What do Tesco and tracker funds have in common?

For a start they are both liked by Warren Buffet. Like Warren I like both of these investments. Like Warren, I am smarting from my losses in Tesco. Tesco has been a painful lesson.but I don't believe that it negates the advice to be long tracker funds.

In his annual letter to Berkshire shareholders, Warren Buffet says:

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain
instructions I’ve laid out in my will. My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee
managers.

Just prior to making this point, he notes:

I have good news for these non-professionals. The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial.

The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. That’s the “what” of investing for the non-professional.

The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties. Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.

So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My observations:

- I am hanging on to my holdings in Tesco. At 400p, Tesco's properties were worth as much as the then  market capitalisation of the company. At 170p, this is not the time to blink but to focus on the tangible value in this business. It will take a long time for a competitor to build a retail footprint as dominant as Tesco's position in the UK. Tesco needs to get back to basics and focus on what made it successful - the right products at the right price. Asda has stolen this position from Tesco and Tesco need to claim back that position.

- UK plc is fundamentally still overvalued compared to US Inc. The US economy is a giant when it comes to being flexible as being able to reinvest itself. The UK economy has fewer weapons in its armoury. Don't fight the US - owning a broad cross section of US companies at the current time is probably the best asset allocation decision one could make today. Doing this via trackers funds is probably the second best investment decision one could make.

- Not all trackers fund are created equally, make sure you shop around. When Vanguard launched their trackers funds in the UK the incumbents were forced to drop their asset management fees. The barriers to entry to the 'low-cost' tracker business are high. Choose a tracker fund that is managed by one of the largest providers and you should generally benefit from the best fees as well as low total expense ratios. Globally the top 3 managers would be: BlackRock, State Street and Vanguard - the latter is also liked by Warren.

Using LDI to set pension fund investment strategy

What is LDI?

LDI is a common acronym for Liability Driven Investment. Globally, corporate-sponsored, defined benefit pension funds have embraced an LDI-framework to setting investment strategy. Adopting an LDI strategy means that investment risk is no longer defined predominantly in relation to the standard deviation of investment returns. Rather, the concept of investment risk is extended to include all risk which could impact the volatility of asset values relative to liability values. In summary, LDI is a framework for setting investment strategy which has, as its end goal, the reduction of volatility in asset values relative to liability values.

Importantly LDI is not limited to consideration of a single asset class, for example, bonds; the LDI framework can (and should) be applied across all asset classes in order to arrive at a holistic view of the volatility of all asset classes relative to the liabilities. The table and diagram below sets out the types of risk that will typically be considered when adopting an LDI approach.

Table 1: Factors influencing asset and liability values

Factors influencing volatility of asset values	Factors influencing volatility of liability values
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	Interest rate risk
Credit risk	Inflation risk
Liquidity risk	Longevity risk
Active manager risk	Model risk

Chart 1: Risk attribution with liabilities

Table 2: Brief description of factors influencing asset and liability values

Factors influencing volatility of asset and liability values	Description
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	This is risk which characterises the asset class to which an investor is exposed. It cannot be diversified by holding a diversified portfolio of securities within the asset class.
Credit risk	The risk of losing some or all of your investment due to deterioration in the credit-worthiness of your counterparty. While it can be included as part of market risk, for some asset classes, such as corporate bonds, it can make sense to measure this separately due to its importance to the overall risk associated with the asset class. Some quantification of this risk can be made by observing historical, long-term average default rates.
Liquidity risk	The speed and cost at which an investment can be sold for cash.
Active manager risk	The risk that an active manager underperforms its benchmark. When considering its strategic asset allocation, a fund may assume that it can achieve certain market returns, however taking a decision to appoint an active manager means that the manager can underperform the market.
Interest rate risk	The risk that the value of the assets (or liabilities) changes in response to changes in interest rates.  Fixed rate and inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s interest rate risk. Liability cashflows are valued to today’s monetary terms by discounting them to the present day. An increase in the rate of interest used to discount these liabilities will decrease their present value and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the interest rate sensitivity of the assets to those of the liabilities.
Inflation risk	The risk that the value of the assets (or liabilities) changes in response to changes in the market’s expectations for future rates of inflation. Inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s inflation risk.   Liability cashflows are valued to today’s monetary terms by discounting them to the present day. Where future cashflows to be paid increase in line with inflation then an increase  in expectations for future rates of inflation will increase the present value of these cashflows and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the inflation sensitivity of the assets to those of the liabilities.
Longevity risk	This is the risk that the liability cashflows to be paid in the future increases as a result of the recipients of those cashflows living longer than anticipated. Generally, deteriorating longevity (pensioner dying earlier than expected) is considered to be less of an issue as it does not lead to a strain on the finances of the pension fund.
Model risk	This is the risk that the actuary’s projection of future cashflows turns out to be lower than those cashflows that actually materialise. Key demographic assumptions are sometimes embedded in these cashflow estimates, for example, assumptions relating to spouses pensions and early or ill-health retirement experience.  The pension fund’s actual experience is likely to differ from this.

What have been the catalysts for this focus on LDI?

Globally we can point to two main catalysts for extending the definition of risk and hence for the focus on LDI:

1. Accounting regulations:

During the noughties changes in global accounting regulations resulted in sponsor balance sheets becoming more responsive to recognising changes in pension fund surpluses or deficits (defined as the difference between assets and liabilities) and the latter moving to the use of mark-to-market approaches to value both the assets and liabilities. Together these developments introduced greater volatility in a sponsor’s balance sheet as a result of changes in the pension fund’s surplus or deficit. CFO’s became increasingly concerned that such volatility could materially (and adversely) impact the company’s financial results for reasons that were unrelated to the company’s core business. This was especially true for companies that had pension fund’s whose liabilities were large relative to the company’s market capitalisation – a small, adverse change in a large pension fund liability could swamp any positive performance in the company’s core business.

The poster-children for the adverse impact that these developments could have on a company were two well-known British companies, British Airways and British Telecom. Table 3 below illustrates that the relative size of the pension liabilities and market capitalisations at these two companies are such that a small change in their liability values would have a large impact on their market capitalisation.  

Table 3: Pension liabilities and deficits (Source: Accounting for Pensions 2010; LCP)

Company	Pension liabilities	Pension deficit	Market capitalisation	Liabilities / Market cap	Deficit / Market cap
British Airways	£12.8bn	£0.6bn	£1.6bn	791%	37%
British Telecom	£33.2bn	£4bn	£6bn	551%	66%

2. Funding regulations:

Following a number of high profile pension fund failures; the result of failure of the sponsor coupled with a poorly funded pension fund, many pensioners were left stranded. Regulators moved to tighten funding regimes for pension funds by emphasising the need for a clear plan to deal with any pension fund deficit and within an acceptable timeframe.  Increasingly, the emergence of deficits in pension funds were at the top of the agenda for company financial managers who could no longer kick the can further down the road. Deficits were having a direct and adverse impact on their cashflows by requiring higher contributions to be injected into the pension fund. All of this was taking place in the midst of the worst financial crisis in history.

In the early part of the noughties these themes played out across Continental Europe and the UK and then, in the latter part of that decade, these changes played out in the US and closer to home in South Africa. Today, corporate pension plans in the US and South Africa are leading the charge to the adoption of LDI strategies with many sponsors in these countries also moving to the “so-called” end-game more swiftly than their UK counterparts, i.e. the transfer of these pension liabilities to an insurance company and, in so doing, entirely eliminating the pension liability from their company balance sheets. But that is a subject for a future article.

LDI in Africa

Defined benefit pension schemes are not as prevalent in Africa as they are in the UK and the US. In South Africa, the continent’s largest pension fund market, defined benefit pension schemes were closed to new entrants in the nineties and their demise was hastened by offering members incentives to transfer out to newly established, defined contribution arrangements. That said, a few large legacy defined benefit pension funds are still in existence and many of these funds have moved towards adopting a LDI strategy, especially for assets backing their pensioner liabilities. The adoption of similar strategies by large pension funds in the rest of the continent is not without challenges due to less developed capital markets but, as discussed, LDI is not about investing in specific assets but rather about the adoption of a framework for the holistic consideration of managing funding level volatility. Adopting such a framework is of paramount importance as a first step towards improved risk management and governance.

Future developments

An LDI framework is not limited in its application and can (and should) be extended to defined contribution arrangements. The absence of a clearly defined or guaranteed liability does not imply the absence of such a liability. In fact, members of defined contribution pension funds are left with no different a challenge – they too need to be sure that they are accumulating sufficient savings in their pension funds on which to ensure a comfortable existence in old age. Arguably, members of these defined contribution arrangements require even greater financial assistance to define clear retirement objectives and goals. LDI can be used to frame such goals by linking savings goals to incomes required in retirement and in this way setting an appropriate long-term investment strategy.

In summary, LDI is a framework for managing investment risk. It has proved to be a useful tool for setting investment strategy especially where there are dual objectives of targeting a long-term savings goal whilst still focusing on the need to ensure acceptable investment outcomes in the short term.  There is an analogy to be drawn between a limited-over cricket game and LDI. In both cases the long-term goal is achieved by the successful achievement of a series of shorter-term goals which when taken together yield the desired end result.

Guns don’t kill people, people kill people: lessons in money-lending from African Bank

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1. Introduction

Events here in South Africa, over the last two weeks, have left me with that feeling of déjà vu. I am referring of course to local lender African Bank being taken into curatorship following an announcement by the governor of the local central bank on Sunday, August 10^th. The week before African Bank’s share price nosedived in response to the unsecured lender’s announcement that its CEO had quit and that the unsecured lender had suffered a further deterioration in financial performance. The bank would need to come to market to raise yet more capital; despite previous reassurances to the contrary. Remembering the events which played out in September of 2008 when Lehman collapsed, I remarked to a colleague prior to that fateful weekend, that I couldn’t see how African Bank would last the weekend.

And then it came. Like Lehman, which was forced to file for Chapter 11 bankruptcy on a Sunday, the local central bank duly made an announcement on the Sunday, although, unlike Lehman, the central bank chose to step in and (mostly) rescue debt holders. Equity holders were not so lucky; six years, 1 month and 4 days earlier, nor was Dick Fuld¹.

  

Lehman employees at the Canary Wharf office in London receive the news of the bank's Chapter 11 filing on Monday    morning September 15th 2008.

The now infamous report by Morgan Stanley analysts which called on equity investors to reload on Lehman stock only months before its collapse.

While I think it is fair to say that 2008 was the year of reckoning for many institutional and retail investors globally, South African investors were, for the large part buffeted from those events. The events of financial distress at that time were many and varied but the poster-child for the period is no doubt the default of the investment bank Lehman¹. The crisis in essence stemmed from the fact that banks lent too much money to people who were unable to repay their debt. That South African banks emerged mostly unscathed was a source of great pride and the local financial system was held up as a shining example of a well-regulated industry with sensible lending practices. And then over the last 6 years as scandal after scandal has emerged - Madoff², LIBOR-fixing³, dark pools⁴, high frequency trading⁵, commodity price fixing⁶ and so the list goes on, I daresay that South African's felt slightly smug.

Bernie Maddoff in happier times

Any delusions of grandeur South Africans may have had about superiority in the appropriate regulation and safeguarding of the financial system were laid to rest with the effective collapse of African Bank and the domino effect that event has had on our banking, savings and investment industries. While, the large South African banks will still feel a certain amount of smugness, the failure of African Bank is, arguably, also an indictment on the lack of a sufficiently responsive feedback loop between regulators and the private sector so that perhaps the latter must shoulder some responsibility?

2.     Lessons from African Bank

Lesson 1: "Credit worthiness is like virginity; it can be preserved but not restored very easily"

Like their global counterparts in 2008, South African pension funds, insurers and individual investors have had 'golden circle' tickets to the greatest show in town. If I were to attempt to distil all the lessons learnt over the last few weeks then much like in 2008 it would be simply this: throw out everything you thought you knew to be true, assume nothing and question everything. If I were to apply this mantra to one feature of recent events it would be to consider the central role that assessments of credit worthiness have played in this latest crisis. I say this because, in the case of both Lehman and African Bank, once it became clear that their lenders had lost faith in their ability to successfully navigate their financial woes their sources of funding dried up and their fate was sealed.

In late 2013, the US government was engaged in a dangerous game of chicken with its lenders. The Treasury Department was fast reaching its borrowing limit (as set by the US Congress) and needed an act of Congress to borrow beyond this limit. Not raising the limit would have meant that the US Treasury would have been unable to borrow money to meet upcoming commitments on its maturing debt obligations. Warren Buffet noted that it would be ludicrous for the US to contemplate defaulting⁷ on its debt repayment obligations and said that "credit worthiness is like virginity; it can be preserved but not restored very easily".

The lighter side of the debate on the US debt ceiling debate

Lesson 2: To assume is to presume

If we accept Warren Buffet’s comment as being an accurate reflection of the importance of credit worthiness, then surely investors should be aiming to ensure that the tools in place for measuring credit worthiness are robust and as infallible as can be. After all, a significant deterioration of credit worthiness could trigger a downward spiral in the financial fortunes of a borrower, one that was difficult, if not impossible, to recover from, leaving the lender vulnerable to not recovering the amount they have lent.

The failure at African Bank has placed the spotlight firmly on those making these assessments, including:

• equity fund managers who chose to buy shares in African Bank and so were implicitly making judgements about the safety of their client’s investments and the likelihood of having their capital returned, let alone achieving an acceptable return on their investment;
• money market and fixed income fund managers who lent African Bank money by buying their bonds and
• credit rating agencies (CRA’s)⁸, professional firms in the business of assessing making credit quality assessments.

Most of the public attention has fallen on the equity and money market fund managers:

• equity fund managers are being criticised because they have lost substantially all of their client’s money that was invested in African Bank shares and
• money market fund managers are being criticised because their money market funds were sold as ultra-safe, something that was close to cash, yet for the first time in history these funds have ‘broke the buck’ – investment speak for saying that investors in money market funds can expect to lose some of their initial investment.

But with the recent credit rating downgrade of the Big Four South African banks (ABSA/Barclays, FirstRand, Nedbank and Standard Bank), attention is turning to the credit rating agencies, professional firms whose business model is premised on making money from evaluating and then rating the credit worthiness of borrowers. Professional money managers, investment advisers and clients place their confidence and trust in these ratings and billions of Rand, Pounds and Dollars are invested by reference to these ratings.

The main criticism levelled against these purveyors of credit worthiness assessments is that they have been slow to react. If all was really well at African Bank why did these rating agencies continue to award African Bank a rating that only the most credit worthy of institutions would have deserved (known as an ‘investment grade’ rating⁹) right up to the point of African Bank going into curatorship. It seems that while referencing a credit rating can be important part of an investor’s due-diligence, it is by no means sufficient to fully assess the credit quality of a borrower.

Given what we have just said about credit worthiness, you may be forgiven for thinking that the global financial services industry would have an established, robust and commonly accepted system for consistently measuring the creditworthiness of a company. It is probably not an exaggeration to say that today, the complete opposite is true and that the most common global approach to measuring credit worthiness, a credit rating issued by a recognised credit rating agency, has embedded flaws.

So what, I hear you say? Well,

• if the people you trust to manage your money place an undue reliance on these ratings then perhaps they are taking more risk with your money than is immediately apparent and
• if the regulators entrusted with protecting the financial system are slow to regulate to prevent the unintended consequences from this flawed system of credit ratings then perhaps investors need to be alert to the flaws of the system and find alternate ways to manage their risk.

 It would be dangerous to assume that credit ratings are a panacea for assessing credit worthiness of borrowers.

Lesson 3: Trust nothing; question everything; historical quirks have created deep ‘fault-lines’ in our financial system. It sometimes takes a seismic event for the ‘fault-line’ to be noticed. Unfortunately such seismic events rarely occur without leaving behind a trail of destruction in their wake.

One way of gauging investor confidence in the financial fortunes of a company is the company's share price. Another way is to consider that company's cost of borrowing or the additional premium demanded by the company’s lenders versus lending to the most secure of borrowers, typically seen as the government of the country. There is, however, a third, and arguably even more influential determinant of investor's perceptions of a company's credit worthiness and that is a company's credit rating.

   

Background: the advent of credit ratings?

Very simplistically, investors in stocks and bonds are lenders of money to the companies they invest in. Ordinary shareholders expect that in exchange for committing their capital to the company, they will be rewarded through a pro-rata share of the company's future (unknown) profits but also recognise that they are first in line to lose money should things go wrong with the company's business. On the other hand, those lending money to a company, for example, by buying their bonds (a form of tradeable loan), expect to be paid a well-defined return on their investment (a pre-specified rate of interest) and ultimately expect their loan to the company to be repaid on time.

Many professional investors have historically relied on credit rating agencies ("CRA's"). Modern day CRA's date back to 1909 when American John Moody started offering credit ratings on American railroad bonds in a book called ‘Analysis of Railroad Investments’. Until then most bond investing was in the public (or sovereign) debt of governments and investors (the bondholders) trusted those governments as being willing and able to honour their obligations. Partnoy (1999) traced the origins of the industry back to Lewis Tappan. Tappan, a 19^th century businessman in the silk industry kept detailed credit information about his customers which proved valuable to other merchants when the silk business ran into difficulties. In 1841, Tappan formed the The Mercantile Agency – the first credit rating agency (Source: BoE: Financial Stability Paper No.9-2011 Whither the credit ratings industry?)

                                                        John Moody, founder of the modern credit rating agency

But in the early 1800's the American railroads were being built by privately owned railroad companies. The large amount of capital needed to finance the building of railroads in what were then 'frontier' regions meant that railroad companies turned to issuing bonds - effectively borrowing money from US and international investors against their future expected profits. Not only was this the beginning of the corporate bond market as we know it today but the development of this market eventually led John Moody to offer a service, rating the credit quality of these borrowers. Remember this was before the establishment of the US Securities and Exchange Commission (SEC), which was created in 1934 and required public companies to issue standard financial statements.

Shortly thereafter, in 1916, the Poor company, started by Henry Varnum Poor, turned its attention from publishing the Manual of the Railroads of the United States (a compendium of financial information on the railroad companies) to rating railroad bonds. The company merged with Standard Statistics in 1941 to form Standard & Poor's (S&P). Today Moody's and S&P are the world's largest credit rating agencies. 

So powerful have the rating agencies become, as the definitive voice on a borrower’s credit worthiness that Thomas Friedman, a television interviewer on PBS, would say on 13 February 1996:

"There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me it’s not clear sometimes who’s more powerful."

Rating agencies are the strangest of hybrids; a seemingly split personality. Most organisations with a regulatory role are non-profit organisations. Credit rating agencies (CRA’s) on the other hand are profit-making companies performing a regulatory role¹⁰. The conflict is problematic mostly because of the manner in which the CRA’s are remunerated. When John Moody first conceived his rating agency (or manual), in exchange for selling his rating manual, Moody was remunerated by his investors who were end users of the information he provided. In the 1970s, the concept of ‘issuer pays’ began to take hold. Under ‘issuer pays’, the entity issuing bonds (borrowing money), pays the CRA to rate their bonds. There have been many reasons put forward for the change¹¹. One of the quirkiest reasons is that the advent of high-speed photocopying in the early 1970s meant that once a single investor had bought and paid for a rating, it could be easily duplicated and passed on free of charge to other investors. Whatever the reason, with the benefit of hindsight, the conflict of interest in the ‘issuer pays’ model is clearly apparent – it can be compared to a restaurant paying a food critic to evaluate the quality of the dining experience on offer. More bluntly, the question critics raise is around the temptation for a rating agency to massage up a rating in order to prevent an issuer seeking a different (possibly higher) rating from a competitor agency.

Regulators have long recognised the Jekyll and Hyde nature of rating agencies and are now setting about to change this, specifically by eliminating references to credit ratings in new regulations governing financial stability. Globally, the Financial Stability Board (FSB), chaired by the Governor of the Bank of England, Mark Carney is leading the charge. In October 2012, the FSB, of which South Africa is a member, published a roadmap for implementing its principles for reducing reliance on credit rating agency ratings¹¹. The roadmap to removing the references to credit ratings embedded in regulations is being implemented globally, including here in South Africa, and there is now widespread acknowledgement that mechanical reliance on credit ratings to ensure the credit-worthiness of an investment is no substitute for fundamental due-diligence and analysis. Furthermore, baking into regulations a reliance on credit ratings as a means for measuring financial strength may in fact be compounding the problem of mechanical reliance and fails to recognise that the credit rating business has embedded conflicts of interest.

Mark Carney appears in front of the UK Treasury Select Committee in advance of his confirmation as the first non-Brit to become Governor of the Bank of England. Carney assumed the role on 26 November 2012

What is not yet changing is the ‘issuer pays’ model and so while the split personality is changing, the conflict of interest to investors relying on these ratings will likely persist for some time. The winds of change will, to many, feel more like a breeze but what this does highlight is the potential for latent conflicts of interest in our financial system to pass undetected for long periods of time. These conflicts of interest are, in of themselves, not necessarily problematic. What is problematic is not taking being aware of the conflict when using these ratings in ones assessment of credit risk. As we will illustrate in our next point, whilst the current model may be imperfect, the rating agencies themselves are transparent on these points so it should be the role of the end-user to understand how best to use the output from the credit rating agencies.

Lesson 4: There is no such thing as a free lunch; if something looks too good to be true it probably is. A credit rating does not reflect all information about the credit worthiness of a portfolio. If regulators are changing regulations to remove references to ratings as a measure of credit worthiness perhaps investors should, at the very least, try to broaden their approach to controlling the credit quality of those they lend money to.

Rating agencies have a long history of slow reaction to financial distress. This dates back to the default of Penn-Central Railroad¹³ and First Executive Corporation but it was the defaults of US companies Enron on 28 November 2001 and WorldCom on July 21 2002 that drew the ire of US politicians who reacted angrily to the fact that the Big Three rating agencies maintained an ‘investment grade’ rating for Enron’s bonds until five days before Enron declared bankruptcy.

                                                          The lighter side of the Enron scandal

The delayed response by rating agencies was also prevalent when Lehman Brothers defaulted on Monday 15 September 2008. The Friday before (12 September), Lehman bonds held an investment grade rating. This phenomena, known as ‘jump-to-default’ – where a seemingly credit worthy institution can move, literally overnight, to being in default for many investors is seen as all too common an occurrence so perhaps we need to understand why these professional rating agencies seem unable to foresee impending trouble or have investors misunderstood the purpose of these ratings?  

The key lies in recognising that credit ratings are not necessarily designed to be a forward predictor of deteriorating credit worthiness. Furthermore there are many studies in finance literature which demonstrate that a borrower’s future credit worthiness (or more aptly its lack thereof) may be better predicted by a:

-       deterioration in its share price¹⁴;

-       an increase in its credit spread¹⁵ (the additional yield demanded by lender’s to lend to a company rather than a safer borrower, say, the government); and

-       an increase in the implied cost of insuring against a default by the borrower¹⁶;

There are many structural reasons that explain why, by design, credit rating changes may lag actual changes to a company’s likelihood of default and hence why credit ratings may not be the best predictor of future credit worthiness. We outline some of these below.

1.     There is evidence to suggest that rating agencies adopt an approach known as a ‘through-the-cycle’ approach. This means that an assigned rating may not immediately change to reflect adverse events unless those adverse events are expected to be long-term and significant enough to cause a move to a lower category on their rating scale. This means that rating changes by design take place quite gradually and may not be as timely as investors may assume them to be. Rating agencies have come in for a fair degree of criticism on this point from investors demanding a more timely credit assessment. This criticism is too often levelled by those with an insufficient understanding of the credit rating agencies methodologies and their limitations.

2.     Credit rating agencies use a rating scale which has a limited number of categories¹⁷. As a result it is possible that the credit worthiness of a company has deteriorated but that it has not deteriorated to a sufficient extent to warrant a downgrade to a lower rating category. [In technical jargon, credit ratings are a discrete variable whilst the likelihood of default is a continuous variable.]

3.     Credit ratings are not being continuously updated yet, the likelihood of a company defaulting changes in real time. Some lag in updating the rating is therefore inevitable.

There are a few implications that arise from these observations:

-       Credit ratings are not meant to be a panacea and are no substitute for a thorough bottom-up fundamental analysis.

-       Exposure limits set by bond investors for their fund managers (e.g. no more than a certain percentage invested in bond instruments with a particular minimum credit quality) are but one tool for controlling credit risk. A simple mechanical rule for limiting exposure by credit-rating is unlikely to be sufficient to control for credit risk.

-       It is entirely possible for, say,  two fund managers to each construct a debt portfolio with the same ‘average’ credit rating, yet offering very different yields. Investors and their advisers should recognise that, all else being equal, for a given average credit rating, the differences in yield between these two portfolios should act as a flag about the true credit worthiness of the two portfolios. This ‘flag’ with respect to the credit quality would not be apparent by simply looking at an average credit rating.

-       Fund managers should not be adding securities to their money market, income or other fixed income portfolios purely on the basis of the comfort they are drawing from a credit rating about the borrower’s credit worthiness

There are good reasons for the reactive nature of credit ratings and it is the responsibility of users of credit ratings to understand this, and other, shortcomings of credit ratings. Again, the mechanical use of ratings as a panacea for assessing credit quality is unfortunately far too common amongst investors, including professional investors.

Credit ratings have their shortcomings but they are still a useful tool if investors take time to understand and compensate for their limitations. Credit ratings cannot shoulder the blame for the follies of investors who use them without a thorough understanding of their limitations; much like guns credit ratings are only dangerous when used incorrectly and for the wrong purpose.

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Notes

(1)   Dick Fuld / Lehman default

       Lehman Brothers was a US investment bank that filed for bankruptcy on September 15^th 2008. DicK Fuld was CEO of Lehman at the time it filed for bankruptcy and is commonly thought to be the person whose actions, more than any other, contributed to the demise of Lehman. Lehman was the largest bankruptcy filing in US history, as measured by assets held at the time of filing for bankruptcy. Lehman had $691bn of assets at that point. Until Lehman WorldCom was the largest bankruptcy; when WorldCom filed for bankruptcy it had $104bn of assets.

       Source: http://www.businessinsider.com/largest-bankruptcies-in-american-history-2011-11?op=1

(2)   Madoff

       Bernie Madoff ran a pyramid scheme (also known as a Ponzi scheme) out of his Manhattan office, promising investors unusually large returns, using money from new investors to pay returns to older investors. Madoff was caught in December 2008 when investors started demanding returns. Madoff’s shenanigans shocked the already bruised global financial system that was still reeling from the default of Lehman Brothers only 3 months earlier.

(3)     LIBOR-fixing

LIBOR (London Interbank Offer Rate) is the average interest rate at which banks can borrow from one another. London is mentioned in its name because the benchmark is set in that city. A number of banks estimate how much interest they would pay to borrow money on a short-term basis from other institutions. While the process is still overseen by the British Bankers' Association, the calculations are now performed by Thomson Reuters. Thomson Reuters discards the four highest and four lowest submissions as outliers, and averages the remaining ones.

       The data provider then publishes its calculations, generally around 11:30 a.m. London time, along with each bank's submissions. There are actually 150 different Libor rates published every day. They cover 10 currencies and 15 maturities.

       Essentially, Libor is one of the main rates used to determine the borrowing costs for trillions of dollars in loans. Interest rates on some mortgages, student loans and credit card accounts rose or fall when Libor moves. Often the rates are adjusted annually or quarterly, rather than every day. Interest rate swaps may reference LIBOR if they reference a floating rate of interest.

       In late June 2012 news broke of fines of close to $450m being imposed against Barclays PLC. This was the first time that the public heard of the manipulation of this key interest rate even though it would subsequently become clear that the earliest evidence of LIBOR-fixing dated back at least 4-years prior.

(4)  Dark pools

Dark pools are a private trading venue where details of trades are not made available to the public. The main advantage of these trading venues is allowing their participants to conduct trading activity without revealing their true investment intentions – the fear being that if their investment intentions were made public, knowledge by the wider public could adversely impact the performance of their intended investment strategy.

       As the name suggests, these private trading venues operate away from the public exchanges like the London or New York Stock Exchanges. Instead they are operated by large investment banks.

       CBS News noted that: ‘The problem is that so much trading is now happening in dark pools that it may be warping publicly quoted stock prices to the extent that they no longer properly represent where the market is. For example, if a lot of sell orders for stock in ABC123 Corp. are waiting to be fulfilled in a dark pool, then buyers in the pool and elsewhere don't know that the price of that stock should be lower than it is. Further, because dark pools base their prices on the prices from the public exchanges, then the prices in the dark pools will be wrong as well.

       Also, dark pools have several characteristics in common with things that contributed to the financial crisis: lack of transparency, under-regulation and, because of the amount of trades they now handle, they have clear systematic links to the rest of the financial system and the entire economy.’

(5)  High frequency trading

High-frequency trading (HFT) is algorithmic trading that involves the very rapid placement of buy and/or sell orders, in the realm of tiny fractions of a second. It is alleged that HFT firms are often involved in front-running whereby the firms trade ahead of a large order to buy or sell stocks based on non-public market information about an imminent trade. Another criticism is that HFT has increased the level of potential market systemic risk whereby shocks to a small number of active HFT traders could then detrimentally affect the entire market. A related concern is whether HFT could exacerbate market volatility. These concerns have percolated since the “Flash Crash” of May 6, 2010, when the Dow Jones Industrial Average (DJIA) fell by roughly 1,000 points in intraday trading—the largest one-day decline in the history of the DJIA. The crash was analysed in an investigative report by the SEC and CFTC which, among other factors, looked at the role that HFT may have played and determined that it was not the cause, but may have exacerbated the crash.

       Regulators have been scrutinizing HFT practices for years, but public concern about this form of trading intensified following the April 2014 publication of a book by author Michael Lewis.

       Source: High Frequency Trading: Background, Concerns and Regulatory Developments; Gary Shorter and Rena S. Miller; 19 June 2014; Congressional Research Service. http://fas.org/sgp/crs/misc/R43608.pdf

(6)  Commodity price fixing

Prices for oil and other commodities are estimates based on either:

-       standardised contracts that trade transparently on regulated exchanges or

-       data on bids, offers and deals as reported by unregulated price-reporting agencies (PRA’s) which make money by gathering market information and selling it to subscribers.

       The European Commission and the US Commodity Futures Trading Commission (CTFC) in 2013 started investigating possible market-rigging of commodity prices by oil companies. Platts, the largest PRA was raided by the EU in 2013.

      

Source:TheEconomist http://www.economist.com/news/finance-and-economics/21595943european-union-wants-change-how-commodity-benchmarks-are-set-fixing-fix

(7)  Has the US defaulted before?

Not really. There are three examples in US history that come close to default, with the most recent occurring in 1979. Then, the US Treasury inadvertently defaulted on $122m, because of what it said was a word processing error. Although the error was quickly fixed, and even though $122m was a tiny fraction of the $800bn in debt that the Treasury had at the time, a study found that the mini-default raised the cost of borrowing by 0.6%, or $6bn a year.

       The other two instances, in 1933 and in 1790, both involve defaults akin to the current situation in Greece, when creditors were forced to take less money than what they were owed. Some economists have defined this as a default, but it's murky territory.

       (Source: BBC)

(8)   Credit rating agencies

A credit rating agency is a professional firm which issues assessments on bonds that provide investors with an opinion on the credit quality of the bond – i.e. an assessment of the borrower’s ability to pay both interest and capital and the likelihood of default. Bond markets existed for at least 60 years prior to advent of the first credit rating agency in 1909. There are approximately 150 credit rating agencies worldwide although just three agencies dominate; Moody’s, Standard & Poor’s and Fitch. Of these S&P and Moody’s dominate.

       The next largest rating agency after S&P and Moody’s is Fitch. Fitch Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old entrepreneur who had just taken over his father’s printing business. Fitch had a unique goal for his company: to publish financial statistics on stocks and bonds. In 1924, Fitch expanded the services of his business by creating a system for rating debt instruments based on the company’s ability to repay their obligations. Fitch were first to introduce the now familiar "AAA" to "D" ratings scale to meet the growing demand for independent analysis of financial securities. Although Fitch’s rating system of grading debt instruments became the standard for other credit rating agencies, Fitch is now the smallest of the “big three” firms.

       Source: Basel Committee on Banking Supervision, 2000; Langohr and Langohr, 2008, p.384

(9)  African bank credit rating

Note that the rating was investment grade on the national scale but sub-investment grade on a global scale.

(10)   Regulatory role of credit rating agencies

The regulatory role of credit rating agencies dates back to 1934 when US bank regulators decreed banks could not invest in non-investment grade (low credit quality) bonds as determined by a recognised rating agency (or manual as they were then). The only recognised credit rating manuals at the time were those issued by Moody’s, Poor’s, Fitch and Standard. With this, the credit assessments made by these third-party and for-profit organisations attained force of law.

       In the decades that followed, some insurance and pensions regulators followed similar routes by linking what they deemed suitable bond investments to the bond ratings issued by these rating agencies.

       The SEC then finally cemented the regulatory role of rating agencies in 1975 with two acts:

-       the creation of the ‘nationally recognised statistical rating organisation’ (NRSRO) and

-       the grandfathering of Standard & Poor’s, Moody’s and Fitch as NRSRO’s,

by decreeing that only a rating from an NRSRO could be used as a measure of the credit-riskiness of broker-dealers (in 1975) and as a measure of the credit-riskiness of commercial paper held by money-market funds (1990).

       Between 1975 and 2000, the SEC designated only four additional firms as NRSROs: Duff & Phelps in 1982; McCarthy, Crisanti & Maffei in 1983; IBCA in 1991; and Thomson BankWatch in 1992. Mergers among the entrants caused the number of NRSROs to return to the original three by year-end 2000.

       Source: Journal of Economic Perspectives – Volume 24, Number 2- Spring 2010 – Pages 211-226. The Credit Rating Agencies by Lawrence J. White, Professor of Economics, Stern School of Business, New York University, New York. Lwhite@stern.nyu.edu.

(11) Reasons for moving from ‘investor pays’ to ‘issuer pays’

Some of the reasons given include:

-       The advent of the high-speed photocopying machine meant that many investors would have been able to simply photocopy the rating manual from other investors thereby reducing the rating agencies’ revenue.

-       The bankruptcy of Penn-Central Railroad in 1970 was a catalyst for bond issuers to have credit rating agencies vouch for them by rating their debt and reassuring investors about their low risk status. This made bond issuers more willing to pay for the rating.

-       Bond rating firms realised, somewhat belatedly, that regulations had been passed in the US requiring some institutional investors to hold debt with certain ratings. This observation would make issuers more willing to pay for a rating to get their bonds into those portfolios.

(12)   Press Release: FSB publishes thematic peer review report on reducing reliance on credit rating agency (CRA) ratings http://www.financialstabilityboard.org/press/pr_140512.htm

(13) Penn-Central Railroad

In May 1970, Penn Central Railroad, then on the verge of bankruptcy, appealed to the Federal Reserve for aid on the grounds that it provided crucial national defence transportation services. The Nixon administration and the Federal Reserve supported providing financial assistance to Penn Central, but Congress refused to adopt the measure. Penn Central declared bankruptcy on June 21, 1970, which freed the corporation from its commercial paper obligations. To counteract the devastating ripple effects to the money market, the Federal Reserve Board told commercial banks it would provide the reserves needed to allow them to meet the credit needs of their customers. In 1971, the government provided $676.3 million in loan guarantees. In 1976, the federal government consolidated the still struggling Penn Central with five other railroad companies that were also failing to form Consolidated Rail, or Conrail. The government spent $19.7 billion, including roughly $7.7 billion for the initial investment, to keep Conrail operating. By 1981, Conrail began to earn a profit. The government sold Conrail in 1987 for $3.1 billion. In addition to the sale price, the Treasury received a $579 million dividend from Conrail.

       Source: http://www.propublica.org/special/bailout-aftermaths

(14)  Norden, L. and Weber, M. (2004) Informational Efficiency of Credit Default Swaps and Stock Markets: The Impact of Credit Rating Announcements. Journal of Banking and Finance, 28, 2565-2573. http://dx.doi.org/10.1016/j.jbankfin.2004.06.011

(15)  Hull, J., Predescu, M. and White, A. (2004) The Relationship between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements. Journal of Banking and Finance 28, 2789-2811. http://dx.doi.org/10.1016/j.jbankfin.2004.06.010

        Note that in emerging markets (like South Africa), the usefulness of credit spreads can be more limited than in developed markets, due to the lack of a readily liquid secondary market. Furthermore some methodologies used by exchanges to mark corporate bonds to market require a minimum traded amount to be reached before prices (and hence credit spreads) are updated.

(16)  Hull, J., Predescu, M. and White, A. (2004) The Relationship between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements. Journal of Banking and Finance 28, 2789-2811. http://dx.doi.org/10.1016/j.jbankfin.2004.06.010

(17)  Response of rating agencies to criticisms of their discrete scales

Moody’s and Standard &; Poor’s have adopted refined rating categories by adding modifiers (e.g. “+” and “−”, or “1”, “2”, and “3”) to the generic rating categories to indicate whether a bond is on the upper, middle, or lower end of the rating category. The refinement of the rating categories can be viewed as a step moving from a discrete rating system toward a continuous spectrum. So refined ratings not only reflect the default probability more precisely, they also may trigger a rating change more quickly as rating agencies do not have to wait until the financial positions of bond issuers to deteriorate (or improve) to the next broader generic rating category to make rating changes.

       Source: Do Credit Rating Agencies Sacrifice Timeliness by Pursuing Rating Stability? Evidence from Equity Market Reactions to CreditWatch Events Jenny Gu, Jeffrey S. Jones, Pu Liu, 13 May 2014

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