19 July 2011

Moody's Blues

The last couple of weeks were interesting, not just for the obvious Guardian taking down the Evil Empire but also, for rating agencies asserting their role to protect the global finance capital.

It began with Standard and Poor warning that rolling over the Greek debt will be treated as a technical default because it would give investors less than the maximum they hoped to gain by lending to Greece.

It continued with Moody's it's-the-fourth-of-July-but-this-can't-wait decision to downgrade Portugal debt to junk. Which was countered with this timid statement by the mighty European Commission:
"The timing of Moody's decision is not only questionable, but also based on absolutely hypothetical scenarios which are not in line at all with implementation," said Commission spokesman Amadeu Altafaj.

"This is an unfortunate episode and it raises once more the issue of the appropriateness of behaviour of credit rating agencies."

Commission President Manuel Barroso added that the move by Moody's "added another speculative element to the situation".

He also said it was strange that none of the ratings agencies were based in Europe.
"[This] shows there may be some bias in the markets when it comes to the evaluation of specific issues of Europe," he said.
No kidding.

Then, EU's largely powerless Parliament voted to place some restrictions on naked credit default swaps. And got promptly chastised for its efforts by the Alternative Investment Management Association
The Alternative Investment Management Association, which represents hedge funds, has warned that a naked CDS ban could “push up government borrowing costs.”
Le Monde had a blog post that criticized rating agencies for lack of credibility and transparency and having a terrible sense of timing. But then turned around and decimated the European governments for "attacking the barometer for bad weather" or words to that effect.

Then on 12 July Moody's downgraded Irish debt to junk status.

And on 15 July Standard and Poor decided to influence the budget deficit talks in Washington by announcing that there is a 50-50 chance that the Triple A bond status of the US will be downgraded in the coming months.

Why Are They Doing This?

Despite what you may be reading in papers (like the Le Monde quote mentioned above) rating agencies are not impartial organizations, they are agents of bondholders and creditors. And their main purpose is to ensure that the interests of these bodies are defended at all times.

Sounds rather cut and dry and a tad old school Marxist, doesn't it?

Let's take a closer look to see if I exaggerate.

The genesis of the bond market was in Renaissance Florence. Everyone knows that the Medici family and others created the modern banking system and made capitalism possible. One of their innovations was the creation of bonds as a way to pay for continuous medieval wars. This way, people of Florence would "invest" in their principality and receive interest payment as compensation. As these bonds were considered liquid assets, they were bought and sold outside the state-citizen/investor setting, that is, in the bond market.

Through this simple mechanism, the bond market became the most important structure within financial capitalism. It sets not only the basic interest rate within an economy but it also prices the sovereign debt in terms of its risk factor. Since the states are medieval creations (remember Weber's definition of state as the legitimate monopoly of instruments of coercion) and had warfare (or national defense and national security, if you like) as their original job description, bonds established the link between political power and economic power.

If you are curious about this interesting relationship, take a look at this clip about the emergence of the bond market. It is highly instructive, not only about how bond holders limit political power and affect the outcome of wars but also about the rise of pervasive antisemitism in Europe.

In any event, the nature of this transaction means that, the state has to make sure that the value of the bond remains constant: if it got devalued, the state would be unable to borrow anymore and it would lose its ability to wage wars.

This is why, inflation has been such a huge priority for all states. Despite pronouncements to the contrary, the state's concern about inflation has nothing to do with the purchasing power of its fixed income citizens but everything to do with the repercussions of such an eventuality in the bond market.

Besides making sure that its debt remains valuable, the state also has to make sure that confidence in their ability to repay what they borrowed remains high.

Enter the rating agencies. Such agencies are not neutral referees mediating between two parties. They are watchdogs for bondholders. They rate sovereign debt and set risk pricing for it. They intervene in state policies and actions, not because they want to promote a stable or prosperous economy, but because they want to ensure that the sovereign debt remains valuable.

In recent times, these agencies expanded their role beyond this watchdog function and they began assisting large financial institutions (funds and banks) invest large sums. Since their biggest asset was their ability to price risk factor, to facilitate large investment they started lying about the specific risk factor. This is how, they  stamped their coveted AAA rating on toxic assets.

This is how Iceland, with a GDP of €.58 billion ended up owing €50 billion. International banks and funds were pushing cheap money with the blessing of these agencies. The recipients of that cheap money prospered by going into an asset buying spree in Europe and by buying an selling assets in crazy real estate deals.

And when international finance asked for their money back, they folded.

This is also how Ireland got into trouble. Again these agencies encouraged the flow of cheap money into the market.  To use that cheap money, Irish banks went into crazy real estate deals, gave money to unthinkable projects and for a short period they prospered by buying and selling assets over and over again.

And when international finance asked for their money back they folded.

Here is the interesting part. Throughout that period, rating agencies gave Irish banks stellar grades. As late as September 2006, Anglo Irish received a A+ rating from Fitch.

Moreover, in September 2008, the Irish government asked Merrill Lynch to assess the situation and advise them:
It would have been difficult for Merrill Lynch’s investment bankers not to know, at some level, that in a reckless market the Irish banks had acted with a recklessness all their own. But in the seven-page memo to Brian Lenihan—for which the Irish taxpayer forked over to Merrill Lynch seven million euros—they kept whatever reservations they may have had to themselves. “All of the Irish banks are profitable and well capitalised,” wrote the Merrill Lynch advisers, who then went on to suggest that the banks’ problem wasn’t at all the bad loans they had made but the panic in the market. The Merrill Lynch memo listed a number of possible responses the Irish government might have to any run on Irish banks. It refrained from explicitly recommending one course of action over another, but its analysis of the problem implied that the most sensible thing to do was guarantee the banks. After all, the banks were fundamentally sound. Promise to eat all losses, and markets would quickly settle down—and the Irish banks would go back to being in perfectly good shape. As there would be no losses, the promise would be free.
Basically, Merrill Lynch told the Irish government that confidence is the most important thing in the eyes of bondholders and rating agencies and consequently, they should back the private debt as a way to bolster the bond market's confidence. And the Irish government, believing the neutral, impartial nature of the advice and the omnipotence of bondholders, agreed to do that.

Overnight, the Irish taxpayers became €100 billion poorer. The irony is rich considering this:
Not long ago I spoke with a former senior Merrill Lynch bond trader who, on September 29, 2008, owned a pile of bonds in one of the Irish banks. He’d already tried to sell them back to the bank for 50 cents on the dollar—that is, he’d offered to take a huge loss, just to get out of them. On the morning of September 30 he awakened to find his bonds worth 100 cents on the dollar. The Irish government had guaranteed them! He couldn’t believe his luck. Across the financial markets this episode repeated itself. People who had made a private bet that went bad, and didn’t expect to be repaid in full, were handed their money back—from the Irish taxpayer.
The irony is even richer as these same agencies are no longer accepting even a simple roll over of the Greek debt. They want full profit payment of every cent invested. Not just the principal invested, but the all of the expected profit as well. That is because, they realized that, no government has the power to punish the financial institutions. When they say, jump, everyone says, how high. They brought down the US economy (by setting the same cheap money casino). They brought down half of the European economies and I am sure, as we speak, they are setting up the same cheap money casino in one of the emerging Asian economies.

Yet, they were bailed out in all situation (except Iceland) and now they are so emboldened that they demand that risk pricing should be ignored and they should be given everything they hoped for when they invested.

And to ensure their extortion works, they go beyond the Greek economy (which is something like 3% of the Eurozone) and threaten, Portugal, Spain, Ireland and Italy.

The idea is to make EU leaders feel the pressure and do what the Irish did, that is, guarantee the Greek debt, perhaps by converting that into a Euro bond (implicitly backed by Germany).

They are being told right now, that if they did that the bond markets will be reassured, confidence will be restored and everything will be all right.

The European governments should simply tell the "investors" that these bonds were risk-priced and they should no longer expect to get as lucky as they did with Ireland. And that they will get a hair cut regardless.

If they don't they will pay such a huge price that it will dwarf the Irish scenario.

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