Bailout Fund Ratings And Snake Oil Don't Mix

The response to the downgrade of the Eurozone bailout funds from Aaa has yielded a fascinating political response from the head of the fund. 

Moody's, the ratings agency, says the €700bn European Stability Mechanism (and the the EFSF it replaces) is now a riskier proposition since France lost its Aaa rating earlier this month. It considers that, if the full fund were needed, France would have to stump up 20%. The whole purpose of the fund is to invest in the debt of weaker Eurozone member states whose creditworthiness is highly correlated. So, if one runs into economic trouble, they all do. That also makes for a "highly concentrated credit portfolio." And if push came to shove, Moody's doesn't think France would prioritise it's ESM contributions above its own debt payments. Similarly, in that event it would be unlikely that other member states would make up France's shortfall.

Both the chairman and managing director of the ESM were keen to claim political support for the fund. The ESM's chairman said:

"The 17 euro area Member States are fully committed to ESM [and EFSF] in political and financial terms and stand firmly behind both institutions."

And the ESM's managing director said:

“Moody's rating decision is difficult to understand. We disagree with the rating agency's approach which does not sufficiently acknowledge ESM's exceptionally strong institutional framework, political commitment and capital structure."

Of course, the political reality is actually the flaw in the single market and Euro fantasy: there's no credible plan to discipline profligate states, as the continuing Greek tragedy demonstrates. Those who negotiated the Maastricht Treaty foolishly believed such states would ultimately behave in the interests of the Zerozone, just as Alan Greenspan thought the boards of Lehman Brothers and others would refrain from driving their firms into a wall out of concern for the interests of shareholders and taxpayers... snake oil. 

The only real disciplinary option is for creditor states to 'send the boys around' to the debtor states. In that event all political solutions will have been exhausted, and the 'European Union' long gone. 

So Moody's is right to discount the politics - and the ESM's credit rating.

If the politics is not to further undermine the ESM, politicians have to demonstrate that the disintegration of the Euro zone is survivable. 

Of Creative Destruction, Auditors and Ratings Agencies

Among the lessons to be learned from the financial crisis, so far we've rightly heard a lot about self-restraint and more effective financial regulation. But we've not heard much about how the market for external audit services and credit ratings will change to help protect taxpayers from footing the bill for future bail-outs.

There have been many significant accounting scandals in the decade since the the Dot-com bubble burst on 10 March 2000. Enron died in 2001, eventually taking accounting giant Arthur Anderson with it. WorldCom filed for Chapter 11 in 2002, the same year the Tyco scandal broke - among many others. In 2003, the Ahold and the Parmalat scandals broke. In 2004, it was AIG under investigation, which duly restated its net worth as being 3.3% lower. Madoff's activities went on unchecked until 2008. Meanwhile investment banks packaged the riskiest types of mortgages into allegedly low-risk bonds as due diligence methodologies became outpaced by the sheer scale of debt issuance, seriously undermining confidence in the standards set by ratings agencies.

More scandals and surprise losses are on the way. Only yesterday, internal auditors at 75 major UK corporations recently confessed in a survey conducted by a major accounting firm that they are failing to stem the rising tide of fraud, and are increasingly vulnerable to it:

"The three most common types of fraud were misappropriation of assets, suffered by 31 per cent of companies, improper expenditures (22 per cent) and procurement fraud at 16 per cent. Poor financial controls and collusion between employees and third parties were seen as important drivers of fraud."

In these cases one might conclude that accounting, financial controllership, auditing and the assessment of credit risk all succumbed to the same illness. In fact, there are more similarities than differences between the activities of ratings agencies and audit firms, so they ought to share the criticism of the state of the market for those activities.

There have always been arguments about where the scope of external audit responsibility begins and ends, and whether firms who offer audit services should continue to be free to also offer accounting, regulatory and risk management advice - or, indeed, credit ratings - where they make most of their money. But the fundamental reality is that auditors and ratings agencies purport to offer to external stakeholders some verification of a corporations' activities, yet their fees are paid by the corporations they audit or rate. So there are inherent conflicts of interest to be managed right from the start. We've also now reached the awkward stage where only four firms audit most of our major corporations, including banks. And only three ratings agencies assess the risk of default on most of planet Earth's 'investment grade' securities. Worse still, in May 2010, two of the 'Big Four' major global audit firms said they were planning to launching ratings businesses.

Little wonder that the Financial Reporting Council's Professional Oversight Board believes that the Big Four accounting firms outweigh their regulatory constraints (hand-wringing we've seen before). And that the G20 leaders wish to reduce their reliance on ratings (see the October Basel Committee report), while global regulators are calling for an alternative to single-grade ratings by rating agencies (note the particular frustration of the SEC and the FSA on this front).

Worryingly, however, we are only seeing expressions of frustration from the bodies we rely upon to control the situation. Certainly, the European Commission's dithering over the stranglehold of the Big Four suggests we won't see a more robust approach in the EU any time soon.

Experience suggests that these sorts of issues are only resolved after a crisis has occurred - the process of creative destruction traced in The Ascent of Money. It is also said that industries naturally concentrate and fragment, although customer dissatisfaction and the competitive activities of players normally considered to be in other markets play a role - e.g. social finance models involve parceling loan amounts into tiny loans at inception, rather than introducing layers of securitisation.

So, eventually, life will get pretty rough for the auditors and the ratings agencies. And for the taxpayer. Again.

Slim comfort.

Image from Critter's Crap.