Friday, November 17, 2006

Quality Control

A few days ago, Business Week and Standard & Poor's published an article about the growing number of speculative bond issues and the deteriorating credit quality of issuers, i.e., of the major U.S. companies in their universe. Before panicking at an article like this, one should consider that the situation is probably worse than S&P makes out. S&P said what they said on the basis of the credit ratings which they give, saying, for example, that "[a] mere seven non-financial firms are now rated AAA, compared with 24 a decade ago.... These data suggest that a relaxation of credit standards may have occurred.". In other words, even if S&P's ratings themselves had a constant value, credit quality would be deteriorating.

Unfortunately, it's not at all clear that S&P's ratings have a constant value. In fact, a 2005 article by the New York Fed says that "For cohorts established since january 1971,... the cumulative default rate within all rating classes BBB and below has increased roughly threefold. The 1971 to 1989 increase is from 0.4 percent to 0.8 percent for A-rated bonds, 1.1 percent to 3.2 percent for BBB-rated bonds, 5.1 percent to 19.7 percent for BB-rated bonds, and 11.1 percent to 34.3 percent for B-rated bonds." (The article actually seems to be using Moody's data with S&P class names, as far as I can make out.)

But wait. It gets worse. A letter by two ratings professionals posted on the SEC website points out that "Enron was rated investment grade by the NRSRO's four days before bankruptcy; [t]he California utilities were rated "A-" two weeks before defaulting; WorldCom was rated investment grade three months before filing for bankruptcy; Global Crossing was rated investment grade in March 2002 and defaulted on loans in July 2002; AT&T Canada was rated investment grade in early February 2002 and defaulted in September 2002. (Emphasis added.) So even without the Fed's statistics on what it calls the "drift" in "default probabilities associated with specific letter ratings", we might have reason to worry about the competence and/or honesty of the ratings agencies, or at least the predictive value of the ratings.

Am I finished? No. About a year ago, Jim Jubak estimated that there were 8.4 trillion dollars in credit derivatives outstanding. This worries, many people, including him; they are worried about the possibility, admittedly remote, of an implosion of the financial system as a result of a domino effect among those who hold derivatives, including the world's largest banks. For comparison:

1. In 1998, a single hedge fund, Long-Term Capital Management, managed to collapse with $1.4 trillion in derivatives on the books. Our old friends the New York Fed organized a bail-out, "ostensibly in order to avoid a wider collapse in the financial markets".
2. According to the November 16 Fed release, the entire M2 money supply is less the seven trillion dollars right now. This will give you some idea of the Fed's ability to come to the rescue if it should happen again that one of the larger holders runs into a derivative problem.

What does all of this have to do with our questions of deteriorating credit quality and the ratings agencies' knowledge thereof? Well, ask any statistician what he thinks about models and predictions of the future likelihood of an event which happened only once previously in history, and under conditions very different from what they are now - for example, of a derivative implosion at a major bank or other holder. And this very lack of future knowledge greatly (or unmeasurably) increases risk, since our lack of knowledge of a debtor's future ability to pay is what credit risk is about. Yet the rating agencies rate those financial institutions and their creditors, but seem not to be taking this new kind of risk into account - even if they could.

Just to emphasize my point again, after so many numbers and citations: Standard & Poor's, who should know if anyone does, says that credit quality among U.S. corporations is deteriorating. In fact, if you take the general drift and problems with the ratings industry into account, it is deteriorating much more steeply than they care to admit, or maybe than they realize.

So what does this mean for investors? As far as I can see, it means two things:

When thinking about credit quality, the ratings are not good enough. Do your own number crunching, and trust the feelings in the pit of your stomach, too. (The feelings in the pit of my stomach didn't save me from AT&T Canada or Kemper, but they did save me from Enron.), and
If you look at the best medium term investment grade bonds available at the moment, in terms of yield and apparent risk, you will discover that they are almost all financials. Do you really want to load up on them that much right now? Is the market telling you something that the rating agencies aren't?

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