AAA ratings - 10 little indians...and debt deflation (why Irving Fisher is right).

The title of this post is a refence to the wonderful book by Lady Agatha Christie written in 1965, as there are only 15 countries left in the world with AAA rating at Standard and Poor's, and four from the G7, Germany, France, United Kingdom and Canada.

In my previous post, "AAA, the most endangered rating, regulating the rating agencies and Basel III", In June 2010, I was expecting more downgrade to come. I am not going to go through the analysis made in relation to the much needed regulations of the rating agencies as I did it in the post mentioned above. In relation to my well founded critics of the rating agencies, I also discussed how the rating agencies behaved in 2008 and 2007 in the following post: Markets and Macro Update - Dude where is my Risk?

The downgrade of the mighty USA by S&P to AA+ is a significant event because it can have significant consequences if S&P follows up with Germany, France and Italy. It could in effect, destabilise completely the EFSF funding vehicle and render it powerless if Germany, France and Italy gets dowgraded.
So, have we crossed the Rubicon?

As a reminder from my post "Europe, The end of the Halcyon days", this is the amount owned to Germany:

European debt map:

European countries cross border exposure:

In November 2010 in "The European Vortex" post, I went through the analysis of the EFSF. I stated at the time:
"There is 440 Billions Euros available (probably less given its similar resemblance to a CDO structure). Clearly not enough to bail out everyone. If the EFSF wants a AAA to issue bonds to fund the oncoming bailouts, it will need to overcollateralize to 120% and maintain a cash buffer. It cannot lend against backing of troubled nations. The more countries in trouble, the smaller the pot available for bailing out countries in trouble, simple as that. Given Austria is witholding already its funding for Greece, the entire unity of the European Union is being tested."

Therefore, it S&P follow up on the downgrade of the USA and start downgrading the core members of the EFSF structure, such as Germany, France and Italy, the whole structure is in trouble.

The EFSF mechanism:

The reserves held by the EFSF needs to be invested in AAA paper.

I previously argued that "a way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided there is a haircut on the existing peripheral debt". The latest proposed plan for Greece involves small haircuts, bond buy backs, reduced coupon and maturity extension as well as debt swaps, but so far no mention of Euro Bonds. Time is running out and we need decisive action from European politicians.

The economic picture for the US is already bleak, and the downgrade of the US, will indeed raise the cost of funding, not only for the US as a country, but for the banks and agencies, as you can expect, some rating actions following this decision by S&P.

In past crisis when Velocity dropped significantly, recession occurred, as I posted in "Nightmare on Main Street - The impact of the rise of energy and food prices on US Households".

And velocity is dropping, confirming we are heading for a double dip in the US. In the monetarist theory deflation is associated with a fall in the velocity of money. We are in a credit deflationary environment, comparative to the Great Depression and Japan.

Irving Fisher's theory has been largely ignored by our keynesians friends at the FED. It is of no surprise given that Ben Bernanke largely ignores its influence and wrote in 1995:
"Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects."
Ben Bernanke is wrong.
"Bernanke's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium – in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading."
Ben Bernanke also added in 1995 about Fisher:
"Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties."
For Keynesians, the fall in aggregate demand caused by falling private debt can be compensated by growth in public debt, a government credit bubble. It isn't working.
Here comes Irving Fisher solution for the debt deflation situation - Forward Tax Receipts.

Forward Year Tax Receipts

"Recognizing that the federal government issues liabilites (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired."

For those interested in the subject, I encourage you to review the post "The inflation debate or why you can have inflation in a deflationary environment" on the subject of the Austrian Business Cycle theory and Fisher's contribution to the debate.
"Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio of Bridgewater Associates, who suggests it as the template for understanding the financial crisis of 2007–2010."

In the post "Low rates environment and the risk of evergreening à la Japanese", I described the following:
Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."

I can see a solution for the US deflation thanks to Irving Fisher equation of exchange.

Low rates environment and the risk of evergreening à la Japanese

In this new environment, corporate balance sheets appears to be in outstanding shape whereas banks balance sheets still appears to be bloated with toxic assets (non-performing loans).

This is can be reflected in the massive divergence between the Itraxx 5 year CDS Main index in Europe (125 CDS names) versus the Itraxx Financial Senior 5 year index:

As you can see the spread is now at around 62 bps between both indices.

UK Banks sub debt is as well following the trend for wider SUB CDS 5 year spreads, as of the 12th of December as indicated below:

As illustrated below, some corporate CDS 5 year spreads are tighter than both sovereign as well as banks senior CDS spreads, in this example, large European Chemicals versus Banks Senior 5 year CDS spreads:

It is interesting to see that Rabobank being one of the only AAA rated bank in the world, is trading wider than single A rated BASF as well as Dow Chemical currently rated BBB- by S&P, the lowest investment-grade rating.

Reason being is the following, corporate leverage has continued to decline in the third quarter of 2010, approaching its lowest level in two decades. In addition to this, large corporations are sitting on very high level of cash. They have been hoarding cash.

U.S. companies are hoarding almost 1 trillion USD in cash!

As per Reuters:
Cisco Systems (CSCO.O) has the largest cash balance, at 39.86 billion USD, Microsoft (MSFT.O) is second with 36.79 billion USD according to Moody's. Google (GOOG.O) has the third-largest balance with 30.06 billion USD, followed by Oracle (ORCL.O) with 23.64 billion USD and Ford Motor Co (F.N) at 21.89 billion USD.

Technology companies held the most cash as a sector, at $207 billion, followed by pharmaceuticals with $124 billion, energy at $105 billion, and consumer products with $101 billion, Moody's said.

They are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty.
Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet.

These are effects you can see in a balance sheet recession as I posted earlier in "Honey I shrunk the balance sheet"

The deleveraging process will take years.

In relation to the title of the post, in the latest speech of the Governor of the Bank of Canada (thanks TPC for posting the link on your site pragcap.com), Mark Carney clearly highlights the risk of a prolonged low rates environment and the risk of creating asset prices inflation (a must read):
http://www.bankofcanada.ca/en/speeches/2010/sp131210.html

"Past experience has shown that low policy rates allow “evergreening,” or the rolling-over of non-viable loans. The classic example was Japan in the 1990s when banks permitted debtors to roll over loans on which they could afford the near zero interest payments but not principal repayments. By evergreening loans instead of writing them off, banks preserved their capital, but this delayed necessary restructuring of industry. Moreover, the presence of non-viable (or “zombie”) firms limited competition, reduced investment and prevented the entry of new enterprises."

Spot on Mark Carney! What crucified Japan in its lost decade were its zombie banks evergreening their toxic assets. It is better to restructure and fast. As I blogged about Ireland in September (Zombieland 2...The sequel...), Ireland is impaired by its zombie financial system.
In relation to the current predicament of US banks, I have argued as well the need for a new Resolution Trust Corporation (RTC II), similar to the one established following the Savings and Loans Crisis in the nineties.

What is as well outstanding from the speech from the Governor of the Bank of Canada is how well Canada has managed its financial sectors using strong regulations and using "selected use of macro-prudential measures" as a third line of defense. I hope the FED and Bank of England are taking notes. Outstanding work. Canada is indeed Canada, a great exemple of successful structural reforms and efficient banking regulation.

"In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation. Importantly, following the agreement of G-20 leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this framework."

The role of Central banks as so clearly illustrated by Canada should be extended to prevent the creation of credit bubbles. Alan Greenspan, Ben Bernanke please read carefully, you might learn something...

"In the housing market, the Canadian government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner."

As a reminder about the Austrian Business Cycle Theory:

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory


"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

Quod erat demonstrandum

In the post "The inflation debate or why you can have inflation in a deflationary environment", I reviewed the Austrian Business Cycle Theory in conjunction with Fisher's formulation of debt deflation and the following chain of consequences.

Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867
I used this quote in "Creative destruction and the Minsky moment" in May 2010, at the start of the Greek sovereign crisis.

Financial fragility levels move together with the business cycle.

In relation to banks current conundrum with their impaired balance sheets bloated with toxic assets, Mark Carney stated in his speech: "For example, over the past year and a half, banks have used low short-term funding rates to rebuild capital by investing in long-term government bonds. This strategy is effective to a point, provided complacency does not set in over the duration of low policy rates. Making consistent positive carry may diminish the sense of urgency with which banks reduce leverage or write down bad assets. Financial institutions may also take this game too far, underestimating the risks."

It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery.

I will conclude this post quoting again the Governor of the Bank of Canada, "a massive deleveraging has barely begun across the industrialised world."

"Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates."

Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.

Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount. How convenient...

I commented previously about the first quarter being the perfect game, the second quarter will be seriously different for Banks profits this time around.

A fast and furious tightening of credit spreads allowed Banks to publish record profits for 2009.

With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard times to reap in similar profits they made in Q1.

As per below's Bloomberg article, Banks are now using the same accounting trick they used previously to boost their profits in a difficult trading environment.

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a3Eg4vzAbneA

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

The capital buffer is shrinking...and the DVA (Debt Valuation Adjustments) are returning with a vengeance.

DVA Gains:

"Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Citigroup Analyst Keith Horowitz’s estimates."

Accounting ‘Abomination’

"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

David Hendler, Senior Analyst from CreditSights Inc. sums it up nicely in the Bloomberg article quoted above:

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,”

Hence the recourse to DVA accounting practices.

When the game is not going your way, just change the rules...

Another nice move from FASB in 2007.

FAS 157 was reviewed in 2009 to allow more flexibility and issued in September 2006.

http://en.wikipedia.org/wiki/Mark-to-market_accounting

"On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.

On April 9, 2009, FASB issued the official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly boost banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates."

Basically, FAS 157 enabled banks to boost earnings in good times and pay themselves record bonuses and suffer catastrophic losses during the credit crisis, generating excessive margin calls on derivatives trades.
At the same time FAS 159 for DVA, enables banks to increase earnings in bad times.

The issue was anyway excessive leverage in conjunction with inappropriate accounting principle FAS 157, which led to seismic losses in US banks. Whereas in Canada bank leverage was capped to around 20 times. The capital buffer was therefore more significant. RBC still boast a AAA Rating.

The shadow inventory of REOs (Real Estate Owned, following rises in foreclosures) is putting additional strains on banks earnings. Inevitable adjustments to interest rates would as well put additional pressure on Banks Balance sheets. The current steep yield environment is helping tremendously banks in shoring up capital, provided their play is short duration (2 to 4 years). The risk is higher for Banks if they start buying longer duration trades on MBS (Mortgage Backed Securities). MBS are more abundant than US treasuries or short term liquid investments and are also offering higher yields as well. The temptation is there...and the risks are real if there is a sudden rise in interest rates.

AAA, the most endangered rating, regulating the rating agencies and Basel III

This title sounds like a warning issued from the WWF, relating to endangered species. Truth is the coveted AAA rating ranks have been seriously depleted by the past and current credit crisis we have been through. We will look at what happened in the corporate sector and as well in the sovereign space as well as the role of the rating agencies given the recent turmoils and scandals, regulations and Basel III implications.

Given the latest downgrade of Spain from AAA to AA+ is the latest in an increasing list given the current deflationary environment and credit situation in Europe, we can expect many more downgrades to come.

First we will look at the decline of AAA ratings in the corporate world:

The link below refers to an article which was published in 2002.

1969: 61 American Companies were AAA
1982: 21 American Companies were AAA
2002: 9 American Companies were AAA
2009: 4 American Companies were AAA

As of October 2009 only 4 remains rated AAA by S&P:

Automatic Data Processing (NYSE:ADP)
Johnson & Johnson (NYSE:JNJ)
Microsoft (NASDAQ:MSFT)
ExxonMobil (NYSE:XOM)


http://articles.sfgate.com/2002-03-03/business/17537097_1_credit-ratings-major-rating-agencies-moody-cash-flows

In 1979, there were 61 American companies that earned a top-level Aaa credit rating from Moody's. Ten years ago, there were 21. Today, there are only nine.

The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality.

"Corporate America has become more risky," says James Van Horne, a finance professor at Stanford's Graduate School of Business. "The triple-A decline is a manifestation of the decay of credit ratings in general."

In the same article, Kathleen Pender also review the list of AAA corporate entities in 2002:

The bankruptcies of Enron, Kmart and Global Crossing are refocusing attention on credit ratings and balance sheets.

"We've always focused on the balance sheet. In this environment, we've been even more focused," says Scott Glasser, co-manager of the Smith Barney Appreciation fund.

Glasser's top 10 holdings include five Aaa-rated companies: Berkshire Hathaway, ExxonMobil, General Electric, Pfizer and American International Group.

The other four Aaa-rated companies (excluding government-backed companies such as Fannie Mae) are Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Service.

In 1979, Moody's list of Aaa companies included 12 banks and insurance companies, such as Bank of America, Chase Manhattan, Chemical Bank and Citicorp.

It also included 25 industrial and consumer-oriented companies, such as Minnesota Mining & Manufacturing, General Motors, Ford, IBM, DuPont, Kellogg, Procter & Gamble, Sears Roebuck, Federated Department Stores and the major oil companies.

The remaining 24 companies were telephone and electric and gas utilities.

"The '80s really gutted the list," says Moody's economist Kamalesh Rao.

We all know what happened to the AAA for banks as well as for GM, Ford and we all know the dire situation of Fannie Mae, Freddie Mac and SLM.

From the same article:

"The major reasons cited for the decline in triple-A companies are deregulation, global competition, debt-financed mergers, bad management decisions and a growing tolerance for risk among investors.

Many banks also got hurt by the collapse of real estate in the early 1990s."

You would think the banks would have learnt from the real estate collapse in the early 1990s following the Savings and Loans debacle.

Does that sound familiar? We are talking about the economic environment of 2002...

The article goes on:

"Money managers are not too worried about the long-term decline in Aaa companies, mainly because the difference between a triple-A and a double-A company is slight.

They're far more concerned about a recent, widespread decline in ratings across the credit spectrum.

"You could do a story on the demise of double-A and single-A companies as well," says Putterman."

http://stocks.investopedia.com/stock-analysis/2009/the-aaa-rated-bond-club-gets-smaller-gexommsft0305.aspx

It is true the reputation of the ratings agencies have been seriously tarnished in the last two years given the evident conflict of interest which came with the business of providing AAA rating to dubious structured credit products.

This is what Bill Gross from PIMCO had to say about the rating agencies and discussion around reforms of their model:

http://www.guardian.co.uk/business/2010/jun/02/european-union-credit-agency-watchdog

"Credit rating agencies have fallen out of favour with top investors. Bill Gross, founder of Pimco, the world's biggest bond investor, recently said: "Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply it."

He added: "I come not to bury the rating services, but to dismiss them. To tell the truth, they can't really die – they serve a necessary and even productive purpose when properly managed and more tightly regulated.""

Truth is all the concerns regarding regulating the ratings agencies were previously discussed and not applied by many authors and Scholars. Below is an example of previous discussions surrounding regulation of rating agencies.


Claire Hill in a paper published in 2004 called Regulating the Rating Agencies

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=452022

"Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable."

The only way to restore trust in ratings, is to remove conflicts of interest which means not an annual certification as suggested above but a review in the way rating agencies operate.
There was a similar issue with Equity Research Analysts during the run up to the Technology bust in 2000. Henry Blodget was barred from the securities industry because of fraudulent activity.

The only way to regulate is to impose accountability to the Rating Agencies, ensuring the risks twart the rewards. If ratings agencies face losing the license of conducting business due to high conflict of interests similar to what we have seen during the build up to the credit crisis, they might do a better job and serve their necessary purpose of independent assessment of credit risk.

Although credit ratings can be a good indicator in measuring the risk of a corporate or country, they always lag the market. Credit spreads and Credit Default Swap (CDS)spreads are better at indicating increased perceived credit risk in issuers.

The implication of ratings downgrade are very important in relation to assessing the risk for financial institutions, when taking into account Basel II regulation. This was particularly the case for structured credit positions in Banks.

http://en.wikipedia.org/wiki/Credit_rating_agency

"Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation."

Because of the need for independent assessment of credit risk, Rating Agencies must be regulated in a way that the ratings which are issued enable investors to trust these ratings and use them as a guidance in their investment.

As well as reviewing the role played by the rating agencies in the financial crisis, it is essential that bank regulation takes place.

Basel III proposed reforms are going in the right direction:

http://en.wikipedia.org/wiki/Basel_III

The introduction of a leverage ratio is essential to avoid the same mistakes which were done. The Canadian banking system had the leverage capped to around 20 times which meant that the Canadian Banks were in a much better situation than their American neighbours when the financial crisis occurred.

The idea of also promoting the build up of capital buffers in good times, is also a very good one.

There is great resistance from the bank to fully implement Basel III as indicated in this article from The Economist:

http://www.economist.com/business-finance/displaystory.cfm?story_id=16231434

If the same idea of capital buffer could be implemented for goverments in relation to public finances, it would be great but given the propensity of our politicians to overspend in good times as well as in bad times, there is a very low probability of seeing it happen effectively.