Financial Rating Agencies and Risk

Pratt and Whitney J-58 Engine, Lockheed SR-71 Blackbird,

Museum of Flight, Seattle, Washington

How will a recent settlement of a Justice Department suit against Standard & Poor's Rating Agency impact the Rating Agency's assessment of companies that it rates?  With many companies having calendar year financial year ends, this is an emerging question as the various Rating Agencies reviews ratings.

The Justice Department is investigating Moody's Rating Service. The Moody's and Standard and Poor's suits are related to fraud in mortgage backed securities.  Mortgage backed securities experience contributed significantly to the financial crisis of 2008.  The U.S. Justice Department worked with State Agencies in filing the suits.

A recent example of the impact of credit ratings is shown by Standard & Poor's affirmation of General Electric's Credit Rating at AA+ in the wake of its earlier announcement to exit its GE Capital Finance arm and divest itself of real estate assets, as reported in Marketwatch.

Meanwhile, Moody's Investor Service downgraded GE on that decision, concerned about favoring equity investors over creditors. GE Capital has a history of aviation financing, as well as an interest in the future of aviation, as in supersonic flight.

It is interesting to note the responses of the two Rating Agencies in this particular case, in the light of Justice Department investigations and emerging circumstances in the financial markets.  What does the future hold in store?

In addition to the financial circumstances surrounding GE, and in particular, GE Capital, it is interesting to consider that jet engines might serve as a useful metaphor for emerging issues in the financial sector, and for Rating Agencies in particular.

A number of years have passed since the financial crisis of 2008.  In a previous blog article on August 22, 2011, I discussed the downgrade of  United States Long Term Sovereign Credit from AAA to AA+.  In this article I discuss some of the issues involving Rating Agency and other capital models.

Capital models are complex analytic models designed to measure the soundness of institutions.   The U.S. Justice Department has been evaluating a number of rating agencies to assess their impact on the financial markets and their adequacy in measuring company risk.

Generally, capital models look at total capital available and compare it a risk based capital measurement.  The risk based capital measurement is a formula based on the risks a company assumes in its various lines of business, assigning weighting capital factors to measure important items such as asset risk, insurance risk, asset liability/matching risk, business risk and other factors.  These types of measurements vary considerably between different types of business.  Depending on the use of the capital model, the structure of the model and the types of metrics used, the factors, and the analysis will differ considerably from institution to institution.

Rating Agencies serve to provide information to investors that help them decide whether to invest in a company.  Thus the analysis of a rating agency focuses on issues of financial soundness, potential for growth, and a wide variety of issues that are of interest to potential investors, in both debt and equity securities.  Rating Agencies include such agencies as Standard & Poor's, Moody's, A.M. Best and Fitch.

Rating Agencies perform valuations of companies. Rating Agencies will provide a rating for a company based on data readily available through public sources.   However, in order to have a comprehensive financial evaluation, Rating Agencies typically require a fee to be paid which will enable the company under valuation to interact with the Rating Agency, allowing it greater access to information obtained by the Rating Agency and more sharing of information.

Rating Agency models will differ from models used by regulators to assess financial soundness.  For example, state insurance commissioners who regulate financial soundness of insurance companies will also model risk based capital.  Their analysis,  however, is focused more on solvency issues than indicators of growth to potential future investors. This is because state guarantee funds, which insurers pay into, are regulated by the states. State guarantee funds provide some funds according to regulation to certain classes of policyholders in the event of insolvency. The downside risks and upside benefits are different for regulators versus the various classes of investors interested in a company.

Because the focus of capital models vary widely according to the use for which they are intended, they tend to produce different types of results.  Regulatory models might be established through cooperation between certain government or quasi-government-private bodies that seek to promote some degree of uniformity (.e.g. the National Association of Insurance Commissioners - NAIC).

Private Rating Agency models by such major players in the system such as Standard & Poor's, Moody's, A.M. Best and Fitch will vary because each of these rating agencies are seeking to gain business by rating companies and each has developed its own model. This is called competition. Thus when a company is evaluated by rating agencies, their rating may vary between different rating agencies.  This is because different rating agencies will weight various activities differently than others.

Rating agencies have a considerable amount of power to impact the way in which a company is viewed in the marketplace.  The specific metrics and factors used by a rating agency to judge a company may impact whether a company gains or loses business and may influence a company's decisions.  An action by a rating agency to downgrade a company may result in the company losing a considerable amount of business, and even cascade that company to failure.

There is a certain psychology at work in companies dealing with rating agencies.  Because companies have an opportunity to gain a more favorable rating by interacting with a rating company if they pay a fee to have a more comprehensive analysis, the two entities are now bound by some sort of cooperative relationship (symbiosis) whereby it is in the interest of the rating agency to keep getting the fee.  The rating agency, however,to ensure its credibility, needs to report adverse conditions that may lead to failure of the rated company at some point.  Thus the rating agency is on the horns of a dilemma, whereby it must at some point act to ensure the credibility of its ratings.

However Rating Agency models are just that, models, and models may not take into account all the protective factors that companies use to ensure continued operation.  Rating Agency models reflect the biases of those who engineered them and may reflect psychological factors such as confirmation bias and cognitive dissonance.

The ability of a Rating Agency to cascade a company downhill towards failure,  into the hands of investors ready to swoop it up at bargain prices, may hinge on the use of specific metrics and factors which are keyed towards certain predetermined models or results.

A Rating Agency model, like the companies it rates, are very complex models.  Perhaps a jet engine is a suitable metaphor, in terms of complexity, in considering how such models operate in an ever complex world where problems such as climate change and global warming loom ever larger. My recent blog articles on the Polar Pioneer and Seattle-Tacoma International Airport discuss some of these issues which may impact aviation.

A jet engine such as the Pratt and Whitney J-58 engine, operating in conjunction with the titanium-skinned aircraft itself, a SR-71 Blackbird, needs to be able to operate in a range of atmospheric conditions reflecting different atmospheric pressures, levels of oxygen and carbon dioxide, and under various heat constraints and mechanical stresses.  The pilot's own physiological and psychological stressors are of paramount importance in such an environment, which includes exposure to a variety of environmental hazards, in various feedback modes.

It is in this context that we consider Rating Agency models not simply as a static model based on year end performance or occasional interaction with companies they rate but also a dynamic model that must take into account many complex factors and interactions in an environment where physiological and psychological stress tests, as experienced by test pilots, operating in a real environment may be the most dangerous elements, especially when so many unknown factors must be taken into account.

Many companies perform complex modeling analyses to stress test their operations under a range of potential situations.  The question is how Rating Agency models reflect the balance of risks and who, in this complex society is actually directing the emergence of results.

These are all very significant issues as we live in an interconnected society, perched on a bifurcation point of climate change and global warming, that has impacts on many sectors of the society, and, in fact the planet.  Externalities and systemic risk are major factors in our ever changing society as we address issues that go beyond individuals, corporations and governments.

Fuel and energy sources are important factors in a global economy, issues that affect many on a personal scale, in many ways that many not suspect, due to their ever increasing complexity. Rating Agencies, and their impact on society are but one of a number of factors influencing the outcomes of these very important issues as we tackle these significant problems.

Senescence

Gingko Biloba Tree

Senescence is the process of growing old, or aging.  Senescence can refer to a process that occurs on many different levels, from cellular levels, to the whole body level, to higher organizational levels and including physical and psychological structures.

Aging occurs at different rates and different times in different life forms.  Senescence is directly or indirectly a major cause of death.  Senescence may reflect underlying biological processes, mediated by gene expression, can reflect programmed cell death and can be accelerated by environmental factors, such as exposure to radiation.

My 2014 blog article discusses senescence in  the Gingko Biloba Tree, a living fossil dating back to the Permian era (270 million years ago), which exhibits clonal reproduction.  Natural leaf senescence in the Gingko Biloba has been researched in male and female trees, with regards to impacts of reactive species and anti-oxidants on the rates of senescence.

Senescene on a cellular level, expressed as replicative senescence, reflects a cell's attainment of the Hayflick limit.  The Hayflick limit refers to a limit on the shortening of DNA telomeres,  which cap the ends of the DNA strands.  As the cell divides, it loses telomeres in the division process.  The Hayflick limit reflects the end of the telomere line, at which point the cell becomes senescent.  Senescence is accelerated by exposure to reactive oxygen species,  exposure to oncogenes, and to cell to cell fusion, a process where cells join to form what is callled a 'syncytium'.  I discuss a number of the processes that may encourage the early development of senescence in other blog articles, listed below.

Exposure to radiation generates reactive species.  This can include anything from high energy ionizing radiation which liberates electrons from atoms and molecules, to non-ionizing radiation.   Ionizing radiation may include cosmic and gamma rays and some ultraviolet wavelengths.  Geomagnetic storms may result in increased exposure to high energy particles, as would exposure to nuclear radiation.

Non-ionizing radiation includes radar microwaves and those used by cell phones, which can disturb lymphocytes  in rats. Some ultraviolet wavelengths including UVA, UVB and UVC are non-ionizing. Disturbances in the Ozone layer result in increased ultraviolet exposure, with the Antarctic having historically greater ozone depletion than the Arctic. 

 Reactive species can be produced through natural bodily process, in Oxidative Phosphorylation (OXPHOS), in the production of Adenosine Triphosphate (ATP) through mitochondrial processes.  The Metabolic Theory of ecology deals with these issues. It reflects Kleiber's Law which relates metabolism to body weight .  I discuss these issues in my blog on "The Odd Couple - The Mitochondria and the Cell Nucleus", where cellular processes are both exposed to and create oxygen radicals.  This article also discusses other sources of reactive species, including pollutants, chemicals and toxins.

Exposure to oncogenes can also lead to senescense.  Oncogenes can arise from a variety of sources, including potentially avian sources which operate within our body's innate and adaptive immune system transcription factors.

Induction of cell-cell fusion, as occurs in syncytium, can also lead to senescence.  Syncytium can form in protists such as rhizarians, in fungi, in heart muscle and skeletal muscle, and, importantly, in the placenta where they take on a meaning relating to group immunity systems, as discussed in my blog article.  The heart is a critical organ in the human body and tests such as the Cardiac MRI Adenosine Stress Test (using a gadolinium contrast agent) tests the ability of the heart to act "in sync".

 Adenosine is an important nucleoside which modulates a variety of important physiological processes, including heart activity, and as an important moderator of the sleep-wakefulness cycle. Caffeine is an antagonist of adenosine receptors in the brain.  The action of Adenosine is also impacted by theophylline (found in tea) and theobromine (found in chocolate). Adenosine is an inhibitor of the central nervous system and relaxes the heart muscle.  Adenosine also increases hair thickness.  The modulation of adenosine may be related to senescence.

Organismal senescence is a decline in the ability of the organism to respond to stress, and an increase in various symptoms characteristic of aging, including a decline in homeostasis, the ability of the body to respond to various cues.  Alzheimer's Disease is one condition which may be associated with senescence, and may relate to various environmental factors as discussed in my blog article.

Senescence can be mitigated through increased exposure to anti-oxidants, which can be obtained through certain foods (e.g. blueberries are a food high in anti-oxidants),  and internally through transcription factors such as superoxide dismutase.

Senescence may be impacted by a variety of processes germane to environmental issues relating to climate change and global warming, including natural processes and anthropogenic forcing (originating in human activity).  These processes may all impact factors germane to reactive oxygen species and anti-oxidants.