Tuesday, August 9, 2011

Understanding sovereign credit ratings

John Moody invented bond ratings in 1909, focusing initially on railroad bonds (which were the bread and butter of the US capital market at the time). As time passed, he expanded his coverage to include corporates and, in 1918, munis and foreign governments. He did not rate foreign governments out of personal interest, but because his US subscribers were being sold new or seasoned dollar-denominated sovereign debt. (The London capital market was closed due to the war; New York remained open, without exchange controls.)

Moody's rating scale was originally based on railroads and industrials. He intended  for the rating scale to have room for large railroads and corporations in the Aaa category. When munis and governments were added, they were slotted into the same scale but with different definitions (some of which were very politically incorrect!).

Sadly, his track record with “government” ratings wasn’t so good. The Great Depression was very bad for munis, Latin America and central Europe. World War II was not good for defeated powers which hadn’t already defaulted.

I might add that the Depression wasn’t good for the US either. When the banking system collapsed in 1931-33, the bond market dried up, and the Fed was too busy trying to stem the gold drain to worry about the Treasury. Treasury almost defaulted in 1933 between the election and the inauguration. It had run out of money due to a huge deficit and lack of market access.

What’s interesting is that I know all this arcana because I have read John Moody’s investor newsletters during the Depression. He was all over this near-default, but maintained the Aaa throughout. I have to assume that this was for ordinal, rather than cardinal reasons. In a rank ordering of bonds in 1933, Treasuries were still on top and “money good”. Even when the US repudiated (3/33) the promise to redeem its bonds in gold, it remained Aaa.

The USA, on a cardinal basis, was not a great credit in 1945 with an enormous war debt, but, on an ordinal scale, it was the best in the world if you don’t count Sweden or Switzerland which saved themselves billions by staying out of the action. The UK looked even worse than the US, but was still Aaa and has always been, if my memory is correct. (I don't think the UK should have kept its Aaa in the postwar period, nor when it was begging from the IMF in the seventies.)

The global capital market closed in 1930, and did not reopen until over fifty years later.  When it did, and American investors were once again being sold soveriegn bonds, the agencies began to assign ratings to foreign governments selling dollar bonds in the Yankee market and the eurobond market. In the 1980s, sovereign credit methodologies were primitive and not very good. Mistakes (in retrospect) were made. 

Over the next thirty years, the quality of sovereign credit analysis steadily improved, as did the quality of the analysts and their methodologies (and their data). In the 1990s, the agencies dramatically expanded their coverage from a dozen countries to over 100, in order to establish "sovereign ceilings" for bank ratings.

To oversimplify, there are essentially three sovereign methodologies at the agencies: one for developing economies, one for high-income economies, and one for economies which either borrow in foreign currency (eurozone), are dollarized, or  are hard-pegged to the dollar (or any other foreign currency). All of the methodologies are tied to ratios and other data. As of 2007 (when I retired), Moody’s published the most comprehensive and uniform data, in its Country Credit Statistical Handbook. It is possible that S&P and Fitch now offer similar products but I doubt it; these things are very labor-intensive.

So, why does S&P think that the USA is a worse credit than it was in 1945, and a worse credit than Johnson & Johnson? I would advance two reasons.

One is that the (salutary) development of prescriptive sovereign methodologies has resulted in an ontology which is unintentionally separate from the corporate scale in terms of expected loss. Can I prove it? No. But I feel it. And I’ll take a Treasury any day over J&J.

Another is that the cardinal aspect has gotten a lot stricter since 1933 and 1945. The ratios are the ratios, the CBO projection is awful, and that’s that. You’ve got to do what your methodology says to do.

But I will conclude with this observation: I don’t think that the UK, France or Switzerland are better credits than the US. The UK and Switzerland have large contingent liabilities (banks), and France has a socialist mindset. Our banking system is manageable, and few of our politicians (outside of Vermont) are avowed socialists.

1 comment:

sternlaw said...

Excellent history lesson. Can you adress s&p's methodology, and comment on any flaws releva t to the downgrade? I believe it now ranks France higher than the US