Credit ratings agencies: The truth does not belong to any one

Ratings agencies are an important source of information for investors. However, it is difficult to judge the accuracy of the information because while ratings agencies may have the capacity to run simulations on a given set of assumptions, they cannot be certain about the information given to them

There is a common expression in English, 'There are three types of lies: lies, damn lies and statistics.' There have been many attempts to attribute the expression to a person without success. The closest and earliest seems to be in a different area, the law. In a reference dated to 1885, the quote goes "A well-known lawyer, now a judge, once grouped witnesses into three classes: simple liars, damned liars, and experts." For investors there can be nothing more important than statistics and experts. One of the most difficult things for markets to do is to judge the accuracy of information. But to make money this analysis is perhaps the most important of all.

One excellent way to determine the quality of information is to see who is attacking it. One appalling example came recently from the president of the European Commission Josée Barroso. This week Moody's downgraded Portugal's bonds four notches to junk. President Barroso responded by accusing Moody's of "mistakes and exaggerations". He felt that the experts at Moody's were incompetent to make the determination of Portugal's financial health. Instead he proclaimed that "our institutions know Portugal a little bit better". Perhaps, but as everyone is well aware, President Barroso's institutions have a bit of a bias.

The bias was echoed by Wolfgang Schäuble, the German finance minister, who said "We can't understand the basis of this announcement," and then threatened "to break the oligopoly of the ratings agencies." Both statements basically confirmed what the markets knew anyway, that Portugal's bonds were junk and that Moody's recognition was a rather late confirmation.
It was not just the Europeans who were annoyed with the ratings agencies that had given them bad marks. The American government was annoyed as well. When S&P cut its outlook for US bonds in the midst of budget negotiations between the White House and congressional Republicans, senior US Treasury officials questioned the timing and accused S&P of being misinformed about the budget talks.
It is not that the ratings agencies have never been wrong before. They are still recovering from their horrendous calls. Four weeks after Moody's rated Enron's debt as investment-grade, the company declared bankruptcy and defaulted on its bonds. But what really caused the credit agencies downfall was their work rating structured finance/subprime.

Structured finance was a method developed in the 1980s to turn many disparate mortgage loans into standardised, regimented and easy-to-assess bonds. The process could be manipulated to provide different degrees of risk. Exactly how the deal was structured depended upon what rating it was trying to get. So the ratings agencies were brought on board early, rather than after the products were created. This totally changed the ratings agency's bias. They were no longer an independent expert witness, but were providing a service for clients. In the case of structured finance, it meant that they were working for the creators of the products, the investment banks, and not investors. The rest, as they say, is history.

Because the ratings agencies have a particular bias that governments don't like, the governments decided that since they are free from bias, that they should create their own taxpayer funded ratings agencies. A plan by the European Union (EU) fortunately received a poor reception from the European Central Bank because it would need "extensive data, models and experienced staff" and could take years for it to become fully effective."

Although start-up problems prevented the formation of a ratings agency owned by the EU, they did not bother China. China has three credit ratings agencies, Chengxin International Rating Co, which is 49% owned by Moody's, and China Lianhe Credit Rating Co, 49% owned by Fitch Ratings Inc. The third and most interesting is Dagong. We don't really know exactly who owns Dagong. It is not revealed on their web site. We do know that it works closely with the Chinese government and at times can be particularly protective of what it considers its 'national sovereignty'.

It was denied an application by the US securities watchdog, the Securities and Exchange Commission (SEC), to become a "nationally recognised statistical rating organization", or NRSRO, a designation that allows a firm's ratings to be used as benchmarks in US laws and regulations, because "it was not possible at this time for Dagong to comply with the record keeping, production and examination requirements of the federal securities laws". Dagong refused to comply because it said it would have to remove 'state secrets' from documents requested by the SEC.

So which expert is right? Well, none of them. Moody's ratings software has the ability to run over a million simulations on a given set of assumptions, but part of their problem were errors in the code to say nothing of the information given to them. So investors like jurors at a trial must weigh the word of an expert against their bias and remember that the truth does not belong to any one.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)


Indian stocks to see soft opening: Monday Market Preview

Investors will focus on the quarterly earnings seasons amid signs of a slowdown in the domestic economy

Global cues indicate a soft opening for the Indian market, as the US market closed lower on Friday on a less-than-expected rise in job numbers and fears of the government defaulting on its debt. Markets in Asia were lower in early trade on Monday on concerns that the slower growth in the world’s largest economy would impact exporters in the region. The SGX Nifty was down 13 points to 5,651 compared to its previous close of 5,664.

The market fluctuated between losses and gains last week, mainly on global cues. While positive economic indicators from the US kept hopes of the global recovery alive, the Moody's downgrade of Portugal's bond rating to junk capped the gains. The market ended the week with a gain of 1%.

On Monday, the market recorded modest gains, riding on the news of robust US manufacturing data for April. The indices settled lower on the next two days, on concerns over the downgrade of Portugal's bond rating. On Thursday, the announcement of a decline in the weekly food inflation numbers helped the market overcome negative global cues. However, the indices gave up more than half of those gains on the last trading day of the week.

Overall, the Sensex closed the week up 95 points at 18,858 and the Nifty put on 33 points at 5,661. The Nifty, which has been trading above the 5,600 mark all week, is expected to move between 5,600 and 5,800 over the next few days.

Wall Street closed lower on Friday on a less-than-expected rise in employment numbers for June. Non-farm payrolls rose only 18,000, according to data released by the Labor Department. The unemployment rate climbed to 9.2%, the highest since December 2010, from 9.1% in May. However, earlier data like retail sales figures and a rise in manufacturing numbers kept hopes alive. Investors are now tuned to the earnings season which kicks off this week.

The Dow declined 62.29 points (0.49%) to 12,657.20 at the end of trade. The S&P 500 fell by 9.42 points (0.70%) to 1,343.80. The Nasdaq closed 12.85 points (0.45%) lower at 2,859.81.

Lower-than-expected jobs data released by the US Labor Department on Friday and the Chinese monthly inflation data announced on Saturday weighed on the Asian markets which were trading lower in early trade on Monday. The lingering debt crisis in Europe also added to the woes.

The Shanghai Composite fell 0.54%, the Hang Seng declined 1%, the Jakarta Composite was 0.34% lower, the KLSE Composite lost 0.49%, the Nikkei 225 fell by 0.48%, the Straits Times declined 0.87%, the Seoul Composite fell by 0.89% and the Taiwan Weighted was trading 0.95% lower in early trade on Monday.

Back home, Reliance Industries (RIL) has said that it was not being given enough time to respond to the Comptroller and Auditor General’s (CAG) observations on KG-D6 gas fields.

In a letter to the petroleum ministry, RIL senior vice president (commercial) B Ganguly stated that the time CAG has allocated to the company at the 12th July Exit Conference that will conclude the audit of RIL’s KG-D6 field cost, was ‘far too inadequate’ to answer issues raised in the audit.

Previously, the company’s executive director PMS Prasad had written to the oil secretary that CAG neither discussed finding mentioned in the draft report with RIL, nor did it raise them at the 4th June brief interaction the auditor had with the company.


Govt allows fertiliser cos to fix DAP prices

The removal of restriction would boost domestic supply of DAP in the ongoing Kharif season as the fertiliser companies are free to pass on high global prices to consumers

New Delhi: The government on Friday notified the Cabinet decision to allow fertiliser companies to fix the retail price of phosphatic (P) and potassic (K) nutrients such as DAP but asked them to keep the rates at 'reasonable level', reports PTI.

In April, the Cabinet had allowed firms to increase DAP price by up to Rs600 per tonne over and above the maximum retail price (MRP) of Rs10,750 a tonnes prevailing then.

"The market price of subsidised P and K fertilisers including DAP will be open and will be fixed by the fertiliser companies at reasonable level," the fertiliser ministry said in a notification issued yesterday.

Under the nutrient-based subsidy (NBS) regime introduced from 1 April 2010, the retail prices of 22 varieties of P & K fertilisers have been freed. For the 2011-12 fiscal, government raised NBS of P&K fertiliser to insulate companies from high global prices, but restricted them from hiking the MRP beyond Rs600 a tonne.

"The restriction was against the objective of the NBS policy. Last week, the Cabinet gave approval to remove the anomaly in the NBS policy to free P&K fertiliser prices completely," a senior fertiliser ministry official said.

The removal of restriction would boost domestic supply of DAP in the ongoing Kharif season as the fertiliser companies are free to pass on high global prices to consumers, he said.

At present, there is short supply of DAP and other P & K fertilisers as the companies have been shy of importing them due high global prices.

While the companies are entitled for import subsidy on the benchmark price of $612 a tonne only, international prices are ruling high.

According to the notification, the fertiliser companies will be required to print MRP on each fertiliser along with applicable nutrient-based subsidy per bag.

Any sale above the printed MRP is punishable under the Essential Commodities Act, it added.

The annual requirement of DAP in India is about 11-12 million tonnes. Over 8 million tonnes is met through imports from Morocco, Jordan, China, the US and the rest is produced indigenously.


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