John Dizard in “Disquiet on the western front of the credit world,” discusses the politics of the credit crisis, depicting two opposed absolutist camps: those who’d have everyone take their lumps now, no matter how bad they turn out to be, versus those who think preventing a nasty recession is all-important, even if it means terminally trashing the dollar.
The article give a lively account of how this dynamic might play itself out, but makes an observation in passing toward the end that is more significant than what went before.
Dizard believes (and he’d pretty well plugged in) that financial firms will be unable to raise more money from sovereign wealth funds. The rest of their dough will have to come from domestic sources.
We noted nearly a month ago that sovereign wealth funds were quietly rebuffing requests for more funding, but we had taken that to be in part a negotiating ploy. After all, the banks rescuers are sitting on losses. Even the investments that weren’t straight stock purchases are worth less due to the fall in equity prices and rise in credit spreads over the last quarter. Investors would presumably demand much tougher terms and try to build in downside protection.
But SWF are not all that risk oriented and they don’t have a history of being hardball negotiators. So Dizard may well be right, that they’ve decided that this game is not for them. Not that it is quite as black and white as Dizard suggests. Qatar has made noises that it might be willing to make another investment in Credit Suisse, but so far, it also appears to be one of the least damaged major firms.
And if Dizard is correct, this has some serious implications for US firms. Virtually all the money for the last go-round of bank and investment bank capital came from abroad. While the equity markets are bizarrely sanguine relative to debt markets, this isn’t a good time to raise equity if you are a financial player. Even in robust times, private equity firms aren’t interested in bank equity (buying the occasional specialized financial operation is a different matter), and it’s unclear how much appetite the unwashed retail public will have for multiple, competiting offerings when the industry is hemorrhaging losses.
Now perhaps the optimists will prove correct and the credit crisis will be on the wane in six months. That would completely change the appetite for investment in financial firms. But if we still have firms taking losses with no clear picture as to where or when the bottom might be, any new funding will be costly indeed.
From the Financial Times:
The credit world is aligning itself into political factions, divided over the right approach to untangling the present mess. On one side are the trader-fundamentalists, with one hand on the Bloomberg keyboard, the other hand on a dog-eared copy of Atlas Shrugged . They believe in the literal interpretation of scripture, which in this case means that an asset is only worth what the bid side says it is. As far as they are concerned, the only way to deal with the excesses of the credit markets is to take the write-offs and start over, having accepted the revealed truth of what bankruptcy sale buyers are willing to pay.
Opposed to them are the would-be managers of systemic risk. They believe that the aggressive application of the mark-to-market rule would result in another Great Depression, only bigger. Their Qum is Washington DC, where the differences between the Republicans and the Democrats are small relative to their agreement that a deep recession, let alone a depression, must be avoided at all costs. One of those costs could be years of stagnation and low growth. You could call them Keynesians, except that Keynes was strongly opposed to currency debasement. As far as this group is concerned, currency debasement to the point of depravity is a good starting point. (Strangely, they still publicly proclaim adherence to a “strong dollar policy”, even at $1.50 to the euro. What would a “weak dollar policy” be?)
However, the anti-fundamentalists are not just a Washington group. They also have strong representation at the top of the major dealers and banks. While the dealers’ and banks’ trading desks are mostly populated by fundamentalists, management people and board members on the upper floors realise that any thorough “liquidation” would include them.
This political fight is most evident in the US. That’s because the US markets and institutions are further along in recognising the extent of the problems, on balance sheets and in business practices, that built up in the past decade. Up to now, European finance has appeared to be a happier place than its counterpart across the Atlantic. However, both the credit trading fundamentalists in New York and the systemic risk managers in Washington have done their own analyses of European balance sheets, and agree that it’s a matter of time until the storm moves to the east.
As one credit strategist for a major New York dealer says, “I was over doing client calls in Europe last week, and they told me that they believed the US financial system will recover faster because the loss recognition is swifter.” A mark-to-market fundamentalist, he believes that it follows that “Any move to retard loss recognition is, categorically, a mistake.” At the end of the day, the liquidations would win the argument on the integrity of their market economics, while the systemic risk managers, aka Keynesians, would have the politics right. Being politicians at heart, however, the systemic risk managers are going to try to split the difference. That is to say the regulators will try to have as much recognition of losses as possible without any contraction of credit availability for the real economy.
That means that while the central bank people and regulators may be willing to have “flexibility” in the mark-to-market accounting of structured credit product on the books of the financial sector, what they want is to accelerate the recapitalisation of the banks and dealers. Banks and dealers with bigger equity bases could afford to take mark-to-market losses while continuing to lend money and maintain liquid securities markets. Simple, right?
As one official told me: “The easiest way to solve for lack of capital is to go get capital. We are in the early stages of capital raising.” The first stage was that series of calls on the sovereign wealth funds in recent months. Unfortunately, the limit on that source of equity has probably been reached, both for the banks and the SWFs. Most of the new equity for the banks and dealers will have to come from their home markets.
As that official continued, “We have been encouraging institutions to get going and do road shows. There is no shortage of capital on the sidelines.” At some price that is true. Undoubtedly that new equity will have dividends and seniority superior to the old equity. Which is why the bank and dealer management may be hesitant to book those road shows. It’s easy for officialdom to say that the equity holders will be diluted, because it’s true. However, if you’re a C-suite executive or board member, you are supposed to be working to protect the interests of those existing equity holders. We could be talking career death here. So why not put off any decision until we see what the marks will be at the end of the quarter?
Even before the lowest marks-to-market are taken, there are probably some real values to be had in the credit markets. They are not, I believe, to be found in the junk market, which probably does not yet reflect the prospective hits to cash flow from the sinking. But the high-grade credit indexes should see some more tradable rallies.
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Don’t count on help from The Iceheads either:
http://www.prefblog.com/
Naked Capitalism does not explain why all fault lies with the Credit Rating Agencies and not with the issuers and investors; nor does he speculate why Moody’s, for instance, would choose to publish explanations of their municipal rating scale if it’s such a big secret.
There’s a thread on Financial Webring Forum discussing long-term equity premia. It is clear that the long term equity premium will vary, moving marginally up and down in response to transient mispricing – this was discussed in a paper by Campbell, Diamond & Shoven, presented to the (American) Social Security Advisory Board in August 2001 (quoted with a different author for each paragraph):
He almost always takes issue with what I write.
For the record, the official policy of the rating agencies has been for many many years that ratings are supposed to mean the same thing as regards default risk regardless of the type of asset rated.
They have drifted more and more from that policy but have not been terribly forthcoming (note that S&P in the Wall Street Journal yesterday attempted to maintain that the ratings were indeed consistent). Saying that someone is not forthcoming (as Rosner and Mason said in their extensively documented paper) is not the same as saying secret. They’ve chosen to say as little as they can publicly about the issue of the consistency of their ratings because they know their practices have shifted over time (while regs have been static) and they haven’t been candid.
More important, numerous regulations key off official ratings (“investment grade” being the most glaring). The very existence of those standards presupposes that the ratings standards are consistent. But a long-term drift from those standards has created a huge amount of damage, witness the behavior of AAA CDOs. And no AAA rated asset should be able to be cut in a single review by 12 or 16 grades, as has happened more than occasionally.
The rating agencies do not deserve to be defended, period. If it were possible to sue them, even under a standard that limited their liability, they would have gone out of business long ago. The embarrassment of what would be exposed in discovery would have led to a sharp curtailment of their role.
PrefBlog ought to know full well that the US muni market in particular is full of not-terribly-savvy investors who are ratings-dependent. The ratings are supposed to help solve the “caveat emptor” problem, not exacerbate it.
I’d say, don’t count on any rescue. Period.
Really Scary Fed Charts: March
So who does naked capitalism support:
the mark to marketeers, crisis managers, or the split the differnce crowd. What makes me lean toward the mark to market crowd is watching shockingly wealthy people trying to keep their gulfstream rides and bonuses for one more quarter.
blueskies
Perhaps it makes sense to reclaim the bonuses from (fully 50% comp ratios) from the fraudulent securities sold to the “unknowing” public (like the unknowing homeowners). After all, Guiliani went after the mob via RICO, why not the banks and their conduits under the Lemon Laws. At this rate why not go after public equity on a cross asset collateralization basis akin to a multinational. Why is fund x any different than GE but for legal cover? You think that precedent would imporve the due diligence?
Laughing their preverbial #ass#s off are all the bankers and traders who pocketed the fees and commisions. The very people most responsible for this are back in the labratory cooking up the next cup of hemloc
“What makes me lean toward the mark to market crowd is watching shockingly wealthy people trying to keep their gulfstream rides and bonuses for one more quarter. “
Yeah, but it’s not just the bank executives and large shareholders who will suffer from enormous write-downs. Overtightening of credit in response to capital shortfalls will drive the housing market even further down and lead to corporate defaults. Stock market declines will hit people’s pension funds, result in layoffs and reduce government revenue, etc. A crisis of confidence in the banking system caused by a major bank collapse would ensure a severe and painful recession.
There’s a strong argument for the purist mark to market position, but the government/regulators have to take into account the wider economy. Is the presumed long term gain of financial responsibility worth the short term pain?
Ginger Yellow,
That is the same BS argument used during every crisis in the last 25 years. Perhaps they have cried wolf one too many times and people don’t give a shit about the Wall Street elite anymore.
OT, yah yah, but this pisses me off! Not only is the wheat for my birthday cake exploding with hyperinflation, but now my ballons will be ruined!
While rising prices at the pump have kept us distracted, another gas shortage has crept up on us: a worldwide helium crunch.
Unless you’re a scientist or the owner of a party planning store, you probably haven’t heard about the global helium shortage. But the lack of gas is real – and nearing crisis mode.
For months, several of the world’s 16 helium plants have been running at reduced capacity, crippled by bad weather and maintenance problems. But that’s just scratching the surface. Truth is, helium’s a lot like oil: a finite, irreplaceable resource – and one we’re quickly running out of.
The global helium shortage affects more than just Snoopy parade balloons and the Goodyear blimp. Protracted scarcity could bring both high-tech industry and the scientific community to its knees.
http://hardassetsinvestor.com/in…id=675& Itemid=6
OT, yah yah, but this pisses me off! Not only is the wheat for my birthday cake exploding with hyperinflation, but now my ballons will be ruined!
While rising prices at the pump have kept us distracted, another gas shortage has crept up on us: a worldwide helium crunch.
Unless you’re a scientist or the owner of a party planning store, you probably haven’t heard about the global helium shortage. But the lack of gas is real – and nearing crisis mode.
For months, several of the world’s 16 helium plants have been running at reduced capacity, crippled by bad weather and maintenance problems. But that’s just scratching the surface. Truth is, helium’s a lot like oil: a finite, irreplaceable resource – and one we’re quickly running out of.
The global helium shortage affects more than just Snoopy parade balloons and the Goodyear blimp. Protracted scarcity could bring both high-tech industry and the scientific community to its knees.
http://hardassetsinvestor.com/in…id=675& Itemid=6
OT, yah yah, but this pisses me off! Not only is the wheat for my birthday cake exploding with hyperinflation, but now my ballons will be ruined!
While rising prices at the pump have kept us distracted, another gas shortage has crept up on us: a worldwide helium crunch.
Unless you’re a scientist or the owner of a party planning store, you probably haven’t heard about the global helium shortage. But the lack of gas is real – and nearing crisis mode.
For months, several of the world’s 16 helium plants have been running at reduced capacity, crippled by bad weather and maintenance problems. But that’s just scratching the surface. Truth is, helium’s a lot like oil: a finite, irreplaceable resource – and one we’re quickly running out of.
The global helium shortage affects more than just Snoopy parade balloons and the Goodyear blimp. Protracted scarcity could bring both high-tech industry and the scientific community to its knees.
http://hardassetsinvestor.com/in…id=675& Itemid=6
“Perhaps they have cried wolf one too many times and people don’t give a shit about the Wall Street elite anymore.”
And quite right too. But, again, it’s not all about the Wall Street elite. It’s a question of judgement as to whether letting major banks fail will have so deleterious an effect on the economy that it’s worth propping them up. Personally I don’t think the write downs will be that severe in the end and am strongly inclined to let the chips fall as they may, but I don’t know the answer to the big picture question because I’m not an economist. But it is something politicians and regulators have to take into account. Is it worth enduring a Japan style decade of stagnation just so the “Wall Street elite” (and lots of small banks who made stupid bets on real estate) get their just desserts?
SWF/Middle East oil related investments are taking huge losses. Money that has been moving into various European investment houses and Hedge funds the last few years has been lost and the shock is beginning to be seen on the their offical reaction to throwing more money at the West.
check out the disclaimer to FAKEPAYCHECKSTUBS.com …….extremely funny!!!
Yves,
Your website is great.
Have you heard or are you aware of whether the SWFs get most favoured nation status when investing the various troubled banks? I’m hearing that some have secured anti-dilutive rights, but nothing really backs this up. This goes to a point in the FT article today that mentioned that equity holders are being diluted down.
Keep up the great work.
The too big too fail argument is a red herring. For those thinking the governement doesn;t have their hand in the pie already note the price action in the market today – shcokcingly 15 minutes to go and the market rallys. Chance? Treasury comes out in favvor of IMF selling gold last wek after opposing it? chance?
The feds are desperate to plug the holes popping up all over the placre and they will fail. Good article in FT discussing divergence of CDS from equity prices heretofore. As for the what about the pensioners crowd, well what about them? stocks are but an asset class and the prudent manager is cutting their exposure not selling the same old saw that you invest for the long term. Who was it that put the 98-07 study together which said if you invested for the long haul you underperformed treasuries. For all you pensoioners, word to the wise, the mutual fund complex and 401K complex is a business in which they generate fees off you. They have a vested interesd in seeing you put money into equities just like the investment banks have a vested interest in seeing companies do transactions, regardless of value.
The reflation theme is simply delaying the inevitable. The Fed can do anything they want to mortages the fact remains thomes are still WAY too expensive on a relative valuation basis. Therefore, cut away, morttage rates arn;t falling anyway. back in the seventies, houese were 2x avg salary versus the 5x today. Interest rates in the mid seventies compare favorably to today. Where is the sympathy for the savers whohave been repeatedly waterboarded for prudence? No we instead spend out time worring about the 1-2$ of all households that bought houses that they couldnt afford with no money down. The ownership society is a joke. It is a populist political slogan come agitprop. If we assume that all these people are at the low end of the socio economic ladder and lets say it is 1-2M homes at an average cost of 250K we are talking a few hundred million to fix the problem, no? That is a few days interest for Buffet and he could get a tax writeoff. Somehow the numbers don’t add up when we hear the bleeding heart stories – which leads one to conclude as virtually any person equipped to drive a car alone knows that this is entirely about the banking sector bail buckets. Perhaps the gentleman who defends bailouts should enlighten us as to how a contraction in credit (which is happening notwithstanding whether a bank fails or not) is a bad thing structurally for the US economy? Oh you mean we can’t spend 9T on consumer goods anymore to inflate GDP to unsustainable proportions. We can’t build structures that have no chance of occupancy, but boosts GDP? My heart bleeds. Take a look at GDP per capita numbers from around the world – Europe, Europe is half the US approximatly. Convergence will occur and I think the market is telling you the United States is deflating.
Also, where is the sympathy for the repeated waterboarding of the savers in this equation. No we should collect
The structural issues that have created such massive global dislocation have become third rail in the United States. Obama says tax credits to companies that invest in the USA. Yeah that solves the labor arbitrage. This solution is akin. That is like giving the crack addict heroin and marking him off cured.
IS it any wonder the comptroller of currency resigned.
Sorry state of affairs
apologies, that is $250 billion not 250 million!
Yves Smith : PrefBlog ought to know full well that the US muni market in particular is full of not-terribly-savvy investors who are ratings-dependent.
As I understand it, this is precisely why a different scale has been used for the past 100 years. According to Moody’s: Compared to the corporate bond experience, rated municipal bond defaults have been much less common and recoveries in the event of default have been much higher. As a result, municipal investors have demanded, and rating agencies have provided, finer distinctions within a narrower band of potential credit losses than those provided for corporate bonds.
Like the bond markets themselves, Moody’s rating approach to municipal issuers has been quite distinct from its approach to corporate issuers. In order to satisfy the needs of highly risk averse municipal investors, Moody’s credit opinions about US municipalities have, since their inception in the early years of the past century, been expressed on the municipal bond rating scale, which is distinct from the corporate bond rating scale used for corporations, non-US governmental issuers, and structured finance securities.
Compared to Moody’s corporate rating practices, Moody’s rating system for municipal obligations places considerable weight on an overall assessment of financial strength within a very small band of creditworthiness. Municipal investors have historically demanded a ratings emphasis on issuer financial strength because they are generally risk averse, poorly diversified, concerned about the liquidity of their investments, and in the case of individuals, often dependent on debt service payments for income. Consequently, the municipal rating symbols have different meanings to meet different investor expectations and needs. The different meanings account for different default and loss experience between similarly rated bonds in the corporate and municipal sectors.
Moodys also reviewed their consultations with real live investors in their testimony to the House Financial Services Committee.
James,
That is rating agency attempts at revisionist history, now that their practices are under the spotlight. Rating agencies have historically claimed that their rating were consistent across issuer and product; indeed, why would so many regulations (Basel I and II, pension fund and insurance), simply designate gross ratings limitations (AAA, investment grade, and so on) without specifying the grade per type of issuer if it was known that the ratings were NOT consistent as to risk? That defies all logic.
Consider this statement from a paper published last year by Joseph Mason and Joshua Rosner:
The value of ratings to investors is generally assumed to be a benchmark of comparability it offers investors in differentiating between securities. Credit rating agencies (CRAs) have long argued that the ratings scales they employed were consistent across assets and markets. Not long ago Moody’s stated “The need for a unified rating system is also reflected in the growing importance of modern portfolio management techniques, which require consistent quantitative inputs across a wide range of financial instruments, and the increased use of specific rating thresholds in financial market regulation, which are applied uniformly without regard to the bond market sector.”6 In a similar pronouncement in 2001 Standard & Poor’s stated their “approach, in both policy and practice, is intended to provide a consistent framework for risk assessment that builds reasonable ratings consistency within and across sectors and geographies”.7
You can read more, and the citations, starting on page 8.
I have also seen (but can’t recall where) quotations of statements from the agencies the early 1990s that were much firmer regarding the consistency of ratings.
indeed, why would so many regulations (Basel I and II, pension fund and insurance), simply designate gross ratings limitations (AAA, investment grade, and so on) without specifying the grade per type of issuer if it was known that the ratings were NOT consistent as to risk?
The Basel Accords are not quite so mechanical as all that – there is considerable leeway given to national regulators to interpret the principles and apply them to local conditions.
It is my understanding that General Obligation Municipals are assigned by definition a risk-weight of 20% regardless of rating (this is the same bucket as AAA/AA long-term ratings) while Revenue obligations are assigned a 50% risk-weight (which is the same bucket as “A” long-term ratings).
All this is mere hair-splitting, however. An investor who takes free advice without even asking what the advice means would be better advised to find an advisor.
The ratings agencies do what they do because they want to do it. If anybody has a better idea, they’re welcome to compete. Let a hundred flowers bloom, a hundred schools of thought contend!
James,
Competition is most certainly NOT open in the rating agency business. The SEC determines who is a “nationally recognized statistical rating organization.” It does not publish its criteria for how to become one. It took Egan-Jones, the most recent addition, eight to ten years to get the designation.
The Basel I rules made fairly strong use of ratings; Basel II permits more sophisticated organizations to use their own methodologies. But even the Fed’s discount window uses rating agency classifications to ascertain what is acceptable collateral and what hairicut to apply.
Their role is well enshrined in regulations. Per Wikipedia:
Ratings by NRSRO are used for a variety of regulatory purposes in the United States. In addition to net capital requirements (described in more detail below), the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimick the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings from NRSROs to ascertain the strength of the reserves held by insurance companies.
The rating agencies are a protected oligopoly and as a result, are highly profitable. They are not charities.
The most recently recognized US NRSRO is LACE Financial, registered 2008-2-11. Egan-Jones was 2007-12-21.
The big agencies are indeed quite profitable, irregardless of whether or not they’re a protected oligopoly. This is why they are currently under attack by the not-quite-so-profitable, not-quite-so-respected subscription agencies.
Rules for becoming a NRSRO were published in the Federal Register.
You do not need to be a NRSRO to get the “Rating Agency” exemption from Regulation FD, nor do you need to be an NRSRO to sell me a subscription to your your rating service.
You do, however, need to distribute your ratings freely to get the Regulation FD exemption; this is an aspect of the regulations I don’t like at all. It may be logical as far as it goes (the information will not be exploited for gain) but it means that investors cannot perform a fully independent check of the publicly available ratings.
As for the regulatory role of the NRSRO agencies … that’s the regulators’ problem, first and last. I can sympathize with the intent; and the implementation is a tip of the hat to the big agencies’ long and highly successful track record; but the agencies cannot be blamed if the regulators have decided to follow their advice blindly.
James,
I stand corrected on the criteria being available now, but note per above, the NRSRO designation was established in 1975, yet per your link, the guidelines for qualifying were not published till 2007. Egan Jones suffered repeated rejections of its application with no explanation.
In fact, if you had read the Wikipedia article, the SEC had published a “concept memo” in 2003 which set forth criteria that made new entry just about impossible:
The single most important factor in the Commission staff’s assessment of NRSRO status is whether the rating agency is “nationally recognized” in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings.
This as you can imagine is a massive chicken and egg problem. You have to be “nationally recognized” to be an NRSRO, yet who is going to take the risk of building up a sufficiently large operation when the approval barrier is high and ambiguous. This provision seemed intended to close the gate behind the current NRSROs.
Again per Wikipedia, the SEC provided guidelines only as a result of Congressional action:
In 2006, following criticism that the SEC’s “No Action letter” approach was simultaneously too opaque and provided the SEC with too little regulatory oversight of NRSROs, the U.S. Congress passed the Credit Rating Agency Reform Act. This law required the SEC to establish clear guidelines for determining which credit rating agencies qualify as NRSROs. It also gives the SEC the power to regulate NRSRO internal processes regarding record-keeping and how they guard against conflicts of interest, and makes the NRSRO determination subject to a Commission vote (rather than an SEC staff determination). Notably, however, the law specifically prohibits the SEC from regulating an NRSRO’s rating methodologies.
I never said that Egan Jones was the most recent rating agency; the Wikipedia link clearly shows LACE.
It is not hard to imagine that those two additions, which brings the list to nine, was in response to the recent criticism of the incumbents.
Do you have any problems with the manner in which NRSRO certification is awarded now, or is this yesterday’s battle?
I remain a little unclear on the link between NRSRO certification and the rating scale used for municipalities – can you clarify?
Additionally, it seems to me that, should municipalities be rated on the corporate scale, then they’ll be basically split between AAA and AA, with a few outliers. Will this truly improve the utility of the ratings to Joe Lunchbucket? It seems to me that – given a rational response to a lemons problem, and in the absence of independent analysis – issuers with greater financial strength will achieve no benefit, and end up paying more for funding. Have you seen any commentary on this?
I’ve had one other thought about the possible effects of a two-grade rating scale. The prior comment referred to the intra-grade effect on ratings, but there may well be an inter-grade effect as well.
If our good friend Joe Lunchbucket is presented with a list of, say, 100 offerings and their (current) ratings, he sees half a dozen or so categories – he also sees that a recognizable name like California is not in the highest rank.
This multiplicity of grades serves to emphasize the idea that the ratings represent graduated scales. I suspect that if the same list is presented to him with only two significantly populated rating classes, he might consider these to be indications of “good” and “bad” … or, perhaps, pass/fail.
Thus, it is entirely possible that spreads between municipals in the (corporate scale) AAA & AA classes will widen from historical norms – which will cost the lower-grade issuers a lot of money – unless, of course, they purchase evil bond insurance.
After all, municipal bonds are not in much competition with corporates for Joe Lunchbucket’s investment – they’re in competition with each other.
I recognize that it is currently so fashionable to blame the ratings agencies for all the world’s ills that little consideration will have been given to the probable effects of changing a 100-year-old system, let alone any actual work. But if you come across any informed research that addresses the above possibility, I would be very interested to see it.