Goldman Sachs does it better than the ECB . . . or the rating agencies.
Late on Tuesday, the investment bank published a proposal for the European Central Bank’s future role in shaping eurozone policy. The suggestion: a simple system of graduated haircuts on sovereign securities — based on the size of emerging imbalances — that would provide warning signals for markets. In fact, Goldman’s Erik Nielsen (long a fan of sliding haircuts) and Alexandre Kohlhas, argue such a system would probably have helped avert the recent eurozone crisis.
In a nutshell:
The European Commission’s proposals for “economic governance” represent a step in the right direction, but they are unlikely to be enough to engineer longterm sustainability of the Euro-zone, owing to the inherent problem of enforcing agreements among independent states. We argue that short of the introduction of a measurable degree of fiscal federalism, which would require changes to the Lisbon Treaty (a multi-year process, if politically feasible at all), the ECB’s collateral policies need to change. The current set-up is based on the false premise that there is no difference between the creditworthiness of sovereign member states—in other words, that the Euro-zone is a virtual federal fiscal system. This is not consistent with the (lack of) cross-country fiscal obligations and the existing Lisbon Treaty.
And indeed, current ECB collateral rules have all central government and central bank debt instruments classified as Category I. Depending on maturity, the Bank applies a haircut of 0.5 – 5.5 per cent to fixed coupon Category I securities rated at least A- by no fewer than three of the major rating agencies. There’s an additional 5 percentage point cut for those rated BBB- to BBB+.
This, Goldman says, not only means the ECB is largely reliant on credit rating agencies (and remember, that agency downgrades kicked off the 2009/early 2010 Greek furore) but it also means they’re treating Malta largely the same as say, Germany.
Goldman gets fairly harsh at this point:
. . . by relying exclusively on the credit rating agencies for its collateral policies, the ECB is missing important developments in member countries because of the agencies’ history of being lagging indicators of economic developments. Also, the illusion that it bases its policies on ratings has been misleading, at least this year, as changes were made when it seemed that the credit rating agencies’ actions did not fit the greater political objective.
Enter then, Goldman’s system of differentiated haircuts.
These are based on “the state of fundamental macro-factors” and act as an alternative to the current, rating agency-driven, system. Variables included in the ‘fundamental-based score’ are the general government balance, the level of general government debt, the current account deficit and the net international investment position. Add them together, and run them through Goldman’s magic formula, and you get scores such as the below — for Spain, Greece and Portugal:
The implication is that these fundamental scores would have done a much better job in warning markets of impending imbalances than the current rating agency-based system. What’s more, Goldman argues that in addition to historically lagging the market, “credit rating scores have, generally, not contained much information (if any) other than that already embedded in the spread.” Ouch.
Full note in the usual place.
Related links:
ECB must re-examine its dependence on ratings agencies – Erik Nielsen, FT
ECB haircuts are trimmed, ABStylish - FT Alphaville