Paul De Grauwe cautions in today’s FT about the weight currently being placed on rating agencies’ pronouncements about sovereign ratings. Is there a chance, he asks, that where once they were wildly optimistic, they’re now being overly-pessimistic?
In statistics, a distinction is made between type I and type II errors. A type I error occurs when a hypothesis (eg a company is risky) is rejected when it should have been accepted. A type II error occurs when a hypothesis (a company is risky) is accepted when it should have been rejected.
The rating agencies made systematic type I errors in the past. They had an excessive faith in the soundness of the private companies they were rating and failed to identify massive risk-taking by these companies, until the crisis erupted. There is no reason to believe that agencies that have excelled at making type I errors could not equally excel at making type II errors. In fact, we have every reason to believe that they will do so. Having made systematic type I errors, they are now more likely to make type II errors – finding risks where few exist.
In particular, notes De Grauwe, why have some countries – like Greece, Spain and Ireland - seen ratings cut or threatened to be cut, while others – like the UK or Germany, have not. To wit:
Government debt in the eurozone has declined steadily since 2000 (from 69 per cent of gross domestic product in 2000 to 66 per cent in 2007). The government debt of Greece, Ireland and Spain has declined even faster than in the eurozone as a whole. Two of them, Ireland and Spain, had a level of government debt that was about half the German and US levels in 2007.
It’s not quite so simple. Rating sovereigns is a wholly different kettle of fish compared with rating corporates, or for that matter, structured finance products.
In rating structured finance products the process is very much a quantitative one: it’s accountancy larded with a few actuarial skills. What you are trying to model is a mathematical machine. There are of course qualitative risks – you need to keep a constant eye on the applicability of your honed mathematical model to the underlying components it purports to measure (QED – 2000-2007, we didn’t) – but by and large, these are supposed to be secondary considerations.
In rating corporates, the quantitative element is ratcheted down a notch, and more qualitative judgement is needed. Companies’ balance sheets have many mechanical elements, but they’re also highly organic. Companies are more human. You cannot model the rating of Apple based on numbers derived from its SEC filings alone. There has to be room for a Steve Jobs effect too.
And finally, in rating sovereigns, the qualitative element grows in significance yet again. At least with companies, the random qualitative human element is in part restrained – in the modellers’ eyes - by law. Set rules and definitions keep the vicissitudes of human behaviour (fraud, thievery, defaults, for example) in check. Governments have the power to subvert those very rules. In rating sovereigns, you need political risk. You need to be able to gauge the conservatism – reliability – of a country’s institutions. You need to be able to gauge the degree to which a country is bound into the international debt markets and a host of other subjective metrics.
All of which is not to ignore multiple quantitative economic factors too: GDP per capita, government debt denomination, trade balances, tax raising power, etc etc.
Add all these things together and it should be clearer why some countries are less AAA than others; why Ireland is riskier than Britain or Germany, for example, even if its level of debt to GDP is less.
It doesn’t seem that the rating agencies are behind the curve yet when it comes to sovereigns. So far the downgrades have been expected, moderate and timely. Indeed, the process is a world away from the kind of downgrade tsunami we saw in the rating agencies’ structured finance business when the world turned last summer.
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“We live in a two superpower world”, wrote Thomas Friedman in the mid 90′s…
There is the US and there is Moody’s. The US can destroy a country by levelling it with bombs: Moody’s can destroy a country by downgrading its bonds.
This power makes the sovereign rating process in particular a highly important one to get right. It’s an irony then, that being so qualitative, the sovereign rating process is nominally, as per the above, also the most easy to accuse of being wrong.
Related link:
The full faith and credit of the UK – FT Alphaville
Spate of downgrades raises fears a big economy could be next – FT