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.

Ferguson

What started presumably as a simple theft and an encounter with a marked police car and a uniformed police officer has turned into racial rioting in Ferguson, Missouri and elsewhere around the country.  It is a tragedy that an 18 year old African-American young man was shot and killed by a white police officer.  This young man had a potential future ahead of him, and whether or not he stole some cigarillos from a store, and whatever his encounter may have been with the officer, it is a tragedy that his life had to end so soon.

At the same time we consider the actions and state of mind of the police officer in question, who was not indicted, but who will live with his actions for the rest of his life, and who must have gone through his own private and public hell, taking a life in the course of duty.  This was a life, going through that tenuous period in early adulthood. But there probably was more to it than that.

The riots that have followed the incident in Ferguson and the decision by the Grand Jury are an unfortunate commentary on the manner in which society acts to resolve its problems.  The issues in this case are complex.  The issue goes to the core of what it means to be a police officer in a society where the officer is empowered to use lethal force and must, in some cases, at a moment's notice act to preserve the law and/or to protect his own life and well being.

How can society understand the lessons of the Michael Brown and apply them better?  I will focus on  a few broad areas that I feel led to the situation escalating quickly and then  spiraling out of control into a series of demonstrations.

Cognitive Dissonance

One principle is the principle of cognitive dissonance that the police officer has to deal with in his position, whether it be as a beat cop, a patrol officer in a vehicle, or an undercover officer placed in an extraoardinarily difficult position.  Cognitive Dissonance  according to Wikipedia, is the "mental stress or discomfort discomfort experienced by an individual who holds two or more contradictory beliefs, ideas, or values at the same time, or is confronted by new information that conflicts with existing beliefs, ideas, or values." The officer has to deal with threats to his life, health and well being,  as he balances his actions in enforcing the law and in maintaining a civil society.  When these issues conflict, it creates cognitive dissonance.

Bayesian Thought Processes

Another principle the officer has to deal with is "Bayesian Thought Processes", which refer to a manner in which the brain processes information in order to perceive situations.  The brain tends to be programmed in a fashion in order to do forward thinking threat and risk assessment based on prior probabilities, which are conditional.  These conditional experiences represent the statistical evaluation of past experience in the brain.  If the officer has come to associate the evolution of threats with certain populations, then when a threat situation arises, he will be more likely to act on the basis of that threat when those populations are involved.  The associations may relate to personal experience, exposure to media, training or other exposures.  The key to solving the problem, is to address these underlying associations.  This is a difficult task and it is one that reflect's society's views and prejudices.

The Marijuana Symbol

Laws are getting more and more complex and this leads by itself to occasions of increased cognitive dissonance for the police officer.  An example of this is that the officer noticed a marijuana symbol on the socks of one of the men and that impacted perception.  Marijuana laws have become more complex, with some states (Washington and Colorado) legalizing it, while other states and the Federal government consider it illegal.  Medical marijuana is allowed in some cases.  For example, Missouri allows it for use for intractable epilepsy.  These laws by themselves add considerable cognitive dissonance to a police officer who may consider marijuana a 'gateway' drug to other more harmful drugs (and it still may be).  It is possible that the marijuana could be used for a medical purpose, a different association entirely.  Did Michael Brown have epilepsy?  I don't know.

An Officer's Sense of Space and Safety

The subjects approached the patrol officer's vehicle from behind, endangering the officer's feeling of control over his own space.  This was probably the key element in the confrontation.

The race and age of the subjects in question, and the perception that they may be subjects in a robbery the officer had heard about probably also contributed to the officer's sense of personal safety. The issue in question, with the demonstrations, however, is the extent to which the officer's perception of risk to his personal safety was based on preconceptions based on race, which may have influenced the outcome.

The Subject's Behavior and the Officer's Behavior

The officer missed one vital point, the subject's behavior.  If Michael Brown had committed a theft, as it appeared, then why did he challenge the police officer?   Was he guided by outside forces to act in a manner inimical to his own feelings of safety? Was his intent to be caught?  He challenged the police officer when his safest approach would have been to simply avoid the situation. Is it possible that the police officer's reaction, when threatened (by being surprised in his vehicle), triggered past memories of racial harassment in Michael Brown?  Did an emotional memory of a past event trigger an action to challenge rather than avoid conflict (fight or flight?).  At the age of eighteen, a number of issues could have been involved, including unknown existential issues.

Did Michael Brown attempt to surrender and the officer fail to recognize it for some reason?  Why?

Perception of Police and Justice System

The issue in the community becomes the perception of the public towards the police and the justice system as they examine the various roles in a tragedy of a life that ended too soon and the feelings of the police themselves.

How to fix this?  It is a good idea for people to have some understanding of police thought processes, especially understanding their concern about protecting their firearms and their physical space.

Police responses are to a certain extent wired into them by training, as in many fields.  Police need to be trained to act very quickly in risky situations, something not necessarily true of all professions.   In fact many of these hardwired thought processes are what have kept them safe in their jobs, so that seeking to change perceptions of police officers is fraught with many challenges, some of which involve the issues of cognitive dissonance alluded to above.

So the mystery of Michael Brown remains, how do you solve the problem?  You can educate the public, but the public is such a large body to educate.  This is a challenge.  Police training needs to continue to incorporate the importance of psychological factors, perceptions, including  the types of issues discussed above.

It is very possible that the subjects anomalous behavior led to a situation of cognitive dissonance in the officer where it generated a 'fight or flight' situation that the officer reacted to and resolved with his training and his capability to protect himself from potential harm.  It's possible the officer resolved the anomalous situation as only a challenge to his authority when there were other factors as well.  Time will tell as analysis of the situation proceeds.

One thing we do know, and that is suppressing a vulnerable, poor and disadvantaged population can have impacts that reverberate beyond the immediate situation in question.

It is difficult to comment on the legal tactics employed with the grand jury proceeding. The results speak for themselves.

A community mourns and it is time to heal and try to fix the problems.