Wednesday, 27 February 2013

The madness of Moody's

Moody's is mad.

Not because of the UK downgrade, ridiculous though that is. Downgrading a sovereign currency issuer is simply silly. The Bank of England is the "buyer of last resort", so there is zero risk of the UK defaulting on its debt. And as FT Alphaville pointed out, downgrading a country because of the possibility of inflation breaks Moody's own definition of "default". Yes, bond-holders may be paid back in currency that is not worth what it was when they bought the bonds. But that doesn't mean they haven't been paid. "Soft" default, in Moody's definition, is not default. And anyway, inflation wasn't the risk that Moody's identified. The reasons given for the downgrade were poor growth and delayed fiscal consolidation:

"The key interrelated drivers of today's action are: 
1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish  growth which Moody's now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament; 
3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016."

For a currency-issuing sovereign, none of those in any way increase the likelihood of default. Therefore the UK's downgrade on Friday 22nd February was meaningless. Markets reacted immediately - sterling fell, of course. But by Monday morning they'd had time to think about it, and the gilts market stayed solid:











And later that day sterling not only regained what it had lost but rose a bit against both the Euro and the US dollar because of Eurozone worries arising from the Italian election stalemate. So much for those who argued that the downgrade meant the end of sterling's "safe haven" status. Markets thought otherwise:



Chart forGBP/EUR (GBPEUR=X)
(larger version here)

But that's not the madness of Moody's. The madness is contained in this gem of a release. Moody's has seen fit to downgrade the Bank of England, two universities, English housing associations, Transport for London  and five local authorities.

Well, it would be reasonable to downgrade the central bank if you downgrade the sovereign. And downgrading the universities that issue bonds is also reasonable, except for Cambridge (downgrading Cambridge would have been certifiable insanity). As is downgrading English housing associations and Transport for London, which also issue their own bonds. That's not the real lunacy. No, it's the downgrade of local authorities.

It seems that some local authorities in the UK have obtained credit ratings with a view to issuing bonds at some point to fund infrastructure projects. And the Greater London Authority actually issued bonds to pay for Crossrail. It seems reasonable therefore that Moody's might downgrade them. But Moody's have forgotten that unlike US states, UK local authorities do not have independent tax-raising powers. Business rates are set nationally, and household rates are capped by central government. Therefore any bonds that UK local authorities issue are de facto backstopped by the sovereign. Even the individual countries within the UK do not yet have tax-raising powers and therefore cannot issue debt that is independent of the sovereign: the Treasury has agreed in principle that if Scotland remained within the Union (which won't be known until 2014) the Scottish government could be enabled to issue its own debt when it takes on tax-raising powers as part of further devolution. At present, therefore, any municipal bonds issued by UK local authorities are effectively sovereign debt.

Now let's remember what the purpose of agency credit ratings is. It is to inform investors of the default risk of potential investments. Credit ratings agencies are of course deeply wounded after the CDO ratings failures in the financial crisis, so they are trying to redeem themselves by producing "sensible" ratings - which essentially means they don't tell us anything we don't already know. The UK's downgrade was widely expected and already priced in, and Moody's statement added nothing new to the debate. But downgrading local authorities that can't independently issue debt is simply idiotic. Investors cannot invest in the debt of local authorities whose debt is effectively guaranteed by the sovereign. All they can invest in is UK sovereign debt - even if it is called "local authority bonds".

Since UK local authorities cannot issue debt independently of the sovereign, BY DEFINITION they must all have the same credit rating as the sovereign. Separately downgrading them is nonsensical. This action does nothing whatsoever to restore confidence in Moody's. On the contrary, it makes one wonder whether they have the faintest idea what they are doing. Is anyone really going to take them seriously any more?

Related links:

Moody's downgrades UK's government bond rating to Aa1 from Aaa - Moody's news release
This downgrade is nonsense! - FT Alphaville
Talking about a sterling revolution - Financial Times

Moody's takes action on UK sub-sovereigns - Moody's news release

Local councils turn to the bond markets to finance infrastructure projects - Telegraph
Consultation opens over Scottish bond issuing power - BBC

Charts from Bloomberg and Yahoo! Finance.

19 comments:

  1. Moody's isn't reporting on the risk of the UK government being unable to service its debt, which as you say is zero. It's reporting on the risk of political instability leading to the government being unwilling to make debt repayments, which has come close to happening a couple of times recently in the US debates over the debt ceiling. Seen it that light, local authority debt is a bit risker than UK government debt, as there's a higher risk that the UK government will choose to repudiate local government debt than its own debt.

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    1. No. If there is any risk at all that the UK government will repudiate local government bonds, then those bonds are junk, since UK local authorities do not have tax-raising powers. They cannot be rated on any basis other than sovereign guarantee. Therefore Moody's action is nonsense from beginning to end - granting local authorities credit ratings in the first place was nonsensical and so is their downgrade.

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    2. In that case all government debt of any kind is junk, since there's always a risk that a new government will come into office and choose to repudiate debts incurred by its predecessors.

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    3. There is always that risk, yes. But LA debt in that respect does not differ from sovereign debt. The difference is that LAs are dependent on government for most of their income. Therefore their ability to pay is determined by government's willingness to fund them. The credit rating is a judgement of government attitude towards LAs, not a judgement of the LAs themselves.

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  2. UK local authorities can set council tax rates (OK, can't set them arbitrarily high, but there is wiggle room there), and have some degree of discretionary tax-allocation power otherwise they'd not exist at all; that they might end up squeezed to the point of either closing the swimming pools or paying the coupon, and choose to keep the swimming pools open, doesn't seem impossible.

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    1. The majority of LA income comes from central government. Therefore a downgrade really is a judgement of the government's willingness to fund the LA, not the LA's willingness to pay the coupon.

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  3. It is semantics to say their is "zero risk of default" "Default" by inflation is the most dishonest form of default there is. Diluting the value of money and stealing money of its very raison d'etre (a store of value)is de facto default. It also wrecks havoc on the middle classes/working classes.

    Societies where Governments have pursued an inflationary policy have always had an erosion in social morality and a gradual break down in ethics. As inflation is a dishonest policy,you find similar dishonesty arises across society. The black markets grow. Think alcohol,petrol,cigarettes,food dilution. You find discontent starts to arise in pockets across society and will gradually intensify.

    Your right in that Moodys definition is wrong,but they need to change their definition then. Because its semantics and technical jargon to Moodys but its very real for those who struggle to survive due to inflation.

    E Hemingway...The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

    Alas inflation is not a cure,but an palliative attempt and reaction of policy makers to a completely mis-managed economy.

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    1. I refer you to Moody's own definition of "default", which is quoted and linked in the FT Alphaville post. You are entitled to your own opinion regarding what constitutes "default", but Moody's should abide by its own rules. It has not done so.

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    2. Exactly-Thats why I stated "Moodys definition is wrong,but they need to change their definition then"...Its madness to think a country can print money to infinity and in fact are printing huge amounts now but due to technicalities and definitions the rating agency will still have a rating that suggest the country may be on a sound financial footing. The fact is that with the stocks, nations,bonds etc that rating agencies rate, the actual market is way ahead of the ratings anyway,eg CDS spreads,Bond yields,stock price is always trading many notches away from the rating agency stamp. Greece for example was trading at junk yields months before they were certified as junk. Not having a go at you,but rating agency as a poor definition actually hides real default risks.

      Its also complete madness as you point out to rate UK authorities,there is no secondary market for pricing or anything

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  4. Frances,

    To claim "it cannot default" is a bit too strong.

    Suppose Britain joins the EA - for some reason, say in 2023 - then it definitely has a non-zero chance of default in 2043 because its debts will be denominated in Euro.

    I know now the chances are very less - but suppose the EA does come out of a crisis and forms a political union which succeeds and invites Britain to join - which it does. It then becomes a state government and has a chance of default.

    Another case: Suppose Britain decides to peg its currency in 2031 - then like Russia it can default in 2043 right?

    Another case - suppose Britain heavily needs foreign exchanges and needs a lender of a last resort like the IMF. Now suppose the IMF insists that Britain default on GBP denominated debt held by foreigners as part of the lending (or restructure).

    Or worse voluntarily default in 2036

    :-)

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    1. All three of your examples involve the UK relinquishing some degree of sovereignty. Forced default is of course possible when a country does not have full sovereignty, as the Eurozone shows. But while the UK retains full sovereignty, including currency issuance and control, default would be a deliberate choice rather than being forced upon it.

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    2. The first certainly does. Second and third debatable. At any rate, a bond holder in 2013 has a non-zero risk instead of zero-risk.

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    3. True. But even AAA-rated debt does not have zero default risk, really. There is no such thing as a risk-free asset.

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  5. Bond holders are exposed to three types of risk: exchange rate risk, inflation risk, and default risk.

    Describing inflation's effect, which is the erosion of purchasing power, as a default, is disingenuous, serves to muddy the water and often times to advance a political agenda.

    A government may deliberately permit inflation in order to dilute its liabilities but that is not the same as default. Provided the issuer keeps to the terms of the contract, that is, to pay the interest and principal, then do default has occurred.

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  6. Question: how much of the UKs debt is denominated in foreign currency?

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  7. Following your definitions, where does this leave Osborne's claim that he would be judged by the UK credit rating?

    Either (1) he believed that under the agency definition it is nonsense to downrate a sovereign currency so it was a win-win for him as long as the agencies followed their own rules or (2) like Moody's, he didn't understand it at all and was making a macho statement to justify austerity at any cost.

    Either way it was posturing and he has been caught.

    But as almost all major economies are in the deep and smelly at the moment, the market has a problem of where to put its money. So the market has not so much discounted or ignored it but it really has no option.

    I suppose there is always Argentina ...:-)

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  8. The Scottish Parliament has always had tax-raising powers. They can vary income tax by 3p up or down.

    Agree with the general point that a currency user can't legitimately have a higher credit rating than the currency issuer. However, I disagree that the local authorities and housing associations will be de facto the same rating as the sovereign. They are rated on the robustness of their income streams from rents etc, not just their tax-raising powers. I am not sure what you mean they can't issue debt independently of the sovereign. Do you mean the sovereign can change the rules so ultimately retains control? Some of the housing associations have even recently gone to the U.S. capital markets for funding. AFAIK there is nothing legally to prevent them issuing euro or USD bonds. How is that not independent of the sovereign. Social housing bonds are actually quite a good deal for investors because of the spread over gilts. The issues have been quite small but are probably going to grow. However, the ratings have always been different to the sovereign.
    http://www.traderisks.com/wp-content/uploads/2012/07/Social-Housing-Bonds-July-2012-TradeRisks.pdf

    There is an implicit sovereign support but it is not gilt-edged. The bonds could default and the implicit support may not be forthcoming. Hence why they are rated on their income streams and are lower rated than bonds enjoying a gilt-edged promise from the sovereign. Gilts need a sovereign guarantee because one can't sue the sovereign. A housing association or a local authority could be pursued for nonpayment.

    The local authorities usually borrow from The Public Works Loan Board (PWLB) for capital spending at a spread over the benchmark gilt. The spread was 1 percent and recently reduced by 20 basis points. I think the idea behind obtaining their own ratings is to see if they could issue their own bonds cheaper than the PWLB gilt rate if they issued a collective bond.
    http://en.wikipedia.org/wiki/Public_Works_Loan_Board

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    1. I don't really think you can regard the fact that the Scottish parliament can adjust the rate of income tax as giving it tax raising powers. It does not have control over tax receipts and it receives redistribution of spending through the Barnett formula.

      You did not notice that my criticism of Moody's was about local authorities, not housing associations. I know housing associations are rated according to their asset base and expected income streams.

      Regarding local authorities, the bonds were not lower rated than the sovereign and still aren't. They have been downgraded in line with the sovereign and because of it. It is pretty meaningless to talk of LA bonds defaulting when LAs have little control of their own income. In the end, the sovereign will bail them out, whether or not there is an explicit agreement to do so. That is how Moody's have rated them and that is why I think the whole exercise is pointless as far as LAs are concerned.

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