Tuesday, 2 July 2013

How to Correct Ratings


The unreliability of conventional ratings is becoming increasingly apparent. A good example is that of sovereign ratings. In particular, the emblematic case of the US comes to mind as there are Credit Rating Agencies willing to maintain a AAA rating of its troubled economy.  The inconsistency that emerges, especially today, is the feared fiscal cliff, a huger debt of over $16 trillion, large unemployment and the mentioned triple-A rating that are difficult to reconcile. Countries in a far better situation are rated as almost junk. Something doesn't compute. However, the case of the US is not the only one. There are EU countries which also enjoy a triple-A status, such as Denmark, Finland, Germany, The Netherlands, Sweden and the UK. At the same time, there is talk of the collapse of the Euro, of the failure of the European project, talks of Greece abandoning the Eurozone, Spain being close to a bailout. The question that comes to mind is, at this point, this: how can there be so many AAA-rated economies in the EU which, as a system, is on the verge of a depression or even collapse. It seems that it is not only the politicians that have no idea of what a system is, or what systems thinking means. It also includes analysts and economists. Can half of a collapsing system be extremely healthy in the face of the fantastic interdependency that our economies have developed?

Nobody pays for a sovereign rating. It comes for free, at an agencies discretion. So, while the agencies decide to favor some countries, they try to discredit others. Ratings have become instruments of politics and strategy, and also weapons in an economic war. The lower the rating, the more it costs a government to sell bonds as it must pay higher interests rates. A downward rating spiral may kill even the healthiest of economies.

When it comes to publicly rated corporations, it is those who want to be rated that get to pay for it. Since companies want to raise cash, they need a high rating which reflects a company's ability to pay its obligations. The higher the rating the lower the interests a company pays. In the old days, it were the investors who paid for the ratings. After the early 1970s, this model was changed and today the rated companies pay to get rated. A rating has become a product which one can actually buy. Get the drift?

Ratings, when it comes to public companies and national economies, are generally overly optimistic. This is due to a conflict of interest, which has been exposed in many occasions. Rating agencies are controlled by huge investment funds which have interests in the same companies that are rated. This closes the circle. The situation must be fixed if we are to avoid total collapse of the economy today and an even more severe next crisis. Is this possible? The answer is affirmative. A way to break it is as follows:

Rating agencies operate based on objective (albeit, often manipulated) data, such as balance sheets, income or cash flow statements, adding a subjective component on top, which depends on interviews with a company's management and the analyst's final judgement. They use well known numerical methods to compute the Probability of Default (PoD) of a company and translate the result into a code, such as AAA, AA-, AA or BBB, etc.


What rating agencies do not take into account is the resilience (the opposite of fragility) of an economy. A company/country can perform well form a purely financial perspective but still be fragile. This new aspect of business can easily be taken into account. The same balance sheet, income and cash flow statements can be used to compute the resilience of a company to measure the resilience of its business structure. Once you have the conventional PoD rating and the Resilience Rating™, which ranges from 0% to 100% (100% means the business is very resilient and stable, 0% it is dominated by chaos) you simply multiply the two to obtain a Corrected Rating:

Corrected Rating = PoD Rating X Resilience Rating

This is clear in the image below, which puts together the two, the basic rating and a correction coefficient, which ranges from 0 to 100% and represents resilience:

The above formula ensures that the resilience correction coefficient will always reduce the conventional rating. The result of such an operation, when it comes to sovereign ratings, produces the following corrected S&P in the case of the Eurozone countries:



The immediate effect is the reduction of the spread between bond performance to more realistic levels between the various EU countries. Italy, for example, which is 13% more resilient than Germany, is under speculative attacks and consequently spends 2% more than Germany on sovereign bond interests. According to the Italian Central Bank, the real spread between Italian and German bonds should be approximately 2% less than what it is today. Our correction confirms that fully. Moreover, the resilience correction coefficient  ensures that there are no AAA countries in the Eurozone. This sounds far more reasonable. More soon.

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