Credit rating agencies polices could impact developing countries recovery.

The world’s three major private credit-rating agencies (CRA) Standard & Poor’s, Moody’s and Fitch are using their power to prevent low-income countries from restructuring their debts and stimulating their economies. Credit rating agencies realise that developing economies who engage with private creditors, which is part of the G20 Common Framework for Debt Treatments, run the risk that those creditors will incur losses and therefore CRA downgrade the developing country’s credit rating. The Common Framework is supposed to help debt-ridden countries and are the best chance for developing countries to reduce their liabilities but a ratings downgrading damage their prospects.

Standard & Poor’s, Moody’s and Fitch control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. Below are the ratings that each company uses.

We’ve been here before – conflict of Interest and the sub-prime crisis of 2008
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:
Bear Stearns
– rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

Source: Credit-Rating Agencies Could Derail Economic Recovery – Project Syndicate


Central and Eastern European (CEE) economies costs and benefits from Covid-19

The impact of Covid-19 on countries like China, and other parts of Asia, has meant that firms in the large economies of Germany and France might not be keen to outsource work to Asia. Although the infrastructure and the resources are available in these countries the Covid-19 risks associated with them means some European companies are looking at options closer to home – also referred to as “nearshoring” (moves by China-wary western European manufacturers to bring production closer to home). CEE countries especially Czech Republic, Hungary, Poland, Slovakia and Romania are particularly strong in the manufacturing sector whilst Estonia, Latvia, and Lithuania (Baltic states) have a comparative advantage in services. Although outsourcing will help these economies it will take a bit of time before there is any significant change.

This is an optimistic view but for some Eastern European countries the GDP forecast has been worse than that experienced after the GFC.

With the fall of the Berlin Wall, the transition from command to market systems led to severe recessions within countries – accelerating inflation and very high levels of unemployment – GDP fell by over 40% in the old Soviet-bloc countries. The present recession is proving to be much worse and these Eastern European countries are particularly vulnerable. The Economist came up with three reasons:

  • These economies are exported dependent – as a % of GDP exports are 96% in Slovakia, 85% in Hungary.
  • Eastern European countries will find it hard to fund deficits as their credit rating tends to be a lot lower than other countries wishing to borrow money. Bulgaria’s rating is BBB compared to say Austria which is AA+
  • A lot of these countries rely on tourism as part of GDP therefore with Covid-19 the tourist industry has all but disappeared. For Croatia that is about 25% of GDP.

The outlook looks especially bleak for economies that were in a poor economic condition before Covid-19. Even though there have been radical steps taken to nullify the economic impact of the virus it will take a strong and coordinated response at EU level to steer countries out of their economic hardship.

Source: The Economist – Eastern Europe’s covid-19 recession could match its post-communist one. 28th May 2020

Teaching ethics: the sub-prime crisis

Teaching ethics to my Yr 10 class I have used the sub-prime crisis as an example. As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.

Global Financial Crisis

In July 2007 a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis.  Sub-prime mortgages were loans that were high risk and many mortgage holders unable to meet their  repayments. The mortgages were pooled into what was know as a Collaterised Debt Obligation (CDO) which were sliced into tranches – safe – okay – risky. Investors tended to buy safe tranches as they were rated AAA by the rating agencies. However the rating agencies were very generous in their assessment of these investments as they were paid by the banks who created the CDOs. Banks also were able to take out insurance on the CDO even if they didn’t own them. This was called a Credit Default Swap (CDS).

Timberwolf.pngThe flow chart (above) and video (below) shows how Goldman Sachs sold a CDO called Timberwolf to investors and proceeded to bet against that investment by buying insurance from AIG so that when the CDO failed they got a pay out from them. As you maybe aware AIG sold a lot of CDS’s and ultimately had to be bailed out by the US government. However a significant portion of the bailout money went to the banks that had created the problem.

Below is another very good clip from the Big Short that explains how the mortgage market brought down the financial system. Good references to CDO’s in which celebrity chef Anthony Bourdain compares fish to finance?

Credit Rating Agencies – how countries stack up.

Rating Agencies Feb 2013Here is a list of the latest ratings by the three main rating agencies. Notice that Australia and the three Scandinavian countries have top ratings. The UK lost its top rating from Moody’s but maintained the top rating from the other two. New Zealand comes in further down with a top rating from Moody’s but has lost its top grade from the other two. When you get to B status your are talking high risk or junk status and this is quite evident with the PIGS counties.

If you have watched the movie documnetary ‘Inside Job’ you will remember that these 3 credit rating agencies also rated high risk investments – sub-prime mortgages – as AAA, up to a week before they failed. The same could be said about their rating of investment company Bear Stearns.

Ultimately they could have ‘stopped the party’ but delayed ratings reports and made junk status investments AAA rated. But as they testified in front of congress their advice to clients are opinions ‘just opinions’ – I wonder do they share the opinions of those that lost huge amounts of money, including sovereign investments. Recently they downgraded Greece and Spain in the knowledge that the servicing of the debt would now become more costly for those countries and stifle any sort of recovery in the near future.

What do Talking Heads and S & P have in common?

I enjoyed reading John Cassidy’s article in The New Yorker about America’s justice Department charging Standard & Poor’s with fraud over the rating of mortgage backed securities between 2004-2007. The case revolves around the activities of two teams at S & P:

1. A team that rated residential-mortgage-backed securities (RMBS),
2. A team that rated collateralised debt obligations (CDO’s).

These investment were based on subprimes mortgages taken out by borrowers who couldn’t pay – NINJA’s Non Income No Job or Asset. The Wall Street firms that produced these securities paid rating agency S & P big fees to rate them:

US$150,000 for RMBS’s
US$500,000 for CDO’s based on mortgages
US$750,000 for synthetic CDO’s based on derivatives tied to mortgages

Between 2005 – 2007 S & P CDO division made US$460m

The government claim that:

1. 2004 – 2007 S & P deliberately limited, adjusted, and delayed” changes to its statistical models and ratings criteria for subprime securities that would have resulted in the firm issuing lower ratings.
2. March and October of 2007, when it was perfectly clear that the housing bubble had burst, the firm “knowingly disregarded the true extent of the credit risks associated with” securities it rated.

One S & P employee was quite explicit in his views of what was happening in the RMBS market. In March of 2007, a person identified as “Analyst D,” who had studied a series of RMBS. issued in 2006, wrote an e-mail to several colleagues with the subject line “Burning Down the House—Talking Heads.” This is what it said:

Watch out
Housing market went softer
Cooling down
Strong market is now much weaker
Subprime is boi-ling o-ver
Bringing down the house

Hold tight
CDO biz—has a bother
Hold tight
Leveraged CDOs they were after
Going—all the way down, with
Subprime mortgages
Own it
Hey you need a downgrade now
Huge delinquencies hit it now
Bringing down the house

See the live version with David Byrne and Talking Heads – 1984

Is it surprising that Greece got into such a mess?

The Greek economy, burden with huge government debt, continued to adopt stringent austerity plans in order to secure a bailout from the European Union. Although markets received the news of an emergency package for Greece with a positive view one wonders if anyone actually understood the package in the first place. Greece is getting a further €109bn in soft loans from the eurozone and the IMF over the next 3 years taking its overall package to around €200bn. Credit rating agency Moody’s downgraded Greek debt to junk status on the grounds that default is virtually certain. This also affects other economies in the Eurozone (Italy and Spain) as they now know that bailouts from northern countries won’t be forthcoming if they have to take “haircut” (loss).

Will it work? I am not sure as Greece’s debt-to-GDP ratio will still be around 130% and there are few “engines of growth” available to get the economy back on the rails. But is this situation that Greece finds itself in a surprise to any of us?

Tax evasion a Greek national pastime

For years Greek governments have struggled to collect enough taxes to fund their spending. The gap between what tax payers owed last year and what they actually paid was approximately 33% of total tax revenue – about the size of the country’s budget deficit. The “shadow economy” in Greece accounts for approximately 27.5% of GDP and this culture of evasion has the effect of burdening those that are honest and pay their taxes. Greek officials are well known as easy to bribe with cash and there has been little enforcement especially around election time. According to James Surowiecki in “The New Yorker” Greece, with Bulgaria and Romania, is seen as the most corrupt country in Europe.

It is a vicious cycle – as tax evasion is prevalent everywhere people trust the system less, which makes them less inclined to pay taxes. Therefore the government makes up the shortfall by raising taxes on those who do. This then increase the motive to not pay taxes at all. A social inclination toward tax evasion is hard to eradicate and Greece needs more than a policy shift but a cultural one. One wonders how they were able to afford to host the Olympic Games in 2004?

US downgrade not surprising as integrity of agencies at stake

The recent downgrade of the US economy by credit rating agency Standard & Poors shouldn’t have come as a surprise. S&P indicated that even if the debt deal was approved they would still go ahead with the downgrade if there wasn’t a reputable policy of fiscal contraction to reduce debt. But agencies are all to aware of the critcism that they got over the credit crisis and will be mindful of this.

Conflict of Interest
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:

Bear Stearns
– rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

Below are the ratings that each company uses.

Call for a European Credit Rating Agency

The Prime Minister of Luxembourg, Jean-Claude Juncker, has called for a European credit rating agency to be established in opposition to Standard & Poors, Moodys, and Fitch. Recently the head of the European Central Bank, Jean-Claude Trichet, referred to the 3 agencies as an oligopoly.

There is a belief that a European agency would be able to judge better the medium-term outlook for European countries. A couple of examples of ‘bad calls’ that could trigger unforeseen events throughout debt the markets include:

– Moodys cut Portugal’s government debt form ‘investment grade’ to ‘junk’ status saying that the rescue package wouldn’t restore stability.
– S&P stated that the rescue package for Greece would impose losses for holders of Greek debt and therfore constitue a default.
– S&P had issued a warning about downgrading Italy’s debt. This was done before a planned austerity programme had been released.

The real concern amongst politicians is the fact that it seems to transpire that the decisions of a small bank of credit analysts who decide on a country’s credit rating have immediate real-world consequences. All this reminds of the movie documentary “Inside Job” and the interviews with the credit rating agencies, see below. Some interesting comments about opinions.

Why have New Zealand’s interest rates been higher than other OECD countries?

The April Economic Overview publication from Westpac Bank published a feature article focusing on why New Zealand has relatively high interest rates. A paper written by Treasury came up with two views:

1. The Risk Premium View
2. The Excess Demand View

The Risk Premium View

Interest rates in different countries can diverge with different perceptions of risk or inflation. Although New Zealand’s inflation or exchange rate are not volatile in relation to other countries, there is unusually high levels of nationla debt. While our government debt is relatively low in comparison to other countries it is our overall debt which is running at 80% of GDP which is causing concern. This would tend to push up interest rates higher than other countries with lower debt levels, while also pushing the exchange rate lower than it would otherwise be. The graph below plots the average inflation-adjusted interest rates against net foreign debt for a range of countries, suggests that this is broadly true.

The Excess Demand View.
The exchange rate can increase especially as investors look for higher yields as a country might have higher intesest rates – known as the ‘carry trade’. Investors will pile into higher-yielding currencies only up to the point where the exchange rate has become sufficiently ‘overvalued’ for its expected depreciation to offset the prospective interest rate gains. Elaborating on the carry trade idea the significant amount of aggregate demand in the NZ economy has kept the NZ$ high. This strong level of domestic demand has been to the detriment of savings and has also meant that the Reserve Bank has had to keep interest rates above those countries that have higher savings rates. Furthermore increases in domestic demand have meant:
– a higher trade deficit
– significant foreign debt
– an overvalued exchange rate

Is saving the answer?
Saving is not by itself the panacea however there is a high liklihood that there could be lower interest rates and a lower exchange rate. Higher savings would also be rewarded with lower borrowing costs but contrary to the first point, lower foreign debt servicing costs and a more positive report from the credit rating agencies the NZ$ would be inclined to appreciate.

Moody’s downgrade ANZ National, ASB, BNZ and Westpac

Last Friday credit ratings agency Moody’s downgraded New Zealand’s four biggest banks, ANZ National, ASB, BNZ and Westpac. The downgrade from Aa3 to Aa2 status and the rationale for this was New Zealand’s subdued economy and the banks’ exposure to wholesale financial markets for funding.

“New Zealand major banks are structurally sensitive to wholesale funding market conditions. The major banks have around 40% of their total funding base sourced from wholesale funding, with around two-thirds of this being sourced offshore. Over the past 6-months, the major banks have enjoyed relief in funding pressure due to slower loan growth and higher customer deposit growth. The increased savings rate was supported by lower credit and consumption growth combined with moderate income growth. “ However, Moody’s said it believed this was not sustainable in the long-term.

See the TVNZ 7 interview with Bernard Hickey of

Key promises rating agencies that net debt won’t go above 30% of GDP

It seems that the NZ government has promised Standard & Poor’s that it will not allow net debt to rise above 30% of Gross Domestic Product. On his recent visit to the UK John Key was invited to “Tea at The Economist” and said in the interview that

“We have essentially promised the rating agencies that debt won’t rise above 30% of GDP, and it’s our intention to keep to that commitment,”

However the total indebtedness of the NZ economy is about 85% of GDP and this is primarily made up of private sector debt and this is what S&P are concerned about. Key said that he is trying to lift the level of savings and mentioned initiatives that will be present in the forthcoming budget.

Standard and Poor’s placed New Zealand’s AA+ credit rating on negative outlook in November, signaling a one in three chance of a ratings downgrade in the next two years. Below is the full interview with The Economist.

New Zealand’s Credit Rating – downgrade?

I did an earlier posting on Credit Rating Agencies explaining who they are and how they work. The table right (from the Parliamentary Monthly Economic Review) shows the three credit rating agencies and the current rating that New Zealand has as an economy.

It wasn’t until 1977 the New Zealand was actually rated by S&P and Moddy’s – Fitch came into the picture in 2002. You can see from the table that S&P reviewed New Zealand in November 2010 and while maintaining its rating at AA+, they changed the outlook from stale to negative. Fitch also gave NZ the same rating. This means that there is a higher chance of a downgrading which would mean higher interest costs to the government.

Standard and Poor’s raised concerns around the level of New Zealand’s external imbalances, and the weakening of fiscal flexibility for their change in outlook. The
negative outlook on Fitch Ratings’ credit rating for New Zealand is also based on the economy’s imbalances, with the level of the country’s current account deficit and international debt being mentioned.

Following the Christchurch earthquake in February 2011, Moody’s Investor Services made an announcement that they saw no reason to reconsider their Aaa credit rating for New Zealand, although they noted that it would likely “result in another one-time rise in government debt”. The credit rating agency noted that New Zealand government debt levels were below the median for other Aaa-rated governments globally. The Agency stated that it would wait for a fuller assessment of the impact on government debt, when the 2011 Budget is presented.

What does this mean for New Zealand?
The 2011 budget will no doubt assure credit rating agencies that a downgrade is unnecessary and therefore Bill English will provide little fiscal stimulus. In a pre-budget presentation English hinted at $1 billion of new spending mainly in health and education, but this will be “substantially offset” by cuts in other, lower priority, areas.


Here is something I got which was doing the rounds on email – very amusing.

I was asked to explain the Economic crisis in Ireland here is an example
as I understand it….( passed on of course !!)

Mary is the proprietor of a bar in Dublin . She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Mary’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Mary’s bar. Soon she has the largest sales volume for any bar in Dublin. By providing her customers’ freedom from immediate payment demands, Mary gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Mary’s gross sales volume increases massively. A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Mary’s borrowing limit. He sees no reason for any undue concern, since he has the debts of unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Mary’s bar. He so informs Mary. Mary then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Mary cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Mary’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion euro no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Mary’s bar.

Now, do you understand economics in 2010?

NZ$ falls with S&P rating and Korean clash

The NZ$ dropped to its lowest level for 4 weeks against the US$ – now at US$0.76 from a high of US$0.79. Two main reasons for this:

1. New Zealand has the second-highest possible rating, AA+, but Standard & Poors (credit rating agency) has revised its outlook from stable to negative – one-in-three chance that NZ will be downgraded. It is New Zealand’s external position that is the main issue – kiwis borrow more than other kiwis are willing to lend. Net international liabilities of the country (as distinct from the Government) at the end of June were $164 billion. S&P said it seemed likely that as the economy strengthened, the problem of big deficits and ever-rising overseas debt would return, “and possibly with a vengeance”. This information for foreign currency dealers means that there is more risk attached to holding NZ$’s therefore you tend to see a sell-off on the market – supply curve to the right = price drops.

2. The clash between North and South Korea has brought about instability in the area and also made investors risk averse to regional currencies including the Aus$. Most of them have returned to the relative safety of American and Japanese bonds or even the US$. With the turmoil in Ireland and the concern that the rescue package from the IMF and the EU won’t be enough investors are tucking for cover. Additionally other countries with high levels of debt, in particular Portugal and Spain, may also have to seek financial help.

NZ debt – the good news and the bad news

Despite a glowing report from the IMF which stated that New Zealand has the second smallest government debt among 23 developed countries, credit rating agency Standard and Poor’s (S&P) has indicated that the overall level of debt has the country vulnerable. Treasury estimate govenment debt to be 27% of GDP by 2015 but this compares to total net debt at 90% of GDP with much of this in the private sector.
Their concern is that if there is a major budget crisis in other countries this could make markets nervous about investing in high debt economies – both government and private debt. New Zealand is borrowing up to $240 millilon dollars a week and if the former were to happen interest charges on that borowing would go up (maybe a downgrade by credit rating agencies) which ultimately would effect growth in the economy and the NZ$. S&P suggest that there is a need to rely less on foreign funds and generate more export revenue especially from the Asian markets. The balancing act is making sure that debt as a % of GDP doesn’t get too high but at the same time generating growth in the economy. Click here for Brian Fallow’s column in the NZ Hearld.

Credit Rating Agencies

A credit rating agency evaluates the credit worthiness of an individual, corporation, or even a country. The credit rating that they receive is considered from the financial past and current assets and liabilities. Naturally, a credit rating informs a lender or investor the prospect of the subject being able to pay back a loan. The credit rating of a corporation is a financial pointer to possible investors of debt securities such as bonds. These are assigned by credit rating agencies such as Standard & Poor’s, Moody’s or Fitch.

When the word ‘superpower’ is mentioned one thinks of the United States and more recently China. However in the financial world the credit rating agency Moody’s seems to have fallen under this banner. Along with its rivals Standard & Poor and Fitch, Moody’s exert significant pressure in the financial markets. Since these agencies assess risk they are the semi-official forecasters of how all the big companies and indeed governments will perform. Subsequently it is not surprising that the rating agencies have been criticised for their role in the recent credit crisis.