Standard & Poors strike back

Today’s Fin runs a letter from Standard & Poors responding to my column from last week, reprinted here. Unfortunately the letter is paywalled (if anyone would like to email me the text, I’ll make fair use of it), so you’ll just have to take my word that it contains some interesting semantics. For example, the writer takes umbrage at the suggestion that S&P “threatens” governments with the loss of AAA credit ratings, but does not deny that the agency explains to government that certain policies will lead to the preservation of the rating while others will not. (“Nice little state you’ve got here …”)

I’m most interested though, in a claim that, since 1978, the default rate on AAA-rated structured finance offerings has been only 0.5 per cent. Obviously, a statistic like this can mean just about anything, but the claim is surprising to me. AFAIK, the biggest single category of structured finance offerings rated AAA by the agencies were collateralised debt obligations (CDOs) and the vast bulk of these were issued in the last few years. According to Alan Kohler in today’s Business Spectator (I think the ultimate source for this is Gillian Tett in the FT).

Between 2005 and 2007, about $US450 billion of CDOs of asset backed securities were issued. Of those, $US305 billion are in a formal state of default, with those underwritten by Merrill Lynch accounting for the largest proportion, followed by UBS and Citigroup.

The real problem is what has happened after the default. JPMorgan estimates that $US102 billion of the CDOs have been liquidated; the average recovery rate for the super senior tranches – rated AAA – has been 32 per cent. For the ‘mezzanine’ tranches – created from mortgage-backed bonds – the recovery rate is just 5 per cent.

Up to a 95 per cent real loss rate on AAA debt CDOs …

(Note that, although the text is ambiguous, the top mezzanine tranches were typically AAA-rated – the super-senior stuff was supposed to be better than plain old AAA).

The default rate here is over 60 per cent, which is a bit higher than 0.5 per cent, and it’s safe to bet there are more defaults to come. Even assuming that older issues pull the average down, can there really have been anywhere near $60 trillion ($300 billion/0.005) of them issued, as you would need to get the S&P average default rate? Or is this the kind of average that conceals more than it reveals?

Update A kind reader has supplied me with the text, and I’ve selected the relevant bits for reference (OTF). If anyone is still interested, and keen to do an Intertubes meme mashup, we could do a crowdsourced fisking.

In “Risky business needs rethink” (Opinion, February 26) John Quiggin evaluates Standard & Poor’s February 20 downgrade of the state of Queensland to AA+ and in the process misstates the role of a credit rating agency and how credit ratings should be used.

Standard & Poor’s does not “threaten” states or other rated issuers with downgrades or make demands to “implement whatever economically irrational policies”. Nor do we act as an “advisor to bondholders” or “ensure that bondholders get paid in full and on time”.

Our sole role is to provide the market with an independent opinion on the creditworthiness of issuers and their debt. A Standard & Poor’s rating does not speak to the market value of a security, or the volatility of its price. Ratings are not recommendations to buy, sell or hold a particular security. Nor do they replace the need for investors to do their own risk analysis or to seek professional advice.

Like many others in the market, we did not anticipate the speed or extent of deterioration in the US housing market. However, our track record remains strong. Since 1978, only 0.5 per cent of AAA structured finance ratings have ever defaulted, which is broadly similar to corporate ratings performance.


For many decades, Standard & Poor’s has in effect served the global capital markets with high quality, independent, and transparent credit ratings. We have listened to what the market is saying, and reflected long and hard on the recent, unprecedented market events. We are working with market participants and policymakers worldwide to do our part to restore confidence in global financial markets.

116 thoughts on “Standard & Poors strike back

  1. Andrew # 100
    On complete and utter misinterpretation of my comments at 94 as “nationalism”. Nice word (not), intended to distort my view and a totally meaningless misinterpretation of what I said. I object. Its called reality and the practical political process Andrew, not “nationalism”.

  2. That really takes the cake Andrew and yes I am tired of the intention to distort (use of the word “nationalism” by people carrying views that I consider, ill measured, ill thought out, a blanket prescription for the entire globe, a cure all, ideologically driven by the short term self interested who care not one bit for the health of the economy in reality, are prepared to lie to cover their real thoughts (let the majority go to hell as long as I am better off) and propose solutions that are a complete furphy.

  3. Andrew # 100

    As the unemployed queues lengthen before our eyes in the U.S. and the number of unemployed climb by 23,000 persons a day…please come back in two years time and tell me how useful globalisation and de regulation of labour markets, financial markets and other markets really is? Tell me how popular they are or will be in two years time?

    Every single one of those people standing in a dole queue is going to be unhappy and I will warrnat they wont give a fig about globalisation.

    Tonight I heard a friend’s daughter was summarily dismissed from a casual job in a nearby hotel because she couldnt turn up this week to cover for another employee who was sick. The dismissed employee is a uni student. She got the job on that basis (the employer knew about her studies). She was attending uni on the day she was summarily dismissed by phone because she couldnt come in, and her employer knew her uni days in advance. Her mother went down to the hotel to argue her case to no avail whatsoever.

    If this is labour market deregulation, then there is only one word for it.

    It stinks and it exploits youth. How many youth will be voting for free markets and rampant deregulation Andrew, even now? Obama captured the youth vote. Politicians and parties better have a long cold hard look at their platforms and their ideologies in the years to come or they will rapidly be rendered redundant.

  4. The reality is, talk of deregulation, free markets and globalisation may be the fashion when times are good and the longer term cycle is expansionary on a global scale, but its just a cycle at the end of the day and can quickly turn when economies face internal economic catastrophies, of the order we now face.

    There will be no great love of globalisation then Andrew. You are caught in the dominant ideology of your time, but it is contracting and it may be yesterdays time sooner than you can possibly imagine. Neither you nor I, nor any humble (or not so humble) individual view, will be able to influence that. The majority of any society are not stupid, even if slow to change at times, and they know what is best for them and they will express that politically.

    (Unless you happen to live in a society so corrupted and so cowed and beaten down by a despot, like the Zimbabweans under Mugabe. I note Morgan Tsvirangai just lost his wife. I had expected something like this to happen. Didnt we all? Yet still, Mugabe is not worth an intervention from global powers is he?. Not enough resources to bother.)

  5. Alice,

    What is the answer to globalisation? Security through greater legislation over workplace relations between employer-employee? This raises the risk because of higher costs of reducing employee numbers during downturns. This will require investors to demand a higher premium because during the downturn the overhead costs will still be significantly high. Therefore the amount of investment in the private industry will be wound down.

    In Europe, with tough industrial legislation and strong unions, there is a chronically high unemployment rate, a settled underclass in sink estates, you have massive amounts of corruption and nepotism, public services and public finances are a complete mess and inward investment is comparatively weak comprising mainly of mergers and acquisitions of established companies. And when the credit crunch hit Europe they have discovered that all this protection comes to naught because unemployment is rising, the Governments are having increasing problems funding their spending commitments and the unions are striking which reeduces the output for companies.

    Globalisation has lead to a massive increase in prosperity but there are downsides. I do not, neither would anyone else, deny that. However the upside is much greater what is needed however is to recognise that liberalisation of the capital markets, of the labour markets etc is where the government needs to step back but they need to move forward in regards to capital infrastructure, education and welfare reform and healthcare reform to provide an additional layer of security so that businesses can be more competitive compared to overseas companies, people can have a skill-set that allows them to quickly find employment and peace of mind against the risk of serious health-related accidents.

    Government legislation to reduce flexibility in the workforce is a sure-fire way to create exceptionally sluggish growth in the economy during any international upturn.

  6. Andrew, re #98, I agree on most (not all) of your first paragraph. With regard to inequality, this is pretty dangeorous line of thinking: inequality could be ok in hypthetical terms as in your example. In practive, the rise in median incomes in the US is almost entirely due to the rise in incomes of the top 5% of the population whereas middle class incomes are stagnating. Assuming we care most for the elimination of poverty and middle class welfare, this is not a good outcome.

    The other problem is that inequality is self-feeding in political economy terms. As the richer get rich, they also become (evem more) politically powerful and lobby the government in order to entrenh their position. Exhibit 1: Bush’s tax cuts. We thus get a self-perpetuating machine with the end result being a reduction in economic, hate to use the term, but class mobility. In the long run, this is destructive.

  7. “whereas middle class incomes are stagnating”

    Terry Fitzgerald’s study (warning – big PDF) says otherwise.

    The main finding is that—after adjusting the
    Census Bureau data for three key factors—inflation adjusted median household income for most household
    types increased by roughly 44 percent to 62 percent
    from 1976 to 2006. The only household types
    with substantially lower growth were “working-age
    male householder without spouse present” and “male
    householder with children but without spouse,” but
    these types constitute just 10 percent of all households.
    Household income inequality increased notably
    over this period; nonetheless, middle American households
    had substantial income gains.
    Here is a preview of the key data issues that lead to
    the higher estimates of median household income
    (1) The price index used by the Census Bureau
    overstates inflation, and thus understates income
    gains, relative to a preferred price index.
    (2) A changing mix of household types leads the
    overall median increase to understate the median
    increase of most household types.
    (3) The Census Bureau measure of household
    income understates income growth by excluding
    some rapidly growing sources of income.

  8. Alice,
    I am sorry if you think my wording deceptive, but I do not know another word that can accurately describe the intent of your argument. Protectionism – the (naive) view that stopping or reducing trade with foreigners will somehow give advantage to those in my country and that we should not care about the foreigners – can (IMHO) best be described as a form of nationalism, particularly when you look at a good definition of nationalism. To whit:

    the policy or doctrine of asserting the interests of one’s own nation, viewed as separate from the interests of other nations or the common interests of all nations.

    If you do not like it please tell me where I am wrong, but making multiple comments all just flat out denying it and casting aspersions as to my intent does not cut it.
    Eli (@107, provided the number does not change)
    Jarrah Job has already dealt with the first paragraph, so I would like to deal with the second. Lord Acton was correct when he said that all power tends to corrupt. The solution, then is to decentralise the power – increase the numbers with it. To me, democracy tends to work better than any other system because the power does get (more) decentralised.
    The reason I classify myself as a liberal (classic liberal or libertarian also mean similar things) is that I believe power should be held at, as far as possible, the individual level. Where this is not possible, then a local council should have it – and so on up to the Federal Government or some international organisations.
    To me the only way to reduce the corruption you identified is to decentralise power – make it very difficult for any entity to exercise that sort of power – whether they are a company, a trade union, a government or whatever else.
    One of the major disagreements I tend to have with social democrats (apologies if this is a strawman) and conservatives is that they tend to believe in centralising power and revenue in a government. All this does (IMHO) is greatly increase the chances of the occurrence of the sorts of corruption you were referring to.

  9. Andrew, #110, I can agree with the sentiment: the problem in practice is that corruption is limited to centralised from of governance. Going back to the inequality debate, even if we nominally hold power to be at the individual level, the end result of concentrating wealth in a small number of individuals incentivises those individuals to protect their wealth by accumulating other, non-monetary means of power. In effect, it leads to centralisation, only this time in a corrupt fashion.

    This is not to deny that governments can be corrupt. Self-evidently so. They are corrupt however for the same reason: governments are not a theoretic concept, they are a collection of individuals holding power. Etc.

    There is no easy way out of this. My point is narrower: free trade is only good insofar as it lifts overall prosperity without unduly pushing inequality to unsustainable and corrupting levels.

  10. Should be ‘corruption NOT limited to centralised forms of governance’. One of these days I will learn to re-read my posts before hitting the button.

  11. Eli,
    I would agree – corruption can be found whereever there is power. To me the lesson to come from that is that power should be limited in scope whereever possible.
    For example, and hypothetically) say a national government has the power to impose educational standards. Being a normal government they then exercise that power. They then use that power under the influence of (say) a particular textbook manufacturer (X Ltd) to impose a standard that all textbooks shall be published by X Ltd.
    Try that on a state-by-state or even (as in the UK) at a local government level and you would find imposing even a temporary monopoly would be much more difficult and (possibly better) alternatives would get much more of a chance.
    On the free trade point I would respond by saying that it is much more likely that trade may cause harm of the type identified where those corrupt elements are allowed to exercise their influence using legal backing – i.e. where the government imposes those through law. A good example here would be almost any US government agriculture bill. The sheer rank stupidities embedded in those is just plain staggering. There would be much less harm (I contend) if they simply abandoned the whole exercise and did not subsidise anything at all.

  12. jarrah@ 106

    Lemme alone! Im a Gemini. Two posts for the price of one. (you should be so lucky!)

  13. Andrew,

    I will repeat my comment as above because you apparently do not recognise the political cycles in your repeated assertions on the benefits of globalisation. Globalisation and the freeing of financial capital markets has contributed to the growth of monolith banks and the GFC, but this has not ocurred without volatility beforehand that has had catastropihic regional consequences. I suggest its time for a rethink, the IMF thinks its a regulatory failure. Sure open trade has had some benefits and the “complete protection” that you incorrectly misinterpret my comments as (and a rather shallow interpretation I might add).

    However, I will say again the people falling into the unemployment queues in the US at the rate of 23,000 a day are going to want protection not globalisation. You think tyou can convince them of the benfits? Unrealistic and its about votes and political power as much as it is about a nice theory.

    Whats the trade off Andrew? – it could almost be a phillips style curve with globalisation on one end and protection of jobs on the other, or is that a free trade and civil harmony trade off when unemployment is high?

    Do you think those people shouldnt mind about the jobs that have gone to China or India or anywhere else from the US (while they borrowed and spent and their trade deficit was looking dangerously ill 5 or 6 years ago)?? The US cannibalised its own production via imports and their large firms went almost everywhere but the U.S..

    Interesting thought (that the unemployed there shouldnt mind globalisation or free trade now) but not realistic at all, and they do have a vote.

  14. Sean G

    “Government legislation to reduce flexibility in the workforce is a sure-fire way to create exceptionally sluggish growth in the economy during any international upturn.”

    If you are referring to the removal of workchoices you remove it good times or bad. When you have acute appendicitis, you go to the doctor to get your appendix excised, rain, hail or shine.

    Sean, seriously there are people out there who want so much flexibility from workers they are being treated like subhuman garbage. Yet still eployers presse for even greater flexibility (take, take, take).

    This bleating for greater workforce flexibility (translate lower wages and lower costs) is an insult in terms of the absolute failure to even pretend there is any industry going on whatsoever at the top of many firms these days, along with theft of shareholder and employee surplus. Lazy, go to lunch, dont work, do golf days, pay themselves a fortune.

    there really is no end to the business sector crying crocodile tears over “we need more flexibility from the workers” and “we need to lower our wages costs so we can…..ahem …what was it again….. yes…we can offer people more jobs….yes that was it.!!!

    When they do get lower wages, they will want slavery. When they get slavery they will buy guns and want blood. There is no end to this desire on firms’ part Sean. They are not people. They are corporate psychopaths.

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