AAA - A Reply to The Economist
I like the Economist and I certainly like the Buttonwood column under Finance and Economics. In its latest edition (12/11/11, p.71), Buttonwood fires at increasing European political pressure (France/Italy) to hush up credit rating agencies in an effort of censorship. And the European paranoia concerning unfair treatment is wrong because France is still AAA and pays twice the German 10y yield (3,60% vs 1,75%). Admitted, Buttonwood has the intellectual honesty to criticize the credit rating agencies on their share in the the current financial crisis. But the main message and focus at the end of the article still is : "Europe, don't shoot at the messenger".
As usual and following the fact that we are human beings, articles are not wrong or biased for what they say, but rather for what they unwillingly omit to mention. I would very much like to share some comments of my own.
1) Greece and others did not require rating agencies to seal the fate, correct. In other cases, rating agencies are like a pendulum move, from one extreme (vast asleep 2003-08) to over pro-activist, like a fire brigade using kerosine as an extinguisher. But in the case of so-called European paranoia, we do have a justified reason to be, this in view of the US rating agencies' tendencies to act in animal farm style : some are indeed more equal than others.
- Take a look at US debt & deficit, current account and other fundamentals and compare for example with Portugal. Does it justify the 8 notch difference between AA+ and BB+ and the latter no longer investment grade ? Oh, but the US has the $, an important reserve currency. OK, I thought the Euro was as well. But apparently printing money has become an important new yardstick to maintain your credit worthiness these days. UK for that matter still "AAA" as well.
- In 2002/03, Italy was targeted. Of course we had the Parmalat scam (top European dairy producer and important for Italy) and then came double whammy : in no time, FIAT was downgraded to junk. And Fiat is a systemic important company in Italy. It took the rating agencies however a couple of more years to act likewise on Ford and GM while they were no different from FIAT. In fact they were worse, with GM a kind of bank (GMAC) with a loss making car production unit. But Fiat was not a systemic important company for a global bond benchmark index which a lot of mutual funds track - especially in the US - this in contrast to for example General Electric or GM/Ford. So US rating agencies think twice before disturbing Wall Street. As is the FED for that matter. And these benchmark heavy weights can afford more than for example Fiat. And they are willing to pay as well for having their investment grade confirmed.
2) On fees and conflict of interest, a lot has been written on banks paying a lot of money for AAA CDO status. And rating agencies keen on cashing in (tripple fee for structured finance products compared to plain vanilla bonds). Before 2005, Moody's income was in no sense reliant on these fees. By 2008, more than 50% of their revenue came from rating structured finance. And now it gets worse and becomes very cynical. Very recently, a Bloomberg story revealed how US municipals are cornered by the agencies. West Haven (Connecticut) has closed 4 schools over the past 2 years and fired 14 teachers to help cut its deficit. And it now pays a fee twice as high as 6 years ago (12% yearly inflation). Municipals desperately need the rating or get slaughtered by the market. And rating agencies are well aware of this, hence the price hike in fees. And they need the money as well to cover for the forgone fees of the good old structured finance days. And because they are private run companies, they have to show a yearly increase in profits which after the 2008 debacle has become a problem.
3) Buttonwood claims that being a private company is not the problem, it's the lack of competition amongst the restricted amount of rating agencies . I for one believe that being a private company in this case is a problem, even more because of serious conflicts of interest. Take for example their shareholders. In the case of Moody's, Warren Buffet (Berkshire Heathaway) is the biggest shareholder of with 13%. Fund managers like Capital World Investors (13%) and Vanguard (7%) also weigh. Now what are the odds that Moody's would act against their interest ? Indeed, less than zero. Buffet for example was furious when S&P downgraded the US from AAA to AA+ late August, as were other fund managers (probably "long" Treasuries anticipating QE3 or operation Twist). It was probably also a hidden but nevertheless clear warning at Moody's address. And if you would take a look at the off-balance sheet operations of Buffet's Berkshire holding, you would discover a tremendous amount - multi billion USD - written put contracts on equity. And then you would be surprised that Berkshire still is Aa2 rated (by Moody's of course). Conflict of interest and furthermore systemic risk : if the market tomorrow tanks big time, Warren will be wiped out, AIG 2.0 being a fact.
To to cut a long story short : Ideally, I would prefer to have credit rating agencies to operate from another planet, Mars would be nice. As long as they have no strings with Wall Street or other financial markets. It would also help to solve the matter of too big to fail and other moral hazard issues.