Financial Rating Agencies and Risk - Liquidity

Iceberg, Weddell Sea, Antarctica

Updated 9/5/2015:
 

I took this photograph from the Icebreaker Kapitan Khlebnikov, as we transited the Weddell Sea from the Ice Shelf of Halley Bay to the Antarctic Peninsula.  Antarctica (map) is a land of beautiful desolation, and I was able to capture nature photographs depicting its stunning landscapes and the wildlife that inhabits it.  Many countries have stations in Antarctica and I was honored to be able to visit two of them, Neumeyer (German) and Halley Bay (United Kingdom).  

Icebergs have powerful symbolism, expressing concept in many different venues.  In the maritime sense, they represent hidden risk, as ten percent of the iceberg may be visible, the remaining ninety percent of the iceberg underwater.  The Titanic collided with an iceberg in the mid-Atlantic in 1912 and is an example of risk associated with transiting areas with icebergs.  These powerful metaphors or concepts can also be expressed in other venues, including the financial arena, where risk exists and may be hidden, subject to the impact of financial bifurcation points.  

Chaos theory discusses how financial risk, and bifurcation points can reflect hidden factors which sudden express what we term "Black Swan" risk events as typified by Mohamed A. El-Erian's work.

In the financial arena, these risks reside in financial rating models.  My June, 2015 article, Financial Rating Agencies and Risk, discusses Rating Agency models in the context of jet engines, which operate under a wide range of atmospheric conditions. Similarly, financial vehicles are tested under a wide range of scenarios, by various entities such as Rating Agencies and regulators in a wide variety of fields, including banking and insurance, under different legal constructs and governmental agencies.

As discussed in my article, Financial Rating Agencies and Risk, different Rating Agencies, such as Standard and Poor's and Moody's may reflect their analysis of risk in different ways.  General Electric (GE) is used as an example in my blog article. which discussed Standard and Poor's maintenance of GE's rating in the light of its decision to divest itself of real estate assets and exit its GE Capital Finance arm.  Moody's, however, downgraded GE on its decision, indicating GE was favoring equity investors over creditors.  These rating decisions reflect different decision processes by Rating Agencies, not explicit government agencies.  However these Rating Agencies have considerable impact over the manner in which financial decisions are reflected in the marketplace.

Clearly, there is hidden information which Rating Agencies, and governmental entities, are aware of.  When there is a relationship between Rating Agencies and financial entities, as in the payment of a fee in exchange for a rating service, there is an incentive for the Rating Agency to monitor the actions of the company, as money has changed hands, and participate in the decisions of the company involved.. At some point, however, the economic prospects of the company do not warrant the degree of risk assigned to it, and the Rating Agency may choose to exercise a number of financial tools in order to maintain its credibility in the financial marketplace as a reliable partner in assessing risk.

You see, the Rating Agency has two major clients; one, those purchasing its evaluations of companies, and another, two who pay for its services in order to exchange information, maintain a rating as to its financial soundness, and exchange information in order to do so.  Government agencies are a different entity involved, and they sit and cast a watchful eye over the ability of Rating Agencies to remain impartial; they are also concerned as to the ability that Rating Agencies have to move the markets, and, especially, their ability to impact major market moves that could mask efforts at financial or other types of terrorism.

This is where the increased complexity of emerging financial instruments presents a risk for regulators as they seek to keep up with new financial structures and derivatives such as special purpose vehicles, credit default swaps (CDS) and collateralized debt obligations (CDO's).  The Treasury, certainly, is interested in attack on the financial system.

A company does not exist in a vacuum; it exists within a financial structure of ever increasing complexity, reflecting not only national considerations, but a world economic milieu of globalization that impacts its decisions, as nations develop and industries expand, contract and relocate or adopt new methodologies such as outsourcing.  Externalities are always a consideration, and this this issue is discussed in my blog article of the same name.

This brings us back to the iceberg and the hidden factors. GE presents an interesting case study as we look to parse the actions of Standard and Poor's and Moody's in their rating of GE.  My blog article, Our Nuclear Future - Financial Risk and Externalities briefly discusses the issue of the six nuclear plants designed by GE, which were part of the Fukushima Daiichi Nuclear Site's design.  The interesting question is the use of ratings in conjunction with the use of chaos theory and bifurcation points to bring down the economy and financial system.

There are specific provisions (options) in financial agreements that allow a company to take action in the case of certain events such as ratings downgrades.  This puts a particular onus on Rating Agencies who have access to company information; it also presents a challenge to companies being rated as they seek to understand the processes which rating agencies use to rate their companies.

The interesting question in analyzing GE in the light of its departure from GE Capital, which finances GE engines, and from real estate, is its liquidity position and its exposure to risk from liquidity events in the light of the various risks that its operations faces.

Indeed, liquidity is an important consideration in analyzing a company's financial soundness.  An example where liquidity events have taken down companies is General American Insurance, where exposure to risk from institutional investors brought down the company.  General American had high exposure to funding agreements, which allowed policyholders to exercise a put option (withdraw funds without penalty) upon the adverse action of Rating Agencies. The construction of funding agreements involved mark to market issues and the use of put options in mutual funds (7 day put options).  Moody's downgraded General American's insurance financial strength rating from A3 to Ba1 on August 9, 1999.

The interesting question with the actions of Standard and Poor's and Moody's with regards to GE is the divestiture of the GE Capital financing arm and the Real Estate assets; both of these events seem to reflect a move to better match projected assets and liabilities by increasing liquidity, potentially in the light of anticipated liabilities.  These are the hidden, or unknown issues that confront regulators.

Why discuss GE?  With issues of climate change and global warming, jet engines, which operate under a wide range of atmospheric conditions utilize various fuels for combustion under a wide degree of parameters representing different aspects of aviation usages, including private, commercial and government use. My blog article on the Polar Pioneer discusses these issues in the light of exploration and drilling for petroleum products in the Arctic. The availability of fuel and the mode of combustion and types of engines employed will always be an important characteristic of any decision process as we analyze our future options.

Many people have contributed to the issues discussed in these blog articles and I express my appreciation to them and to their contributions.

Liquidity issues are important factors in assessing financial risk.  They represent one category of risk among others that can reflect bifurcation points which can impact the economy.  Organization structure is also important, as indicated by the Barings Bank issue where Nick Leeson was involved on both sides of the house, trading and operations.

Alamy.com - Risk Lightbox

marilyndunstan.blogspot.com:

Financial Rating Agencies and Risk 

Externalities

Polar Pioneer and Climate Change - "Polar Pioneer" and Arctic Drilling

Kapitan Khlebnikov (Icebreaker)

Wikipedia:

Titanic

Fukushima Daiichi Nuclear Site

Mohamed A. El-Erian

Maps:

Antarctica Map -One World - Nations Online

Rating Agencies:

Standard and Poor's

General American Insurance:

General American News - Mississippi Department of Insurance
Standard and Poor's- What May Cause Insurance Companies To Fail--And How ThisInfluences Our Criteria

GE:

GE - Fixed Income Investing

Climate Change and the Thermohaline Circulation

 Sea Ice, Svalbard, Norway

In my previous article on Climate Change and Carbon, I discussed the impact that carbon emissions have on climate change and global warming.  I discussed international agreements, global temperature, carbon sequestration, carbon dioxide as a sensitive indicator of climate change, and global health as a factor in how we interact with a changing world.

In this article I discuss the thermohaline circulation and its interrelationship with climate change. The thermohaline circulation may be explained by chaos theory, as a "bifurcation point", a sensitive indicator which may keep the planet under one paradigm, or place it into another paradigm, presenting planetary challenges.

Planetary cycles (Milankovitch Cycles)  indicate a trajectory at this time towards planetary cooling, or glaciation, reflecting a continuing decrease in  axial tilt (obliquity) .  This long term  cycle (41,000 years) presents psychosocial difficulties for those who are not accustomed to thinking on a scale involving geologic time. Such a scale seems way too far off to appear relevant, eclipsing by orders of magnitude scales such as 100-year floods or 500-year volcanic eruption intervals such as at Mt Rainier as discussed in my 2011 blog article.

At the same time as underlying very long term planetary cycles (e.g. obliquity) are pointing us towards planetary cooling, our earth is warming with the effects of climate change. We are in the throes of opposite systems colliding, facing very different issues.  The immediate climate change issues are important, however considering the long term factors is also relevant to the discussion.  Global health issues are tied up in both discussions, as evolution may take a variety of paths in response to planetary indicators.

My blog article, Climate Change and global health discusses some of the ramifications of health effects of climate change, including those depicted as coastal flooding.  A trend towards glaciation, a Mini-Ice Age or even in the extreme, a Snowball Earth would bring on very different changes, and adaptations and implications for global health.

The oceans are an important factor to consider in assessing such developments.  The Earth goes between icehouse and greenhouse cycles.  These cycles can be captured via examination and measurement of calcite and aragonite seas. A graph, shows the emergence of an aragonite threshold during the current period, which might indicate the emergence of a period of glaciation.  Aragonite seas  contain high magnesium calcite, and less abundantly, aragonite while calcite seas  have lower magnesium content, which increases as a threshold is reached.

The calcites  are inorganic carbonate precipitates, with calcium carbonate (CaCO3) being most common precipitate.  Other precipitates include aragonite and vaterite.  These precipitates emerge in a number of areas, including shells of marine organisms, including  plankton, foraminafera and trilobytes  (where calcite was responsible for development of eyes).
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There are a number of planetary adjustment factors that act to keep the planet in balance.  The National Oceanographic and Atmospheric Administration (NOAA) has a wide variety of information for the general public on science,  research and further  information regarding the thermohaline circulation , the ocean  and its role in climate.   The thermohaline circulation is central to the issue of planetary climate control.

Positive feedback loops work to increase the risk of global warming.  This effect occurs as the sea ice extent decreases, exposing open ocean and thus decreasing the planetary albedo.    Higher albedo is associated with higher reflectivity, or less heat retention, while lower albedo is associated with lower reflectivity and greater heat absorption.

As more heat is retained by the Earth, especially in the polar regions (the Arctic and the Antarctic), warming increases.  With increased warming comes melting, of sea ice, icebergs and glaciers, This melting may impact Arctic regions  such as Greenland and Arctic Ice, as well as the Weddell Ice Shelf in Antarctica.and Antarctic Sea Ice.  Ice may be lost from glaciers, resulting in the formation of tabular icebergs, and calving of those icebergs, which may increase melting, just as a bag of ice cubes melts faster than block ice.

The melting that occurs increases the flow of fresh water into the oceans.  This is particularly felt in the Arctic, where the thermohaline circulation travels northward from the warmer Gulf Coast of North American waters to cold North Atlantic Arctic waters.

The infusion of fresh water in the North Atlantic may disrupt the sinking of the saltier water in the North Atlantic, which develops as the result of formation of sea ice (as sea ice forms, it forms from fresh water and the surrounding water gets saltier, and sinks to deeper depths).  This infusion of fresh water in the North Atlantic could result in disruption of the thermohaline conveyor belt, thus impeding the delivery of warm water from the Gulf to northern areas in both North America and Europe, resulting in much harsher winters.  A shutdown of the thermohaline circulation could have very serious impacts on global climate.