predecessor, Hank Paulson, had been doing when he was Treasury Secretary, and what the FED under Ben Bernanke had been doing. They had been pursuing this totally irresponsible monetary policy that had created so many Dollars in the system, and so many liabilities that we still don't know how far they go. So blaming S&P smacks of hypocrisy. We have the phrase 'a pot calling a kettle black' which means trying to get the attention off you by blaming somebody else. There's no doubt that ratings agencies did a terrible job all the way up until 2008, but we have to be careful now about who's criticizing them and why they're criticizing them before we can say whether that criticism is actually valid. To be fair, if S&P did make a bad decision in downgrading US debt, I think that the problem with the decision is that it should have been done sooner, and maybe it should have been an even starker downgrade than it was because it's very unclear to us that the US deserves its current credit rating. There's a whole bunch of systemic risk in the US system that means, to our mind and certainly to the Chinese and independent rating agencies such as Egan Jones, there's a lot more risk in US sovereign debt than a AA rating would even imply. We have to look at why they're giving these ratings and really what is a fair basis of criticism or not. One thing that strikes us that when we're creating portfolios, we don't really take into account what S&P, Fitch's or Moody's might think about a particular security. As president Roosevelt said, “There's nothing to fear except fear itself.” What actually happens is that no competent professional managers actually pay any attention to the S&P, Fitch's or Moody's ratings, but what happens when they get downgraded is that investors worry that other people are going to pay attention and then it actually becomes a self-fulfilling prophecy that you had better sell because everyone else is going to start selling even though you might not agree with what the S&P rating might be.
There's another problem, which requires us to understand what we're expecting of the rating agencies and what they actually do. A lot of investments are mandated by reference to the quality of the assets that are inside the investment as dictated by the credit rating agencies. In a sense, that makes it easier to understand in that if you buy a AAA rated bond fund, you know that all the securities in there are AAA rated, but the problem is that there may be an incentive for some investment managers to go and start using poorer quality assets because if there are some AAA assets that the market prices at a certain level, but there are other AAA assets that the market is saying “We're not sure about this. We think it might get downgraded. We don't really trust the rating.” That would make a security available at a lower price or a better yield, and in that case there's actually a real incentive for some fund managers maybe to go and try and get a better return, a better yield, by buying the worst possible quality debt they can find within a stipulated rating category, and that's really what happened in Europe. When the EuroZone was formed and we started to get a common rating across the entire EuroZone, Greece and Germany fitted into the same investment bracket at that stage. The markets knew that Germany and Greece weren't the same thing even if they believed that Germany was going to back-stop Greece, and so maybe there was 100-150 basis point spread at that point in Greek debt over the German debt, which narrowed because everybody wanted to buy the Greek debt because it was apparently exactly the same risk but it was paying a much higher yield, so there really is a danger that these things create malinvestment by bunching things together and applying inappropriate ratings.
I think the problem is that no one really knows what the credit agencies' role should be and therefore people still apply too much faith to these things. On one hand, we have professional managers who don't really take the ratings particularly seriously and use their own research and their own ideas. On the other hand, we have parts of the market that still apply too much faith to the agencies. People might say that one way round that would be to introduce regulations, so rating agencies are now covered by Dodd Frank, and we have the S&P leak that France was going to be downgraded being investigated by the ECB, so we have all these situations going on, but that concerns us as well because these are meant to be independent bodies that are going to be giving opinions about, say, the US government, and if they're going to be regulated by a US government body, but they're going to be giving negative opinions about the US government, again that's getting into the conflict of interest area as well. Going forward, it's very difficult to see what the role of the credit rating agencies will be.
What we would say is largely to tend to ignore them. Get proper professional analysis of any particular security - don't just rely on the fact it's got a particular label given to it.If the ratings agencies are still doing anything wrong today, they're still being too optimistic about stocks and securities and for too long. Lehman Brothers was AAA rated virtually until the very end. Irish sovereign debt was AAA rated until 2009, which was two years after the crisis began, so there's a real concern that if they are still doing anything wrong, they're actually still being too lax.