The opinions of a few people in a small number of credit rating agencies (CRAs) dictate the operations of a significant part of the global debt markets. As debt markets rule the financial markets, this is a very powerful position and comes with great responsibility. Yet CRAs are free to provide whatever opinion they decide. Whilst I have no problems with CRA freedom to provide opinion, as we’ve seen on many occasions, these opinions have been unreliable at times with great cost to many.
The real issues with CRAs are not the opinions per se but revolve around how the debt financial markets work and how regulation has entrenched an uncontrollable oligopoly. Financial markets are highly dependent on CRAs to maintain liquidity and operate in any sort of timely fashion.
Most wholesale debt raisings for the world’s governments, banks and corporates happen by the issue of securities or bonds in the global debt capital markets. Investors in the main are able to buy and price securities using credit rating opinions such as AAA, AA, A, BBB etc. AAA is meant to be of the highest quality with the decending grades representing lowering grades of credit risk, although there is actually no clear definition of what AAA means.
Securities and bonds are priced for credit primarily on the rating opinion except for a few notable exceptions. A few countries like the USA and Japan do not rely on ratings for both demand and pricing because other factors are at play. Australia, however, is not in the exception category.
Investors and traders in debt capital markets need a benchmark credit assessment in order to buy or sell on a timely basis as no two debt security issuers are the same, not just in base credit assessment but in the structure of the security being issued. With the volume of issuance and secondary market trading occurring in the markets it’s not possible for most investors to be able to, or have the time to, do their own detailed credit risk assessments. This situation is strongly reinforced by regulation, which in most jusrisdictions, including Australia, investment criteria and capital calculation rules requires the use of CRA opinions, sometimes exclusively.
Thus CRA opinions are a necessary cog in the markets machinery and provide credit risk benchmarks for them to operate in an efficient way. However, CRA opinions are fallible, as we’ve seen, and weaknesses need to be identified and highlighted if systemic problems are not to arise.
Regulators in the US, UK and Europe are recognizing the weaknesses and over reliance on CRA opinions. There is now a movement to remove references to CRAs in regulation in favour of the use of different types of methodologies including CRA opinions. The US Comptroller of the Currency has a detailed legislative proposal now on the table. Most regulatory changes in this area are still on the drawing board.
The ability of the Australian government and banks to raise funds in the international debt capital markets is heavily reliant on credit rating opinions. So what’s the problem? The problem is how regulation has entrenched the CRAs in the system and how that situation has distorted the markets for some Australian issuers at the ultimate cost of most Australians.
CRAs in Australia are regulated by ASIC and in accordance with international standards CRAs must comply with the IOSCO Code of Conduct standards.
For CRAs, a number of other ASIC regulatory requirements came into effect in 2010. There is nothing I can critisize about what’s in the IOSCO Code of Conduct or the ASIC Regulatory Guides. Rather, it’s the issues that are not addressed that are causing distortions and weaknesses in the system of providing credit ratings.
The issue that is not addressed is internal consistency of ratings and the need to explain inconsistency of opinions by CRAs. Actually the code of conduct and regulatory guidelines of creating Chinese walls between different divisions and analysts within CRAs are part of the problem and the cure.
In my last post, I identified the distortion caused by CRAs in recognizing the “externality”, that is the implied Australian government guarantee of Mega Bank, in providing rating opinions of Mega Bank. The Government, the regulators and Mega bank do not formally recognize the “externaility”, yet the CRAs explicitly in their opinions recognize the existence of the guarantee. Statements from the CRAs after the budget again recognized the importance of the “externality” in their opinions. S&P were perhaps the most direct.
All of the CRAs have expressed the opinion that Mega Bank is rated two notches above where it would be without the externality to ensure that the ratings of all CRAs are in the AA- zone, a very important zone for debt capital market investors. Yet Australia is rated AAA. Where does the two notches come from? There should be a requirement for a detailed explanation of the uplift in rating, especially since there is a regulatory requirement to rely on the rating in making investment decisions. The detailed explanation requirement would put focus on the reality of the “externality” and perhaps then put pressure for there to be some accountability.
The bigger issue, however, is the CRAs rating of Australia. There is no doubt that the “externality” is real. Distinguishing between Australia’s balance sheet debt and private debt on Mega bank’s balance sheet without formal recognition of the total liabilities of the government whether contingent through the guarantee or otherwise in providing a rating opinion is just very poor risk assessment.
The situation is being played out now behind closed doors. Clearly a primary driver of the strive for a surplus, is the “externality”. For mine though the horse has bolted and the surplus tactic flawed for the Australian taxpayer.
At this stage, the reader may be concluding that I’m attacking the AAA ratings that Australia has received. I’m not. I’m attacking the lack of consistency in CRA opinions that may protect their business models and paying clients but provide a distortion in the debt markets. This distortion is allowed to have a significant effect on the amount and price of Mega bank’s debt because of the global regulatory requirements to have credit rating opinions.
The lack of direct accountability for the “externality” through including Mega Bank’s debt on the government’s balance sheet has allowed Mega bank to raise funds in international markets in greater volume and at a lower price than it would have. Mega bank would have been required to maintain much higher capital levels in order to achieve their current ratings and therefore the same funding result.
The excess credit has almost exclusively been pumped into mortgages. The amount of excess credit is not just the funding sourced from offshore. The offshore funding has firstly funded the current account deficit, but secondly has allowed Mega bank to create deposits which are then also pumped into residential mortgages. The amount of funds injected from offshore allows the banks to create funds available for lending as a multiple of the original injection through the process which I have previously termed, mortgage rehypothication.
Undoubtedly the credit expansion benefits most homeowners whilst it continues. It also benefits permanently many former homeowners that cash out during this process.
The problem with the excessive expansion of credit is that funding into residential mortgages for existing housing is a non-productive purpose and repayment of those mortgages must eventually be generated through other productive means than the investment in housing. Conversely, this huge investment into non-productive purposes decresaes the opportunity to invest into productive purposes which would support the generation of income needed to repay those mortgages.
To date the mining boom has not generated the income required to support Australia’s foreign debt. It’s also far too concentrated in benefits to provide enough income support for the domestic funding of Mega bank’s mortgage book which is bloated by the existence of the “externality”.
At some point under this system a ceiling is reached which stops the growth because the true risk levels are recognized by both borrowers and lenders.
The primary factor that has kept the system revolving is the expansion of borrowing by the Australia’s governments and Mega bank. A large driver which allowed an inflated level of debt is the distortion, inconsistency and lack of explanation of the effect of the “externality” by CRAs in providing the credit rating opinions on both Australia and Mega bank.
We are now seeing the effects of slowing credit expansion or disleveraging with the slow melt of house prices over the last year or so. The government in its efforts to maintain the status quo is driving for a surplus. Whilst a surplus will have the desired effect on the balance sheet it will undoubtedly reduce the amount of additional funds entering the private sector, thereby supporting disleveraging.
Whilst my opinion is that the process of disleveraging and ultimately deleveraging is now unstoppable, it’s remarkable that the opinions of a few relied upon by many have been an important part of the system that created this trap for Australians.