Friday, January 24, 2014

Of Vikings and Credit Rating Agencies

Yesterday's post reminded me of a story that encapsulates much of my own feelings about credit rating agencies (and, indeed, the naivete that characterised the build-up to the Great Recession).

The year was 2008 and I was working for an economics consultancy specialising in the sovereign risk of emerging markets. We primarily marked African countries, but also had a number of "peripheral" OECD countries on our books. One of these was Iceland and I was assigned to produce a country report that would go out to our major clients.

By this time, the US subprime market had already collapsed and it was abundantly clear that Europe (among others) would not escape the contagion. With credit conditions imploding, it was equally clear that the most vulnerable sectors and countries were those with extended leverage positions.

Iceland was a case in point. The country had a healthy fiscal position, running a budget surplus and public debt only around 30% of GDP. However, private debt was a entirely different story. Led by the aggressive expansion of its commercial banks into European markets, total Icelandic external debt was many times greater than GDP. Compounding the problem was a rapid depreciation in the Icelandic króna, which made the ability to service external liabilities even more daunting. (Iceland was the world's smallest economy to operate an independently floating exchange rate at that time.) Wikipedia gives a good overview of the situation:
At the end of the second quarter 2008, Iceland's external debt was 9.553 trillion Icelandic krónur (€50 billion), more than 80% of which was held by the banking sector.[4] This value compares with Iceland's 2007 gross domestic product of 1.293 trillion krónur (€8.5 billion).[5] The assets of the three banks taken under the control of the [Icelandic Financial Services Authority] totalled 14.437 trillion krónur at the end of the second quarter 2008,[6] equal to more than 11 times of the Icelandic GDP, and hence there was no possibility for the Icelandic Central Bank to step in as a lender of last resort when they were hit by financial troubles and started to account asset losses.
It should be emphasised that everyone was aware of all of this at the time. I read briefings by all the major ratings agencies (plus reports from the OECD and IMF) describing the country's precarious external position in quite some detail. However, these briefings more or less all ended with the same absurd conclusion: Yes, the situation is very bad, but the outlook for the economy as a whole remains okay as long as Government steps in forcefully to support the commercial banks in the event of a deepening crisis.(!)

I could scarcely believe what I was reading. What could the Icelandic government possibly hope to achieve against potential liabilities that were an order of magnitude greater than the country's entire GDP? Truly, it would be like pissing against a hurricane.

Of course, we all know what happened next.

In the aftermath of the Great Recession, I've often heard people invoke the phrase -- "When the music is playing, you have to keep dancing" -- perhaps as a means of understanding why so many obvious danger signs were ignored in favour of business-as-usual. It always makes me think of those Icelandic reports when I hear that.

PS- Technically, Iceland never did default on its sovereign debt despite the banking crisis and massive recession. It was the (nationalised) banks that defaulted so spectacularly. The country has even managed a quite remarkable recovery in the scheme of things. The short reasons for this are that they received emergency bailout money from outside and, crucially, also decided to let creditors eat their losses.

Thursday, January 23, 2014

Home bias in sovereign ratings

 [Rather irritatingly, I wrote the below post at the end of last week and had been meaning to publish it on Monday. Unfortunately, I got snowed in with work and now see that Tyler Cowen and a bunch of other people have already covered the paper in question. Still, in a bid to get some blogging activity going around these parts again, here's my two cents.]
"The Home Bias In Sovereign Ratings" 
Fuchs and Gehring conduct empirical analyses of variation in nine different credit ratings agencies around the world that offer ratings of at least 25 sovereigns[...] The paper is motivated by two good questions: (1) Do ratings agencies assign better ratings to their home countries? (2) Do they assign better ratings to countries that have close cultural, economic, or geopolitical ties to their home country? 
Fuchs and Gehring find clear evidence of “home bias”. Specifically, their analysis finds that agencies do indeed assign higher ratings to their home country governments compared to other countries with the same characteristics. This result was especially strong during the global financial crisis (GFC) years–nearly a 2 point “bump” in ratings.
As someone who has been both a consumer and producer of sovereign rating reports prior to starting a PhD, I find this sort of thing very interesting. The role of inherent biases in the industry is scope for bemusement and alarm. This paper by Fuchs and Gehring would at least seem to go some of the way in explaining why, say, Fitch places the United States in its highest credit ratings category... while (Chinese-based agency) Dagong only places the US in its third highest category.

That being said, Daniel McDowell (author of the above blog post) points out that it is not especially clear how such findings actually stand to affect future ratings. For one thing, changes in sovereign ratings sometimes have zero, or even paradoxical effects, such as when the demand for US treasuries actually rose following the country's downgrade by Standard & Poors in 2011.[*]

On the other hand, it should also be noted that if one of the other major agencies -- i.e. Fitch or Moody's -- had followed S&P's lead in downgrading the US credit score in 2011, then that probably would have had fairly major financial implications. Most obviously, a large number of investment funds have specific mandates regarding the type of securities they must hold... as determined by the average score among the big three credit ratings agencies. For example, a fund might be legally required to hold a minimum proportion of "triple-A-rated" bonds. Given how ubiquitous US treasuries are, some major portfolio rebalancing would almost certainly be required if the US lost its "average" credit rating. You may recall that this is something that a lot of people were worried about at the time. It is also one reason that the ratings agencies continue to have a practical (and potentially deleterious) relevance to financial markets.

Anyway, apologies for getting sidetracked. Interesting paper and blog post. Check them out.
[*] A popular explanation at the time was that the downgrade provided the shake-up that Congress needed in order to overcome the political impasse over the debt ceiling...

Thursday, January 2, 2014

Top posts on Stickman's Corral for 2013

As if you care!

I'll limit it to three because: a) Parsimony, b) Blogger is being recalcitrant b*tch at the moment and is not letting me see any more than that.

1) Econ blogosphere comment form. Way out in front -- with nearly 7,000 views thanks to links from FT Alpha, Barry Ritholtz and a bunch of people on Twitter -- was this spoof of the various personalities, trolls and anti-trolls that populate today's economic blogs. Some of the additional suggestions provided by commentators were golden.

2) Thinking of doing a PhD? My post advocating for postgraduate studies in Norway accumulated around a 1,000 views over the course of the year. It would appear that the idea of drawing a healthy salary whilst having access to great data and clean air could prove a viable alternative to crushing student debt (or miserly graduate stipends) and 80-hour work weeks. As an aside: A fairly large number of hits on this one where referrals from a single comment that I left under one of Noah Smith's blog posts. Thus is the way of the blogosphere layer cake.

3) Review - Extreme Environment (Ivo Vegter). It may not have reached the top spot, but my review of Ivo Vegter's anti-environmentalism screed was certainly the longest post of the year. Five thousand words for around 750 1,000 views may sound like a poor return to some, but it does occupy second place in the Google search rankings for Vegter's book behind only Amazon. Speaking of which: Rather irritatingly, my abridged review on Amazon has garnered more "unhelpful" votes than the other way around. I emphasise the "helpful" bit. This isn't about whether you agree with an author -- or reviewer for that matter -- but rather a question of whether a review enables you to obtain a better understanding of a book and it's relative merits. I guess in-depth, considered criticism is less helpful than gushing, one-line endorsements. (Or lazy dismissals for that matter.) Haters gonna hate. Derpers gonna derp.

If memory serves me correctly, I have a couple posts with 500-odd views here at Stickman's... while my most widely read articles of the year were almost certainly the series I did for the Energy Collective on natural gas. So, it's been a respectable year blogging-wise for yours truly. I might get around to listing my personal favourite posts of the year later during the week.