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

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.

Standard and Poor’s Downgrade of the United States Long Term Sovereign Credit Rating from AAA to AA+

American Eagle on Perch, Skagit Valley, Washington (image on Photoshelter)

Rating agencies, including Standard and Poor’s, Moody’s and Fitch, use different, proprietary models to rate debt and financial strength. While there may be no such thing as a perfect model, each company promotes its own model and methodology. Rating agencies serve a purpose in providing the marketplace with information on the financial health of the companies, governments and financial instruments they rate.

Taking into account differences in models (and agency inclinations), it is not surprising that rating agencies should differ in their ratings from time to time. Thus, Standard and Poor’s downgraded the United States credit rating from AAA to AA+ while Moody’s and Fitch have maintained their ratings while warning that future downgrades were possible if the United States did not enact debt reduction measures and if the economy weakened.

A more definitive statement would have been made if all three major rating agencies had dropped the rating of United States debt.

Standard and Poor’s rating change reflects their perception of the political stasis leading up to the recent move to raise the debt limit.

The Standard and Poor’s downgrade remained in place after a $2 trillion dollar error in their calculations was discovered by the Treasury department. Standard and Poor’s defended their decision, reinforcing the perception that the downgrade reflected to a large degree the inability of our government to get the job done.

Standard and Poor’s is under attack for their rating of mortgage backed securities involved in the financial debacle of 2008. These securities were rated AAA just prior to their default. The U.S. Justice Department is investigating Standard and Poor’s for their ratings of these instruments.

The ratings process is complex. Complex models are involved. When the ratings model indicates problem areas indicating a potential downgrade a number of paths may be taken. A rating agency may work with the organization to solve its problems (or to assure the model is adequately capturing an organization’s weaknesses and strengths). Either way, the focus is to assure capital adequacy.

This may give the organization an opportunity to avoid a downgrade while fixing the problem and risk a potential disastrous cascade into insolvency. There is a balance of risks -- a cascading failure could be a far worse alternative both for the organization , related entities and the economy. However, measures taken to solve the underlying problems should be appropriate, rather than window dressing which overvalues assets or undervalues liabilities.

If the agency does not downgrade an organization (or financial instrument), they risk a potential hit to their reputation if the entity does tank while holding the original, pristine rating.

In many instances companies pay a significant fee to be rated. This raises the issue that the agencies are serving the companies they rate rather than the overall public (or potential investors). This issue is to some degree offset by the reputation issue that rating agencies face when they fail to downgrade a company (or financial instrument ) that fails. Their services are judged by their ability to accurately rate entities.

The actual downgrade aside, Standard and Poor’s was correct in its appraisal of the ineffectiveness of our government in addressing the national debt issues. Standard and Poor’s mentioned the political brinksmanship, differences between political parties, and the failure to consider tax increases among other issues.

The sad thing is that our elected representatives performed so horribly that it gave Standard and Poor’s an opportunity to downgrade government debt from AAA for the first time in the history of the United States. There are many that depend on the United States to provide a stable financial milieu; the threat of a default; the inability of some representatives to compromise was an arrogant abrogation of their electoral duty to act in the best interest of the United States.

It seem that the rating agencies are, in a way, a force unto themselves that rest above governments and pass judgement upon them. Do we really want the institution of money to rule us in this way?

Wikipedia article on 2011 downgrade.

Political Risk

Mt St Helens crater and Toutle River, Cascade Range, Washington, 2011 (image on Photoshelter)

Discussions between Congress and the White House regarding raising the National Debt Limit are an example of the considerable political risks in our current system. My concern is that failure to agree on a solution to raise the debt limit may cascade into financial disaster. It is a balance-of-risks issue that our leaders will ultimately be judged on.

Political risk issues include:

• The polarization of political parties such that the more extreme elements dominate each party, and become nominated for office, crowding out the moderates.

• The emergence of non-elected individuals ‘asking’ that candidates sign ‘pledges’ which politically tie candidates to certain positions, limiting their flexibility to act.

• The inability of politicians to act in the interest of the nation.

Politicians need to be able to consider the best interest of the nation as a whole. Their inability to do so jeopardizes our nation. The clear and present danger is that the United States will default on its debt on August 3, 2011 if the national debt limit is not raised by that time.

Should the United States default on its debt, there would be serious ramifications. Ratings agencies have already given warnings regarding our debt rating. In this July 14, 2011 Bloomberg story, Moody’s placed the United States’s Credit rating under review for a downgrade. In this July 16, 2011 LA Times article, Standard and Poor’s has also warned that they may cut the United States’s top AAA debt rating as a result of the lack of an agreement to raise the debt limit.

In an article in Reuters 7/18/2011, Moody’s stated that the United States should “eliminate its statutory limit on government debt to reduce uncertainty among bond holders”.

A decrease in the United States’s ratings by rating agencies would likely result in an increase in the interest rate that our country pays on our debt. This would increase the cost of financing the United States debt and also have reverberations throughout the marketplace, driving up interest rates generally. Failure to raise the debt limit could conceivably cascade into a financial catastrophe.

The seriousness of what could be a cascading financial disaster is brought home by an article in the Insurance Journal: S&P Threatens Downgrade of Insurers, Financial Firms Over Debt Ceiling” indicating that S&P could downgrade a number of financial institutions should the government fail to act to raise the debt limit.

Currently, Treasuries are regarded as “risk-free” currencies. Should our Government’s rating be downgraded they and other government securities may well be assessed higher capital charges in regulatory and rating agency models. The securities would included various securities including Fannie Mae and Freddie Mac, the latter two key to the mortgage market. Increased capital charges may potentially result in financial institutions being downgraded by rating agencies. If a financial institution is so downgraded as a result of the government failing to act on the national debt, it could trigger other events. “Ratings triggers” in the financial institution’s policies could be triggered, allowing a large withdrawal of policyholder funds from large investors, perhaps at book value,

An increase in the interest rate would have impact in the marketplace, in valuation of assets, in home and auto loans and refinancings. It would alter institutional and personal behavior. Depending on the size of the interest rate increase, an increase in rate could impact stable value funds that promise payout at book value. Importantly, it would cost more to finance the United States debt with a higher interest rate.

Treasuries have been long regarded as ‘safe’ and it is be “interesting” to speculate how changes in their quality rating would reverberate throughout the financial marketplace in the event the U.S. government fails to raise the debt limit by August 3, 2011.

President Obama does not want to “kick the can down the road” instead preferring a longer term solution to the problem that includes spending cuts and revenue increases. The Republicans do not want to consider revenue increases. Some have signed a pledge not to increase taxes and are constrained by that.

The danger is that the United States will default on its debt on August 3, 2011 if it does not raise the debt limit.

We have an examples in history where one small thing cascaded into a major calamity. One event that comes to mind is the Great Seattle Fire of 1889 where glue boiling over into a gasoline fire ignited wood chips and eventually burned down 32 blocks of Seattle, including business district, wharves and railroad terminals.

Do we want our government leaders shackled by the bounds of rigid ideology, watching the debt limit “glue pot” boil over into the “incendiary” market of interest and credit risk, cascading into a market conflagration that “burns” many in our economy?

I would hope our leaders get wise and come to an agreement that will avert disaster in our financial markets. Maybe I am wrong. Maybe these risks won’t materialize or will do so to a minor extent. However it is uncharted waters and do you want to bet the farm that the serious risk will not materialize? President Obama needs to consider a short term deal that gets us over this deadline. The Republicans need to consider raising taxes, even if it means violating a pledge not to raise taxes.

In 2012 the voters will hold our leaders accountable if they watched the pot boil over into the flames and cascade into disaster when they could have come to agreement.

It is an issue of balance-of-risks. The risks of watching the debt pot boil over and cascade into a financial conflagration over over some ideological shackles are just not worth it.