Saturday, August 6, 2011

Update on the rating agencies

I mentioned in yesterday's post that Treasuries had a special status in the rules of institutional investors. The NYT has the details today:

[B]ecause Treasury bonds have always been considered perfectly safe, many rules prohibiting institutions from investing in riskier securities are written as if there were no possibility that the credit rating of Treasuries would be less than stellar.
Banking regulations, for example, accord Treasuries a special status that is not contingent on their rating. The Fed affirmed that status in guidance issued to banks on Friday night. Some investment funds, too, often treat Treasuries as a separate asset category, so that there is no need to sell Treasuries simply because they are no longer rated AAA. In addition, downgrade of long-term Treasury bonds does not affect the short-term federal debt widely held by money market mutual funds.

Also, James Kwak thinks along the same lines as I wrote, but in a far better and more concise way:
S&P downgrading the United States is like Consumer Reports downgrading Coca-Cola. Consumer Reports is a great institution. For example, if you want to know how reliable a 2007 Ford Explorer is going to be, they have done more research than anyone to figure out the reliability history of every single vehicle. Those ratings are a real public service, since they add information to the world. But when it comes to Coke and Pepsi, everyone has an opinion already, and no one cares which one, according to Consumer Reports, “really” tastes better. When S&P rated some tranche of a CDO AAA back in 2006, it meant that some poor analyst had run some model fed to her by an investment bank and made sure that the rows and columns added up correctly, and the default probability percentage at the end was below some threshold. It might have been crappy information, but it was new information. When S&P rates long-term Treasuries AA+, it means . . . nothing. And if any serious buy-side investor were tempted to take S&P’s rating into account, she would be deterred by the fact that the analysis that produced the rating included a $2 trillion arithmetic error.

Debt ceiling and deadlines

The debt ceiling saga of the last couple of months was a shame, but it produced some interesting discussions. First of all, my view is that the problem is mostly a problem of institutions. The debt ceiling is a rigid limit set up on borrowing for spending that has already been allowed. As a rigid limit, it is not robust to an unforeseen increase in borrowing, say because you are in a Great Recession. It is also not robust to a change in the Congressional norms: the increase in polarization has made the debt ceiling an hostage-taking situation, in the words of the Senate Minority leader himself(that is to say that comparing Republicans to hostage-taker is not as counterproductive, or stupid, as calling them terrorists)

In this sense, it is close to the filibuster rule, that allows 40 members of the US Senate to block a legislation or a nomination they disagree with. The filibuster somewhat worked(and that is still debatable) when Senators were nice to each other. Actually, the rule was made with the idea that senators were nice people in mind(see, for instance, Koger's great book) and that they wouldn't dare use the rule abusively.

Both rules have the problem of being extremely rigid. As Bruce Bartlett pointed out in the case of the debt ceiling:
It is permanent law and can be abolished only by repeal or by a ruling by the Supreme Court that it is unconstitutional
And there's also a reason why the main option to get rid of the filibuster is called the "nuclear option".

One interesting thing to come out of the debt ceiling debate is the discussion about deadlines. Tim Geithner announced on May 3rd that the Treasury would hit the debt ceiling on August 2nd. There has been some debate along the way on whether this was a hard deadline, or whether the ceiling would have been hit a couple of days earlier or later, but basically, everybody considered August 2nd as the last day when Congress should come to an agreement.

Now, what happened with the debt ceiling was a pretty good illustration of why deadlines are sometimes bad. As Dan Carptenter wrote in the Washington Post, deadlines create various problems. I'll quote the article in length

Deadlines can’t make decisions for us
Delegating a decision to another group and giving it a deadline can also be a form of procrastination or avoidance. Many deadlines are simply not met. The European Union has for two decades tried to use deadlines to speed up the implementation of its directives, to little effect. From 1995 to 2002, almost 60 percent of the implementation decisions in the Netherlands, for instance, missed the E.U. deadlines.

Deadlines ratchet up stress, limit creativity and force mistakes.

“bad” stress can cause the human heart to respond inefficiently to pressure and can lead to avoidance of the task at hand. Another psychological study shows that as a deadline approaches, group participants disregard those who voice contrarian opinions.

Carpenter's research "found that medications approved right before these deadlines were considerably more likely to be pulled from the market or have significant warning labels attached later on."

Deadlines can slow things down.
Once a decision-maker misses a deadline — and many, many deadlines are not only missed, but are expected to be missed — there is usually much less incentive to continue speedy work.
Many deadlines are missed, leading to disenchantment and poor coordination.
 An externally imposed deadline interrupts a person’s or group’s independent work schedule.

You can find other interesting practical examples of those issues. In a recent article in Foreign Affairs, David Victor and Kassia Yanosek argue that  the imposition of deadlines created short-termism incentives for potential investors in alternative sources of energy.
 Every few years, key federal subsidies for most sources of clean energy expire. Investment freezes until, usually in the final hours of budget negotiations, Congress finds the money to renew the incentives -- and investors rush in again. As a result, most investors favor low-risk conventional clean-energy technologies that can be built quickly, before the next bust. 

Apparently, Carmen Reinhardt thinks that the problem that we saw with the debt ceiling deadline is international(yeah, not really convincing):

Ms. Reinhart said countries often did the greatest economic damage by agreeing on cuts at the 11th hour, in the desperate rush to complete a deal, without sufficient attention to the particulars.“That’s when politicians make the worst decisions often — they cut the things that would yield short-term revenues,” Ms. Reinhart said.

It's hard to say that deadlines are always bad, as any student would tell you. So when is a deadline desirable? I don't want to say something stupid(if I haven't done so already), and it's late so I'll think about it before blogging...

Friday, August 5, 2011

Ratings agencies

I was going to blog about rating agencies tonight, and I guess that now I actually have a nice justification for it. S&P just downgraded the US credit rating by one notch from AAA to AA+. There are two big questions related to what I wanted to write about:
- Does it matter?
- Should it matter?

I was mostly going to blog on the second one as a follow-up to my post 2 weeks ago on polls and forecasts. As I said there, you have 2 possible objectives for those institutions: they can inform(tell you what the state of the world is now) or predict(what the state of the world is going to be). The latter is more complicated. Today's example is quite good to understand that: the very fact of downgrading the debt puts the US(and the world ouh lalalala) in uncharted territory. Thus, it is clear that the downgrade is not supposed to be a forecast, and it should be an assessment. But as Ezra Klein points out, S&P is actually trying to make a forecast on how the deficient US political system is going to deal with the rising debt.  That's one reason why S&P is probably in the wrong. It is not their job to forecast the US credit rating. Jared Bernstein said on MSNBC tonight that the agencies are there to tell us whether it's safe to invest in certain sovereign or corporate bonds. I disagree.  Their job is to inform of the current situation. And the current situation is clear: the US is creditworthy and the only problems are long-term And that's also why there will be no movement as a consequence of the downgrade. As Felix Salmon noted yesterday after the international market crash
if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there. 
More generally, it is really important to wonder why we are using rating agencies. At the time being, with private agencies, we cannot consider them as forecasters. The rating agencies have interests that are not aligned with perfect forecasting. The main issue in financial markets is that they are paid by the issuers of the securities that are rated. More generally, private forecasters usually have competitive and reputational incentives that lead to biased forecasts. Those two things actually have opposite effects. The former problem is discussed by George Henry

[A] technique for seeking attention is to produce a forecast that departs sharply from
the consensus
The reputational factor, instead, might lead agencies to herd, as suggested by Scharfstein and Stein
 herding may become more or less of a problem as a manager’s career progresses. One the one hand, there is apt to be less uncertainty about the manager’s ability, which should reduce the incentives for herd behavior. On the other hand, later in a successful career, wages are probably higher above the outside alternative. . . This latter effect can increase the propensity to herd. 

Usually, the evidence points to the latter. Owen Lamont showed that, for instance, that
ex post forecast accuracy grows significantly worse as forecasters become older and more established.
Errors are growing worse as the forecaster ages, which would point to a strong reputational incentive.

The bottom line is this: if you have private rating agencies, you don't want them as forecast, because their objective is not to have a perfect forecast. You want to use their ratings as information. Again, given the flawed incentives, you will have to adjust the information. Interestingly, this is what people in credit rating agencies will tell you, apparently. In an interview to Liberation, the left-leaning French newspaper, Carol Sirou, president of S&P for Europe, Africa and francophone Middle East,  argues that :
Nos notes sont dans le domaine public, chacun est libre de s'y référer ou pas. Mais le fait est qu'aujourd'hui, nos décisions sont souvent amplifiées et entraînent certains comportements, liés à l'anxiété ambiante. Trop d'acteurs utilisent nos notes comme seul critère de décision. Nous sommes favorables à ce qu'ils considèrent aussi d'autres paramètres. 
What does it mean in practice? The fact that rating agencies should not be used as forecast, but that their decisions should be evaluated as a partially informative signal by investors, means that ratings should IN NO WAY BE IN INVESTMENT RULES.  That is also why I don't really like when rating agencies are blamed for the pains in Europe for instance. We shouldn't care. The problem seems to be mostly political, and legislative.

As pointed in several papers(e.g. Steiner and Heinke(2001)), what you actually see is that downgrades have an impact when the downgrade is from investment grade to junk, and only then. Basically, the downgrades are useless, and their only effect is through the regulations that impose a sell-off by pension funds required to invest in certain categories of financial assets. All is told in the figure here:
You are interested in the lighter curve, which shows the "cumulative abnormal return"(CAR) around a downgrade. The downgrade occurs at time 0 in the graph. You can estimate what should be a "normal" return from the past. Given this prediction, you look at the actual value, and you get a day by day abnormal return(the black thingy). The CAR is just the sum of abnormal returns. What you see in the graph is that at the time of the event, the downgrade has been priced in, and the sudden fall just after the event is just an overshooting, since the situation goes back up after 15 days. Actually, as Steiner and Heinke put it(italics mine, obviously):
In the long run(which is what institutional investors are about!) the investor is better off not to sell the bond on the announcement day because there is a positive cumulative excess return from day 1 to day 90 of 0.526%.
You also see evidence that the size of the downgrade(how many notches) does not matter, evidence for the fact that ratings actually provide few information, and that their only impact is through the constraining rules imposed on institutional investors.

My bottom line, in theory, is this: ratings should not be in the rules. There should not be rules restricting investment to triple A bonds. This does not make any sense.

On the US problem now, it's actually clear, I think, that nothing is going to happen, for a couple of reasons. First, as mentioned above, investors not subjected to binding rules on what they could invest in will not react. As you saw yesterday, people were still flocking to Treasuries during the market crash, while the downgrade has been in the making ever since Barack Obama announced the agreement on the debt ceiling. Reuters most recently reported on a JP Morgan study showing that
The number of investors that are restricted to by Triple A mandates is minimal. Expectations are that around USD40bn could be pulled from US Treasuries as a result of force selling. 
[JP Morgan] see[s] little direct impact of a downgrade in the short term, but the medium term impact is Treasury yields in the range of 60bp higher than otherwise, which is a significant cost to the Treasury.
Third Way has a somewhat larger increase in yields, at 75bp. Fitch does not care
Second, the problem is, again , the downgrade from investment-grade to junk. AAA to AA+ does not matter. As Felix Salmon reported
“the long-term credit performance of ‘AAA’ rated versus ‘AA’ rated issuers,” says Fitch, “is statistically negligible”.
Third, there's nowhere else to go. The US issues 59% of triple A sovereign debt. The other AAA countries(yep, France) do not look that attractive right now.
Fourth, Treasuries have a special role in certain institutional investors(can't find the link, sorry). Basically, those investors can invest in Treasuries not because they're triple A, but because they're Treasuries. Because a downgrade does not change the name of the bond, there will be no impact for them.

Etc, etc... Bottom line: no biggie. I am taking a risk, I don't like making predictions. Well... I should probably start at some point.