Sunday, August 7, 2011

Judicial Temperament Required for Credit Ratings and Portfolio Management

In most professional military forces, important punishments are the result of judicial trials. In these cases, relatively senior officers are chosen to be the judges and when a jury is required, those seated need to have a representation of similar rank as the defendant. When I was in the US Marine Corps, one of my collateral duties when aboard ship was to serve as the legal officer. When there were military courts martial of significance, I had to participate in the selection of members of the jury. In selecting marines and sailors, I was required to be guided by choosing people with “judicial temperament.” This term describes an individual, who after reviewing all of the evidence presented, makes decisions based on the facts without any pre-conceived biases. These judgmental approaches to military jury selection are not shared with either the public or the press. If disclosed, these judicial screenings might spur a rush to judgment that could lead to an unpleasant set of reactions. This weekend after the Friday downgrade of the US Intermediate credit rating from AAA to AA+ by Standard & Poor’s, there were harsh and uninformed statements made in the press by various members of the government and their flacks, all lacking judicial temperament in my judgment.

The Recognition of the Downgrade

To put the action of S&P into perspective, I believe one should understand the function of a credit rating agency. (Important disclosure: we have a position in Moody’s in our financial services private fund.) The job of a credit rating agency is to express an opinion as to the odds on the failure of an issuer of timely payment of interest and repayment of principal. Since their establishment, the three main credit raters, S&P, Moody’s, and Fitch have done a remarkably good job adjusting their ratings to expected risks of default, with one glaring exception. The glaring exception was in the securitized packages of residential mortgages. (The mistake made was to treat these packages on the same risk rating scale as corporate and governmental issuers. Further, the short history of payment of interest and principal in a securitized form was not fully appreciated.) The credit rating process is to gather all the known facts about the issue to be evaluated, as well as the issuer itself; then a ratings setting committee of senior researchers evaluates the whole package as to the likelihood of default. The focus is on all of the evidence not just a sub-set. In assessing the risk of default, both the ability to pay and the willingness to pay should be considered.

The published thinking of S&P (which was discussed with the issuer, the Administration, since last April) was to take into consideration the political will to address the growing deficit. The raising of the debt limit was never a real issue, as the government had numerous ways, all painful, to avoid the immediate need to borrow more money. S&P’s view is that fiscal policy is married to political policy. The unwillingness to find a solution to the deficit issues, in the end led to lowering the credit rating. One should note that the AAA rating is like being number one on any ranking list. The history is that over time, most number ones lose their ranking.

As this is being written on Sunday we do not know what Moody’s and Fitch will do immediately, but both have made statements of concern recently. Their methodologies are similar, but not identical to S&P's. At the moment we have a split rating which at least temporarily gives a combination of AAA/AA+. Many in the traditional fixed income world give Moody’s a slight preference, as the older and perhaps sounder agency. Thus, it will be significant when and how it issues a new opinion. At the moment the focus is only on the intermediate debt, as the belief is that both the short term and the long term debt remains with the highest ratings.

While I believe that the AAA credit rating should have been removed years ago because of perennially unbalanced budgets stretching back to the 1930s, there is ample evidence that all of the recognized credit raters are currently exhibiting sound judicial temperaments.

The Fast Reactors

People believe that securities prices move on the latest incremental bit of information. That is why many analysts and the electronic media are very quick to report any and all incremental bits. To emphasize the importance of the increments, often they proclaim that various securities should be immediately bought or sold to move ahead of those investors whose information is not as current, or those who move more slowly. The prize goes to the first movers. Most often there is not a review of all the relevant facts and so there is a lack of judicial temperament being offered.

The Prudent Long Term Portfolio Manager

As fiduciaries entrusted with quasi-permanent funds, we need to balance the current changing environment with the long term needs as to the disposition of the assets that are our responsibility. We need to weigh carefully the likely impact of the news along with the costs of changing positions in terms of meeting our clients' long term goals. I have believed that the US Government and many other governments have been debasing not only their currency, but more importantly their societies, ever since they have undertaken “to do something” about employment. Thus the recognition of the initial downgrade does provide some comfort that the basic laws of economics do work eventually. As most currencies have been debased through years of inflation from unbalanced budgets, and there is only a limited amount of gold available, I would be surprised to see a major shift near term in the disposition of large portfolios. In the longer term I suspect we will put our faith in commercial companies producing reliable earnings to be our principal store of value.

What do you think?


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