Public Credit Rating Agencies

Public Credit Rating Agencies

Public Credit Rating Agencies Increasing Capital Investment and Lending Stability in Volatile Markets Susan K. Schroeder

PUBLIC CREDIT RATING AGENCIES Copyright Susan K. Schroeder, 2015. Softcover reprint of the hardcover 1st edition 2015 978-1-137-36580-4 All rights reserved. First published in 2015 by PALGRAVE MACMILLAN in the United States a division of St. Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-57011-9 ISBN 978-1-137-35911-7 (ebook) DOI 10.1057/9781137359117 Library of Congress Cataloging-in-Publication Data Schroeder, Susan K. Public credit rating agencies : increasing capital investment and lending stability in volatile markets / Susan K. Schroeder. pages cm Includes bibliographical references and index. 1. Credit bureaus. 2. Capital investments. 3. Business cycles. I. Title. HG3751.5.S37 2015 332.0415 dc23 2015009602 A catalogue record of the book is available from the British Library. Design by Newgen Knowledge Works (P) Ltd., Chennai, India. First edition: September 2015 10 9 8 7 6 5 4 3 2 1

To the memory of my dad David W. Schroeder Sr.

Contents List of Figures and Tables Preface ix xi 1 Introduction 1 2 Functions and Malfunctions of the Rating Industry 9 3 Private Credit Risk 25 4 Sovereign Credit Risk 73 5 Regulatory Capture 105 6 Public Credit Rating Agency: Functions and Structure 125 7 Conclusion 161 Notes 173 Bibliography 179 Index 191

Figures and Tables Figures 2.1 NRSRO ratings by asset class: 12 months ending December 2013 (Total: 2,437,046) 10 3.1 Volatility indicators for selected countries, based upon % change in gross capital formation 57 3.2 Volatility indicators for Japan and Korea, based upon % change in gross capital formation 58 3.3 Volatility indicators for Australia, New Zealand and United Kingdom, based upon % change in gross capital formation 58 3.4 Manufacturing (% of total value added): selected countries 59 3A.1 Minsky s graphical determination of investment and finance 70 4.1 General government debt/gdp: selected countries 95 4.2 Central government debt/gdp: selected countries 95 4.3 GDP growth (% change): selected countries 95 4.4 Central government expenditure (millions of euro) and share of GDP: selected countries 96 4.5 Composition of expenditures by central governments: selected countries 97 4.6 Central government net lending (% of GDP): selected countries 99 4.7 Current tax receipts by source (millions of euro): selected countries 99 4.8 United States: debt/gdp and net lending/gdp 101 6.1 Incremental rate for the US economy (1997 2013): OECD vs. NIPA 134 6.2 Growth rate of real personal consumption expenditures: United States (1990 2013) 135

x F I G URES AND T ABLES 6.3 IRR vs. interest rate: United States (1976 2013) 135 6.4 Smoothed IRR vs. interest rate, 3-year centered moving averages: United States (1977 2012) 136 6.5 IRR without property income (personal & government) vs. interest rate: United States (1976 2013) 137 6.6 Smoothed IRR (without property income) vs. interest rate, 3-year centered moving averages: United States (1977 2012) 137 6.7 Employee compensation and rental income of persons (% of national income): United States (1976 2013) 138 6.8 Compensation & rental income vs. corporate profits (% of national income): United States (1976 2013) 138 6.9 IRR vs. % change in (real) investment, 3-year centered moving averages: United States (1997 2012) 139 6.10 3-year moving averages of selected industrial IRRs: United States (1998 2012) 140 Tables 2.1 Global long-term ratings for major three credit rating agencies 14 2.2 Global short-term ratings for major three credit rating agencies 14 3.1 Key criteria for corporate ratings 38 4.1 Standard and Poor s sovereign factors and indicators 82 4.2 Moody s sovereign factors and indicators 83 4.3 Fitch s sovereign factors and indicators 84 6.1 Rating structure for Export-Import Bank of the United States 145

Preface The book extends an article that I wrote for the Journal of Economic Issues, titled A Template for a Public Credit Rating Agency. The challenge was not simply to reiterate and provide more detail on the vision in the article but also to discuss such how such an institution could stabilize and promote investment activity, encourage lending and growth. Reviewer feedback from the book proposal also suggested that the book address issues such as the robustness of Ricardian equivalence and the influence of regulatory capture on the rating industry, among other things. This book is the product of those exchanges. This project a public credit rating agency was motivated by my desire to come up with something different for stabilizing an economy. There has got to be another way forward on policy and its design than to simply add to the discourse about the relevance and effectiveness of fiscal and monetary policies. For me, new directions ultimately lie in the vision one holds about the inherent nature of investment is it an activity that helps to stabilize an economy or one that destabilizes an economy? One s answer to this response highly influences how one thinks about policy. On the one hand, for mainstream economists the vision is that investment activities promote stability. Mainstream economic policies are primarily oriented to support investment s stabilizing nature by unleashing the power of the markets. On the other hand, for most heterodox (nonmainstream) economists, investment activities are destabilizing. As such, overreliance on the market mechanism ultimately promotes instability. The stance taken here is that investment is inherently destabilizing and what follows will flow from this perspective. This book explores the implications of that distinction for evaluations of creditworthiness, with particular focus on credit rating agencies as the leading, and most publicly accessible, assessors of credit risk. It is important to bear in mind that although the rating agencies are criticized over their ratings of structured finance instruments, they also assess variety of other instruments and issuers that are more

xii P REFACE closely related to productive investment. If the pace of productive investment is influenced by assessments of credit risk, such as ratings, it is important to address the issues concerning the accuracy of ratings, particularly in this context. Are they as accurate as they could be? The presence of a public credit rating agency could stimulate developments that improve the quality and timeliness of ratings, and assessment of creditworthiness more generally. Benchmarks and instruments can be devised that supplement the use of interest policy to promote the stability of financial systems. Moreover, if a public crediting agency were to be coupled with an industrial policy, it could stabilize not only investment but also everything that investment activities influence, such as profit, income, employment, and economic growth. This does not imply that growth needs to necessarily increase at breakneck speed. Slower growth that is targeted to support civilian industries can be just as powerful, if not more so, for setting the foundations for more stable and just societies in the future. Of late, there has been renewed thinking on industrial policy. However, the basis of the discussion still rests on a vision in which investment promotes the stability of an economic system. As will be discussed in the coming chapters, an implication of this vision is that the success of industrial policy rests on worker productivity. Viewed from the perspective of heterodoxy, productive workers are great. However, productivity is not enough to stabilize investment and keep it profitable. There needs to be an effort to support the absorption of supply of goods and services, especially for activities related to civilian industries. Stable growth and income also means stable tax revenues for governments, which, in turn, will help them reduce their reliance on financing current expenditures with new debt. It would also give them the ability to create plans for debt reduction. The creditworthiness of firms ultimately impacts the creditworthiness of sovereigns; in turn, the performance of these instruments supports the health of banks and other financial institutions and investors. The rating agencies understand the importance of economic performance and structure for the resilience of governments fiscal positions. However, the assessments of governments and firms may be overlooking important dynamics associated with investment. An important consideration is whether investment should be considered an inherently destabilizing activity. Revisiting the work of Hyman Minsky and other heterodox economists can provide insights into why that would be the case. What the dominant methods for evaluating creditworthiness may be overlooking is examined here, and how the oversights may explain

P REFACE xiii the sluggishness and pro-cyclicality in the quality and timeliness of assessment revisions, such as rating changes. Toward these ends, a public credit rating agency could provide the space and support to come up with improvements to default and credit risk assessment, and not just for governments and corporations (nonfinancial and financial), but also for assessments of individuals and small- and medium-sized firms (SMEs) in a variety of industries and regions. At this point, an examination of Ricardian equivalence is especially helpful. Ricardian equivalence requires a very specific context in order to have analytical merit. Once debunked, the tax and debt policy options widen considerably to support a Public Credit Rating Agency (PCRA), the justification for reinvigorating industrial policy and the creation of an insurance scheme to protect the trade credits of SMEs, all of which could contribute to the public s interest by stabilizing what is an inherently unstable economy. Please note that I tried to cast the discussion as simply as possible in order to facilitate understanding by those who do not possess sophisticated training in economics. Throughout this project I was reminded of my discussions with my dad about my research interests. The quantitative details were always a bit tough going. I tried to minimize them here. I would like to thank the various academics whom I approached to provide feedback on aspects of this project. I also thank the staff at Palgrave Macmillan Sarah Lawrence, Leila Campbell, and Leighton Lustig for their patience, professionalism, and encouragement. Last, but not least, I would like to thank my support network family members and friends for their patience while listening to me (occasionally) whinge out of fear and frustration. Special thanks to Mrs. Sheila Simpson-Lee for her generous donation of history of thought materials to support this project and others in the works. And, my thanks to anyone who may have been inadvertently overlooked. I hope that you will find this book to be insightful and stimulating. The errors are my own.