S&P Looks at Temasek and Sovereign Wealth Funds Part I
Somehow I missed the November release of the credit ratings agency S&P asking for comments on its proposal for updating standards of investment holding companies (IHC) and government related entities (GRE). This is both a somewhat technical exercise and discussion by credit ratings agencies that takes place to reassess their standards for evaluating credit risk but also has very tangible impact on Singaporeans and can be explained in ways that make sense.
Before beginning to analyze the proposed S&P standards and Temasek’s response, let me try and provide some background to better understand the overall situation.
- S&P is one of the three major global credit ratings agencies along with Moody’s and Fitch. Their market dominance stems primarily from their oligopolist position conferred by the US government within the American market. Less than 10 credit rating agencies in the United States are recognized as “nationally recognized statistical reporting agency” which allows a privileged position for instance in rating investment grade debt held by a large variety of institutions. The big three are estimated to control approximately 95% of the credit rating market in the United States which they leverage into dominant positions throughout the world.
- S&P, in putting forth generalized standards, is trying to create a clear, transparent, framework that they can use to compare different companies rather than make every analysis unique. To take a simple scenario, they might state that companies with a debt to equity ratio of greater than 3:1 will receive a B rating while a company under than will receive an A. Framework standard sacrifice detail and uniqueness, which individual analysts will provide later when researching companies, for broad standards than can be applied throughout the world.
- The broad framework standards used by every credit ratings agency can be used to disguise the true risk. Frameworks to assess credit risk are generally solid guidelines but like all rules can be used to manipulate the overall system. During the global financial crisis, many mortgage linked products met the technical guidelines to receive a high rating even if it clearly masked the true level of risk for that financial instrument. Guidelines laid forth by ratings agencies should be considered fallible frameworks that attempt to capture common risk factors but they absolutely should not be considered final and perfect assessments of individual risk.
- Credit rating agencies are riddled with group think and conflicts of interests, but at the same time historical data reveals a very clear relationship between defaults and ratings. The riskier the rating the higher the probability of default (PDF). Credit ratings are imperfect by any measure with a systematic downward risk bias, but they should be ignored at your peril. There is a strong relationship between both initial rating and adjusted rating and default probability.
- Credit ratings rarely change so consequently, there is a lot more interest in the framework or the rules that allow firms to receive top credit ratings. Unlike credit default swaps (CDS) which trade daily and can be used to predict default probability, bond ratings typically go years without a ratings change so the initial rules of the game matter a lot more. According to S&P, the last time it changed its IHC framework was May 2004 when it was entitled “Rating Methodology For European Investment Holding And Operating Holding Companies.” The “European” in the title should giveaway how outdated the S&P framework is.
- Every firm that does not receive the rating they feel they deserve will loudly protest that there are factors unique to their situation that the ratings body is not accurately weighing. Most of the time, but definitely not always, firms arguments that the ratings agencies fail to accurately understand their industry or firm are poor attempts to gain a better ratings. Credit ratings by the large agencies on average accurately assess the credit risk associated with firm issued debt. If anything, credit ratings agencies on average understate rather than overstating the risk associated with debt products.
- S&P in its framework creation rarely deals with the type of issues I raise such as accounting or corporate governance problems but rather on much narrower concerns focused on whether debt can be repaid and potential stress concerns. For instance, two issue which S&P raises which may seem technical are liquidity and mark to market vs. trailing average over some period. Again, these are broader framework issues narrowly focused on repayment rather than the specific corporate concerns.
So as not to turn this into an excessively lengthy post, I am going to limit this post to the broader framework and background surrounding this issue. This is a very important issue that has very real ramifications for Temasek, Singapore, and everyday Singaporeans. I want to make sure the background and broader issues are understood so that when I turn to analyzing S&P’s proposal and the Temasek argument, everyone is aware of what is unfolding.
This may seem somewhat technical and boring but let me assure you it is vitally important and will be very important.