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Weekly Digest (Economics, Finance and Banking) 16 August - 22 August 2016


The f(ph)antastic is not an escape from reality, but an opening up of new realities, of new forms of social, political, and visionary modes of being toward reality. Reality is not a cage for thought and feeling, not a prison house within which the rich and powerful can command and control the feedback loops of some industrial mediatainment complex and thereby the vast populations of the world. No. The fantastic is about subverting these vast systems of power and control that seek to keep us ignorant and asleep in a world of consumption, slaves to our desires for more and more and more. The earth does have its limits and we will confront them willy-nilly whether we like it or not. The corrupt world that capital built is falling apart at the seams and the writing is on the wall of what is coming with climate collapse and the depletion of our earth’s natural resources. We must discover new ways to meet these challenges and being able to navigate the real with a larger symbolic order based on an open and unfinished vision of the world and universe is what the fantastic is about. It offers nothing more than a way out of our present predicament, an exit into reality rather than a closure in the hell hole of modern neoliberalism’s dark fantasia of an austere hell of debt and poverty. ‘Otherness’ is all that threatens ‘this’ world, this ‘real’ world, with dissolution: and it is this opposition which lies behind the several myths which have developed in the modern fantastic. Behind the modern fantastic is both a spiritual and political struggle to replace cultural life with a total, absolute otherness, a completely alternative self-sustaining system. The sense that the global order within which humans live and work is a false order, a symbolic order that has them enslaved like zombies in a movie unable to do anything but consume more and more of the products of an illusionary world. The dark fantastic returns us to the hinterlands of freedom, of the wilderness outside the control of the prison keepers of the current global system. It hints at another realm where one can become one’s true self, one’s other more dangerous and non-utilitarian self, and an outlaw and renegade to the current Reality system of governance and control. Those who police the Reality Matrix hunt down those who seek escape and lock them away as insane or criminals of the civilized world. Yet, some ride that hedge, that fence between two-worlds like masters of chaos, and bring back out of the abyss images of freedom, bits of information that helps awaken the sleepers of Time from their long sleep. It is to these that the dark fantastic calls… to those willing to dare all, to follow their minds and hearts into the chaos just this side of madness… out there where one becomes one’s Other…

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Some days back, a friend, Maju asked a question on Ratings Agencies (RAs hereafter), and if there is anything viable or subsequently pliable of these? So, this is a delving into the world of RAs, with a due note of caution that the piece is liable to technical morass. I don't think I can help emaciate that, and so readers not too glued to technicalities can happily "skip" this. Another caveat here is the number of loose ends rooting and branching out to nowhere, or rather everywhere, for, the political of the neoliberal is an all-encompassing compass far larger than adherence to revolutionary struggles of the peripherals, and rooted in nodal points and events that bring such thoughts to fruition in the first place. RAs' political economy ties in perfectly with the neoliberal and financialisation of capital in stitching these loose ends. So, it is time to go back to man is the political animal (Reasoning) of Aristotle from the present-day cow is the political animal of scores and scores (Pun intended!)....

Public Finance Public Accountability Collective (PFPAC) Weekly Digest (16 August - 22 August 2016)​ 

Ratings Agencies Part 1
(Part 2 would be separate from Weekly Digest and released before next Monday)

Lets begin with indemnities, the technical parlance for insurance, wind and wade through probabilities and reach a designated 'credit police', for this is where historical roots of RAs lie. Edmund Halley (Yes, the same astronomer giant credited with the eponymously-named comet!) in 1693 is credited with publishing the first-ever mortality tables based on the parish records for the Polish-German town of Breslau showing a mortality rate of 1 in 30 every year. These figures corroborated to a setting aside of a thirtieth of a company towards life insurance and annuities, whereby anyone investing in to this fraction by a company would be a policyholder, a member of the population subject to patterns of death and disease, and measured, averaged and thus risk-managed. Below is the original table that Halley came out with. 


​Now, if an insurance company brought together a large enough pool of policyholders, individual uncertainty was almost magically eliminated, so long as the actuary did his math correctly. The math isn't really subjected to individual vagaries, but culminates in an objective reality, an often debated and nuanced extreme of statistical probability theory based on data analysis. So far, so good. But, how does this augur with banking and finance?  Analogising the death-disease parametric of insurance with bankruptcy and default of banking and finance, there is a relationship of equivalence to be drawn here. Just like insurance is subject to probability over long periods of time, a bank with a loan portfolio is played upon equivalently by probability over long periods of time, and both of these draw parallels in alleviating anxieties, or eliminating risks. 

Jumping over from insurance. There is a catch here. Actuaries could potentially be instrumental in reducing risks or anxieties through their mathematical genius, but would that mean a trade-off with risk assessments, or due diligence as the latter is gaining currency? As in the case of insurers, who would require a bonafide 'health certificate' before bestowing policies, banks too would require such certification (at least ideally that is how it is supposed to work). Enter "Credit Police". As Nicholas Dunbar in his The Devil's Derivatives says of them: these might be the credit officers at a bank or, more ubiquitously, a credit ratings agency paid by the borrower to provide them with "health certificate". Instead of an actuary counting deaths, lenders can turn to a RA to count defaults and crunch the numbers. 

This brings us to the definition of RAs: Rating agencies, or credit rating agencies, evaluate the creditworthiness of organisations that issue debt in public markets.  This includes the debts of corporations, nonprofit organisations, and governments, as well as “securitised assets” - which are assets that are bundled together and sold as a security to investors.  Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organisation will be able to repay both the principal and interest as they become due. 

The first ratings agent (credit police) in the world is often considered to be a financial journalist, who went by the name John Moody, whose interests in the American railroads in the earliest part of the 1900s led him analytically to opining on uncertainty on bonds, wherein all it required was scouring public records in determining what was really owned and how was it being performed. But, there seemed to be a parallel action in the form of Henry Poor's firm that had been doing something similar fifty years before Moody sprang on to the scene. But, what really distinguished Moody from Poor and made the former a credit police was categorising the companies into creditworthiness. These categories is what is almost followed universally even today, and were alphabetically-based. 3 As (Triple A) was the elitist of these categories with a credit standing to the mighty USA itself. This was followed by 2 A (Double A), 1 A or just A (Single A), and B (similar sub-divisions), C (similar sub-divisions) and finally D, or Default. But, Moody drew another distinction, viz. Bonds above Ba rating were called investment grade, whereas below Ba were termed speculative grade. It is to be noted that investment graded-Bonds have a minimal risk of default, whereas speculative grade issue or issuer ratings are all ratings below BB+ or Ba+ included, down to CC-. Speculative grade or sub-investment grade issues can be considered "less vulnerable in the short run but face major uncertainties and exposures to adverse business, financial and economic conditions" (BB) or "subject to substantial credit risk" (Ba), to "a marked shortcoming has materialised" or ’typically in default’ (C). Speculative grade ratings are also called junk bonds. Moving on, what Moody did was sort sheep from the goats, in that, he promulgated investment grades as having a less chance of defaulting compared to speculative ones, and sold his bond ratings via a subscription newsletter winning trust through his analysis. 

So, how does statistics/probability that tames uncertainty also quantify and qualify the loss? Dunbar makes a compelling argument. A portfolio of bonds of a particular grade would need to pay an annual spread higher than that of a risk-free cash investment, to compensate for the average default rate for bonds. In the same way that life insurance premiums vary according to the age of the policyholder, there is a credit spread for a particular rating of a bond - so, for example, bonds rated Baa by Moody's should pay about a quarter of a percentage (Caution: pdf) in additional interest to make up for expected defaults over time.  If you make it your business to lend money to a large number of Baa-rated companies, then on average, over time, your business will theoretically break even - as long as you charge these companies at least a quarter of a percent more a year than the loan rate enjoyed by the Government. Investment grade companies re happy to pay this premium in return for borrowing money, and the spread earned on corporate bonds or loans is typically a multiple of the statistical default loss rate. Such actuarial approaches work if investments are not given up on prematurely. Moreover, default rates could fluctuate year-to-year even under the consideration of the stability of long-term average, but helps in riding out a recession by waiting for the good loans in your portfolio balancing out the losses over time. This is where RAs get political, for the actuarial approach set forth by them is through the cycle to describe their ratings, to legitimise their analysis, to reassure the implication  that their actuarial approaches were recession-proof.  

This political toning isn't really a theoretic, as journeying back into history has ample attributions to elevating RAs in tune with their stellar reputations to a sinecure by US regulators. Forwarding by six decades, the integrity of these RAs twisted from charging investors to charging issuers. As the value of the rating agencies derives from their reputation for independent credit analysis and reporting, the issuer-pay model poses definite problems for independence, at least in appearance, starting with the questions of partiality. The perception of such potential conflicts of interest may partly explain why S&P did not choose to follow Moody’s and extend its issuer-pay model to corporate bond issuers in 1970. At the time of Moody’s announcement, S&P declared, "the income from the publications that carry our ratings and the expansion of our commercial paper rating activity enable us to provide corporate bond ratings without charge at this time". Moody’s and S&P’s ability to successfully implement an issuer-pay model reflects their market power and reputational capital. However, when the SEC (US Securities and Exchange Commission) recognized Moody’s and S&P as Nationally Recognized Statistical Ratings Organizations in 1975, this directly increased the regulatory use of credit ratings and gave the two agencies enormous power and prestige (Cantor and Packer, 1994; Partnoy, 1999). Very likely, this designation also made the issuer-pay model sustainable. Although many technological and economic factors led to the switch from investor-pay to issuer-pay fees for credit ratings three decades ago, the question of whether this revenue model is associated with actual conflicts of interest remains an empirical one. Recent rating down- grades for bonds rated Aaa prior to the financial crisis have led some to speculate that the issuer-pay model has weakened rating agencies’ due diligence and led to poor quality ratings. Both Congress and the SEC have considered ways to change the issuer-pay model. Although the newly passed Dodd–Frank Wall Street Reform and ConsumerProtection Act does not address the issuer-pay model, it requires the Government Accountability Office to prepare a study of alternative ways of compensating rating agencies. It also asks the SEC to adopt new rules concerning the conflicts of interest that arise from rating agencies’ sale and marketing practices.

In light of the above controversy, rating agencies contend that their concerns for reputation discourage them from engaging in any short-term opportunistic behavior. Indeed, Moody’s claims, ‘‘We are in the integrity business’’, and S&P takes it one step further, claiming, ‘‘Our reputation is our business’’ The SEC concurs: "The ongoing value of a rating organization’s business is wholly dependent on continued investor confidence in the credibility and reliability of its ratings, and no single fee or group of fees could be important enough.".......

But, what of countries? How are they given sovereign ratings and why should they even matter? Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country. More governments with greater default risk and more companies domiciled in riskier host countries are borrowing in international bond markets. Although foreign government officials generally cooperate with the agencies, rating assignments that are lower than anticipated often prompt issuers to question the consistency and rationale of sovereign ratings. How clear are the criteria underlying sovereign ratings? Moreover, how much of an impact do ratings have on borrowing costs for sovereigns? These are the questions to be taken up in Part 2 to be released later this week...... 

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