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Sovereign Final

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					   Do Sovereign Ratings Promote
Economic Development or Reinforce
         the Status Quo?
     United Nations University  December 16, 2009
       Questions We Considered

1. What is a sovereign rating?
2. Is sovereign rating a viable concept?
3. Is it methodologically sound?
4. Do sovereign ratings create perverse incentives?
5. What is the source of rating agencies’ authority
   over sovereign finance?
6. Are there better formats for sovereign credit
   information gathering, analysis and disclosure,
   that recognize success and failure in sovereign
   asset management?
                                                  2
A Sovereign Rating Is A Type of Credit Rating,
 Provided by a Type of Credit Rating Agency

   STANDARD & POOR’S                MOODY’S INVESTORS SERVICE
“sovereign credit ratings reflect     “the credit risk facing an investor
its opinions on the ability and       who holds debt securities issued
                                      by that government.”
willingness of sovereign              “In contrast to non-governmental
governments to service their          economic agents that are forced
commercial and financial              to default because they no longer
obligations in full and on time.”     have the resources to repay debt,
“…not country ratings, an             governments, by the distinctive
                                      nature of possessing sovereignty
important and often                   (freedom from a higher authority)
misunderstood                         can make the deliberate choice to
distinction…address the credit        not repay their debt.” – A Guide
risks of national governments.” –     to Moody’s Sovereign Ratings,
                                      August 2006
Sovereign Credit Ratings: A
Primer, March 2004
                                                                        3
                     What Do Ratings Do?
Look through the Optics of Capital Structure
    John Moody envisaged ratings as a way for investors to look through the “optics”
       of risk (“Class A must be safer than Class B because it’s in a senior position.”)
       to the substance of risk. I.E., the asset side of the issuer’s balance sheet. The
       context of his rating concept was US railroad bonds, which are very similar to
       today’s structured products.
Make wholesale credit markets possible via “standardization”
     Ratings have evolved in tandem with the growth of modern capital markets.
       They have become a market-accepted norm for mass customization of graded
       borrower payment certainty.
Create a filter for regulating investment behavior
    Most bank, insurance and pension investors are prohibited from buying non-
      investment grade securities.

    …BUT IS IT EVEN MEANINGFUL…
         to talk about complex capital structures and standardized treatment of
            sovereign credits?
                                                                                       4
   What Rating Agencies Don’t Consistently Do
Strive for consistency
   Through the 1990s: “*the+ Approach, in both policy and practice, is intended to
   provide a consistent framework for risk assessment that builds reasonable ratings
   consistency within and across sectors and geographies”- S&P
   Moody’s mission was similar.
Supply predictive measures of risk
   A default is not a risk. A loss is not a risk. Both are certainties.
   Actionable risk measure means empirically and statistically defensible estimates of
   the variability of performance.
Explain the motivation and materiality of changes to their methods
   Methodological changes can be motivated by many factors, but not all serve the
   general interest equally well.
Respect the value of information as capital
   Rating agencies seem to misunderstand their mission. The market does not need
   another information monopolist. The market, to function, needs an informed and
   trustworthy arbiter of information quality who transforms information into capital.
                                                                                       5
         Are Sovereign Ratings Predictive?
• Does the act of observation impact that which is observed?
   – Increased volatility is demonstrable.


• Anticipate? What is it they anticipate?
   – “A change in the risk assessment by the three leading rating agencies is preceded by a
     similar change in the market’s assessment of sovereign risk” (Reisen and von Maltzan,
     OECD Development Center)
   – Dubai example
         • Negative watch after the announcement of a Dubai World restructuring.
         • Anticipate moral hazard as they did with the GSEs, pressuring sovereign support for firms that
           likely pay for their ratings. (“The ratings on these fours banks are higher than their stand-alone
           credit profiles (SACP) and factor in our expectation of some exceptional government support in
           case of need.”)
         • SIGTARP Report on AIG: FRBNY was further concerned – as it was throughout the AIG rescue –
           about the reaction of rating agencies”

• Lag?
   – If they lag, do they cause more damage after the damage is already done?
   – “After a country’s rating has been downgraded, the market appears to vindicate the
     agencies’ assessment over the next 30 trading days with an upward movement in
     relative yield spreads.” (Reisen and von Maltzan)                                                      6
            Let’s compare Moody’s published record of
             sovereign and corporate defaults in 2008:
Sovereig
   n
 Rating         1         2         3          4          5          6         7          8          9         10
  Aaa       0.0000%   0.0000%   0.0000%    0.0000%    0.0000%    0.0000%   0.0000%    0.0000%    0.0000%    0.0000%
  Aa2       0.0000%   0.0000%   0.0000%    0.0000%    0.0000%    0.0000%   0.0000%    0.0000%    0.0000%    0.0000%
  A2        0.0000%   0.0000%   0.0000%    0.0000%    0.0000%    0.0000%   0.0000%    0.0000%    0.0000%    0.0000%
 Baa2       0.0000%    0.552%    1.172%    1.872%      2.678%     3.53%     3.53%      3.53%      3.53%      3.53%
  Ba2        0.898%    2.039%    4.017%    6.272%      8.753%    10.582%   13.101%    15.962%    18.346%    20.829%
  B2         2.830%    6.182%    7.451%    9.539%     11.591%    14.111%   16.297%   18.2510%    20.909%    24.721%
 Caa-C      22.642%   27.222%   33.333%    33.333%    33.333%    33.333%   33.333%    33.333%    33.333%    33.333%

Moody’s Global Credit Policy: Sovereign Default and Recovery Rates: 1983-2008, Moody’s Investors Service, March 2009.


Corporate
 Rating         1       2       3       4       5       6       7       8       9      10
  Aaa        0.000% 0.016% 0.016% 0.049% 0.088% 0.136% 0.188% 0.193% 0.193% 0.193%
  Aa2        0.019% 0.061% 0.099% 0.172% 0.247% 0.290% 0.321% 0.346% 0.367% 0.413%
   A2        0.026% 0.131% 0.306% 0.482% 0.679% 0.892% 1.105% 1.337% 1.550%          1.711%
  Baa2       0.182% 0.516% 0.928% 1.412% 1.893% 2.362% 2.815% 3.237% 3.657% 4.139%
  Ba2        1.145% 3.169% 5.690% 8.293% 10.484% 12.472% 14.222% 15.845% 17.320% 18.736%
   B2        4.330% 9.828% 15.268% 20.087% 24.469% 28.667% 32.665% 36.002% 38.925% 41.451%
 Caa-C      15.834% 25.752% 34.005% 40.545% 45.890% 49.619% 52.430% 55.663% 60.016% 65.563%

                                                                                                                7
 Are issuers ruled by the Law of Large Numbers when
                   they get a rating?
Sovereig
   n                                from Moody’s first 2003 Sovereign bond default study
 Rating        1          2          3       4           5         6        7          8             9          10
  Aaa      0.0000%    0.0000%    0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
  Aa2      0.0000%    0.0000%    0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
  A2       0.0000%    0.0000%    0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
 Baa2      0.0000%    0.0000%    0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
  Ba2      1.5600%    3.3700%    5.4900% 10.8600% 12.6200% 14.9800% 18.1300% 22.2300%           28.7100%    40.5900%
  B2       7.8900%   14.2500%   18.3300% 18.3300% 22.2200% 27.0800% 32.6900% 38.8100%           45.6100%    53.3000%
  Caa      0.0000%   50.0000%       NA      NA          NA        NA       NA         NA            NA         NA
                                   From Moody’s latest 2008 Sovereign bond default study
 Rating        1         2           3       4           5         6        7          8             9         10
  Aaa      0.0000%   0.0000%     0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
  Aa2      0.0000%   0.0000%     0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
   A2      0.0000%   0.0000%     0.0000% 0.0000% 0.0000% 0.0000% 0.0000% 0.0000%                 0.0000%    0.0000%
  Baa2     0.0000%    0.552%      1.172% 1.872% 2.678%          3.53%    3.53%      3.53%         3.53%      3.53%
  Ba2       0.898%    2.039%      4.017% 6.272% 8.753% 10.582% 13.101% 15.962%                   18.346%    20.829%
   B2       2.830%    6.182%      7.451% 9.539% 11.591% 14.111% 16.297% 18.2510%                 20.909%    24.721%
 Caa-C     22.642%   27.222%     33.333% 33.333% 33.333% 33.333% 33.333% 33.333%                 33.333%    33.333%


 Moody’s Investors Service, Ibid.
 Moody’s Global Credit Policy: Sovereign Default Rates: 1985-2002, Moody’s Investors Service, March 2003.

                                                                                                                8
                       Definitional Notes

Default is defined as
1. There is a missed or delayed disbursement of interest and/or principal.
2. A distressed exchange occurs, where
   – the issuer offers bondholders a new security or package of securities that
     amounts to a diminished financial obligation such as new debt instruments
     with a lower coupon or par value; or
   – the exchange had the apparent purpose of helping the borrower avoid a
     "stronger" event of default (such as a missed interest or principal payment).

The reference rating is the lower of
• the domestic rating on the sovereign bond, or
• the cross-border rating on the sovereign bond.


                                                                                     9
       Are Sovereign Ratings Self-Fulfilling?

• A diversity of opinion exists on how to approach the sovereign rating
  problem, which is healthy. EG:
    – Asset-based orientation, emphasis on balance of payments surplus (“current
      accounts”) and domestic economic output (“gross domestic product” or GDP).
    – Liability-based orientation, emphasis on the constraints on creditworthiness
      (“ceilings”) beyond which the government may decide not to repay debt as it
      comes due.
    – Market-value orientation, emphasis on empirical measures of the risk and
      value of the sovereign wealth as implied by traded spreads.

• But, what is not clear, is the extent to which the existence of a rating
  actually determines risk and value, rather than merely measuring it. EG:
    – An asset-based orientation that relies on one or two measures may not reflect
      the full picture of value or risk.
    – A ceiling-based approach soon makes the ceiling the object of investigation
    – Market value-based approaches, which have been in vogue recently, are only
      as valid as the quality of information in the traded prices.


                                                                                  10
   The S&P “Ramp”: 10 Key Measures



                        Level of        Ratio of
                         Gross           Gross
                       Domestic        Domestic
                        Product         Product



                            Current Account
                                Receipts




     Political Institutions         External Finances, Liquidity
(depth, transparency, stability)        (diverse measures)
                                                                   11
Moody’s Sovereign Ceilings




                             12
                                                           Market-Based Credit Assessments
Sovereign Residual Value derived from market spread data




                                                           Sovereign Assets-Sovereign Liabilities = Cushion (creditworthiness)


                                                                                             Sovereign Assets

                                                                      Distance to default at a point in time


                                                                                           Sovereign Liabilities
                                                                                              (Book Value)

                                                           Time



                                                                                                                                 13
       Do Sovereign Ratings Create Perverse
                 Incentives? I.e.

• Reward the developed world for being developed
• Limit the development of the developing world
  – Sovereign Ratings provide a functional ceiling for sub-sovereign regions.
    As of mid 2009, only 1.4% and 3.8% of LRGs monitored by S&P and
    Moody’s respectively, had a FC rating higher than their sovereign.
    (Norbert Gaillard)
  – “The contribution of sovereign risk to firm ratings is high in developing
    countries but is negligible in developed countries”, the almost
    monopolistic market structure of their industry might not be able to
    guarantee that RAs make the socially optimal effort to measure the
    creditworthiness of firms in emerging countries. RAs might actually
    indulge in under-investment, particularly vis-à-vis entities in emerging
    countries, where RAs’ own business is negligible. “ (Ferri & Liu)

                                                                        14
    Perhaps the Single-Metric Rating is
              Problematic?


• RMBS refer to a credit that is less complex than
  countries, and single point ratings fail to be
  reliable.
• CDOs as credits are less complex than countries,
  and single point ratings fail to be reliable.
• Corporations are less complex to analyze than
  countries, and single point ratings fail to be
  reliable here too.

                                                 15
Who Authorizes Sovereign Ratings?




             You do.




                                    16
   What Governs the Sovereign Rating Process?
REGULATORY:
Nothing more than an agreement – IOSCO’s non-binding “Code of Conduct”

SELF-REGULATORY:
Rating agencies state they have:
     – “no obligation to verify or audit any information provided to it from any source or to
         conduct any investigation or review, or to take any other action, to obtain any
         information that the issuer has not otherwise provided ” – Fitch
     – “ no obligation to perform, and does not perform, due diligence with respect to the
         accuracy of information it receives or obtains in connection with the rating process.
         Moody’s does not independently verify any such information. Nor does Moody’s audit
         or otherwise undertake to determine that such information is complete. Thus, in
         assigning a Credit Rating, Moody’s is in no way providing a guarantee or any kind of
         assurance with regard to the accuracy, timeliness, or completeness of factual
         information reflected, or contained, in the Credit Rating or any related Moody’s
         publication” - Moody’s

THE APPEARANCE OF OVER-RIDING SELF-INTEREST CANNOT BE DISMISSED:
On the very same day that S&P upgraded China’s artificial sovereign ceiling, S&P immediately
    upgraded the corporate ratings of eight Chinese companies. This appears to have been a bid
    to profit from the expanded debt issuance capability of Chinese corporations.
                                                                                                 17
        What If the Model were Inverted?

1.   Seek to understand the strategy for growing and revitalizing the
     economy. Create a model representation. Sovereign as Asset
     Manager.
2.   A cube of directional information as part of an analysis package.
     Visual representation of the sovereign with component detail but no
     composite rating. Comparability across countries and time but not a
     basis of rating.
3.   Update the model as frequently as the sovereign allows, with new
     information; and make the outputs the basis of a structured dialogue
     with consumers of sovereign ratings. Investor as Knowledge-Worker.
4.   Publish ratings on the quality of information and dialogue—where
     “quality” means timely, comprehensive, precise. Rating Agency as an
     Informational Critic.

                                                                        18
      Considerations for a New Paradigm

• “A sovereign’s rating normally caps all other ratings from that country.
  However, there are several exceptions to the general rule. ” (Fitch)
   - The exceptions prove the rule is flawed
• Sovereign ratings should be predicated on a series of objective,
  observable and comparable data.
• The data should be grounded in the political and philosophical
  choices made by the sovereign on how they want to grow and
  manage the economy.
• Sovereign ratings should relate the credit analysis to the tenor of the
  securities offered.
• To serve the diverse needs of analysts, breaking down the analysis
  into meaningful components is highly desirable (bank CAMELS
  components).
• Directional value should be given to each component.


                                                                      19
                            References

Sovereign Credit Ratings: A Primer, Standard & Poor’s, March 2004.
A Guide to Moody’s Sovereign Ratings, Moody’s Investors Service,
    August 2006.
Moody’s Global Credit Policy: Sovereign Default and Recovery Rates:
    1983-2008, Moody’s Investors Service, March 2009.
Moody’s Global Credit Policy: Sovereign Default Rates: 1985-2002,
    Moody’s Investors Service, March 2003.
The Determinants of Moody's Sub-Sovereign Ratings, Norbert Gaillard,
    EuroJournals Publishing, Inc. 2009.
How Do Global Credit-Rating Agencies Rate Firms from Developing
    Countries?, Ferri and Liu, 2004 .
A Ratings Based Approach to Measuring Sovereign Risk, Remolona,
    Scatigna & Wu, 2008.
Assessing the Effort of Rating Agencies in Emerging Economies: Some
    Empirical Evidence, Ferri & Liu, 2005.

                                                                      20
Information and opinions presented in this report have been obtained or derived from
sources believed by the authors to be reliable, who make no representation as to their
  accuracy or completeness and accept no liability for loss arising from the use of the
   material presented in this report where permitted by law and/or regulation. This
     report is not to be relied upon in substitution for the exercise of independent
                                        judgment.

				
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