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China’s Rating Revenge

China's Dagong ratings agency is shaking up the West's 19th-century model...

THERE'S A NEW NAME in the credit-rating-agency business these days, writes Martin Hutchinson at Money Morning.

It's Dagong Global Credit Rating Co. Ltd. – a Beijing-backed business that represents China's bid for a spot in the global-credit-rating oligopoly.

Dagong's Chairman Guan Jianzhong doesn't think much of his long-established US competitors.

"The Western rating agencies are politicized and highly ideological and they do not adhere to objective standards," Jianzhong told the Financial Times earlier this month.

Is he right? And does the newly passed Wall Street Reform and Consumer Protection Act correct their flaws, or does it make matters worse? It's a question that affects all investors – even those of us that don't invest in bonds, as we'll soon see.

The credit-rating-agency system we have today grew up in the 19th Century. It was supposed to provide a way for bond investors to get information about credit quality of the corporate bonds they held or were interested in buying or selling – a bit of data that was very hard to get in those days, given the almost invisible standards of disclosure.

As regulators took over such industries as the insurance sector following the Great Depression, it appeared to make sense to use credit ratings as investment guidelines for the insurance companies' bond portfolios. When securitization came along after 1980, credit-rating agencies were naturally used to provide assurances about the underlying pools of assets that investors had no hope of assessing independently.

With corporate debt, the credit-rating system worked reasonably well. The rating agencies were paid by the issuer, which was theoretically a conflict of interest. However, investors were protected by the fact that the rating agencies needed to preserve their reputations: If too many AAA-rated companies went belly-up, the rating-agency system would have fallen into disrepute.

Internationally, there were always problems. Just take Venezuela. For decades, the rating agencies – blinded by the beauty of that country's oil reserves – rated Venezuela as a "triple-A" investment. We saw how badly that ended. But domestically the system worked pretty well. The rating agencies got pretty good at corporate credit assessment, preserving themselves from trial lawyers by stating firmly that they were only expressing an opinion on the value and quality of securities – like journalists, really.

The problem arose with securitization. It is now clear that neither the originating banks nor the rating agencies really understood securitization credit risk. They took a portfolio of assets being securitized, looked at historical default rates and applied so-called"binominal distribution analysis" to calculate the probability of the bonds defaulting.

If the portfolio consisted only of prime home mortgages, this approach wasn't all that inaccurate.

The problem came with assets of less-than-prime quality, and tranched securitizations, in which the top tranche would be issued as AAA-rated bonds and lower tranches as lower-rated bonds.

According to modern financial theory, the probability of default of the top tranche of even subprime mortgages was very small, indeed. However, the theory failed to take account of the possibility that the defaults might be correlated. If underwriting standards deteriorated, all the mortgages written during a bubble might be of extra-poor quality. If house prices declined nationwide, all the riskier subprime mortgages would be in trouble.

The theory underlying the calculations of default risk was rubbish, so the ratings were rubbish. Yes, rating agencies were in a conflict of interest, and allowed the investment-bank quants to "help" them in their analysis. But the investment bank quants – who were paid only if deals got done – also did not think hard enough about possible flaws in the theory.

That was the catalyst for the collapse of the U.S. housing market. From late 2007, AAA-rated tranches of subprime mortgages started defaulting. Double securitizations, in which securitized assets were re-securitized (for example, BBB-rated tranches of mortgage bonds were packaged together and tranched again) were even more screwy than ordinary securitizations, because the errors in the calculation were doubled.

Needless to say, rating agencies became pretty discredited. But they haven't been successfully sued, because they were able to claim that their ratings were just like a novel really – artistically elegant, but pure fiction.

The new Wall Street Reform and Consumer Protection Act attacks the rating-agency problem, but misidentifies it. It assumes that the rating agencies were seduced by the issuers into issuing misleading ratings, and that their integrity was at fault.

But that's not really correct: There has been no great epidemic of mis-rated corporate debt defaults. The rating agencies simply did not understand the characteristics of what they were rating in the securitization area – they were stupid rather than venal.

However, the Democrat Congress being what it is, its solution has been to force the rating agencies to take firm legal responsibility for the ratings that they issued – thereby handing them over to the tender mercies of America's trial lawyers when things go wrong.

In the short period since the law passed, the rating agencies have essentially refused to issue public ratings (they'll tell a bond buyer what his bonds should be rated, but only secretly). If this continues, of course, the agencies will soon have no business at all. So it won't continue forever.

In the corporate-credit arena, the market will probably re-establish itself – after some heavy work by the rating agencies' lawyers and a massive increase in costs. After all, the rating agencies really are quite good at rating corporations. However, given modern standards of disclosure, investors are also competent in this area. So the involvement of the rating agencies won't be absolutely essential.

A problem remains with securitizations. For anything but the most standard assets, investors have no way of accurately assessing the credit risk of a pool of miscellaneous assets. Given the legal liability they now face, the rating agencies will be extremely cautious in granting ratings to anything that isn't rock-solid.

There are two possibilities. The legal advisors may tell the rating agencies that the risks of rating securitizations is simply too great – in which case securitization will disappear altogether, and banks will be forced to hold the home mortgages, credit-card debts and auto loans they originate. That might work in the long run, but would cause huge disruption for several years, and probably a very deep recession.

The most likely outcome will be for the rating agencies to continue to rate securitizations, but very cautiously. In that case, mortgages, auto loans and credit cards will be more difficult to get, but not impossible, and the junk issued during the bubble of 2002-07 will not reappear. On balance – given the tendency of the U.S. consumer to take on too much debt – this could be a very good thing.

For investors who buy bonds, credit ratings in 2011 may be somewhat more conservative than they have been. So a 2011 ‘AA' may be equivalent to a 2010 ‘AAA.' For investors who as consumers want a mortgage, credit cards or an auto loan, the future does not appear so bright.

Of course, we could always get our credit ratings from Dagong – which, incidentally, is backed by Beijing. If that's the route we travel, allow me to wish the US trial lawyer community the best of luck going forward. When the time does come to sue, they'll not find it so simple to navigate China's legal system.

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Broken Rules, Broken Budgets

US municipal "muni" bonds are over-valued and overdue for a slump...

OF ALL THE speculative excesses that misguided monetary policy and a prolonged recession has caused, the one that poses the most danger to investor wealth is the financial bubble in state and local municipal bonds, writes Martin Hutchinson at Money Morning.

Municipal bonds – usually referred to as "munis" – are very popular portfolio plays because of tax advantages that, in effect, enhance their rates of return. There's also an allure because of their local nature: Investors can invest in specific bond issues that provided the money for projects such as schools, highways, bridges, hospitals or housing that actually affects the community in which the investor lives. That makes them a very tangible investment.

But there's a problem.

State-and-local-government finances have taken a bigger beating during this economic downturn than during any other recession since World War II. Even worse, that beating came after the easy money available during this stretch encouraged those same governments to venture well beyond any reasonable limits in terms of their borrowing. They're now stuck with a bigger-than-warranted debt load – which can't be covered by the property tax stream that's been reduced by record-level housing defaults.

The bottom line: At the present time, "munis" may not be the benign – or even alluring – investment that they've been in the past. In fact, thanks to continued fallout from the worst financial crisis since the Great Depression, some munis may be more akin to bombs than bonds – ticking away and just waiting to blow up your portfolio.

Brokers will tell you that particular state and municipal bond issues are "safe," meaning that they are rated highly by the rating agencies. However, the rating agencies got it wrong on subprime mortgage instruments, and it seems pretty clear that they are getting it wrong on states and municipalities.

Theoretically, state governments should not have this problem. All the states – with the sole exception of Vermont – have prohibitions against running budget deficits. Those prohibitions are in place for a reason: By avoiding deficits during healthy periods, the budgetary strain won't be nearly as severe when tax receipts and other revenue drops off during a downturn.

Defensive Investing Unfortunately, states have discovered various accounting dodges to get around the deficit prohibition, meaning the supposed safeguards aren't all that tight.

The state "funding gap" for the fiscal year that began July 1 is $144 billion, which is 8% larger than the $133 billion shortfall for the just-concluded 2009-10 fiscal year.

But the outlook is actually going to get even worse: The federal stimulus spigot gets turned off in December, ending a flow of funds that states had been using to offset their revenue shortfalls and narrow their budget deficits. Make no mistake: The end of the stimulus money will leave a huge funding gap going forward.

In most cycles, energetic economic recovery rescues state budgets, although state budgets typically lag – for example the state budget gap peaked in 2004 after the 2000-2001 recession.

Given the poor current financial condition of so many of the U.S. states, a drawn-out/sluggish recovery – or even worse, a "double-dip" recession – could upend state finances for years to come.

Recession Hammers At the municipal level, the primary revenue source – aside from "direct transfers" from state coffers – is local property taxes. Property-tax rates are set as a percentage of home values. When the housing bubble caused stratospheric increases in housing values in the middle part of the decade, property-tax revenue soared in kind – enabling municipalities in thriving areas to expand lavishly.

Since 2007, needless to say, this has all been reversed. What's more, if municipalities respond to declining house prices by jacking up property tax rates, as many are doing, they run the risk of causing a wave of regional mortgage delinquencies.

Homeowners who were already struggling to make ends meet now find themselves facing an additional cash-flow demand that they cannot meet. Some in this predicament may gamely stick with it for awhile, attempting to meet the additional demand in order to keep their mortgage current – before finally succumbing to the inevitable realization that they just can't do it. Others literally walk away from an asset that has declined in value and become a burden.

In either case, the homeowner defaults on their mortgage. And needless to say, any further decline in house prices following the ending of the $8,000 buyer subsidy will strain municipal finances further.

Municipalities – like many homeowners – are struggling to make ends meet. Municipal-bond defaults may soar well beyond 2009's $6.4 billion, the most since 1992.

Last year, the state in most difficulty appeared to be California, because of the severity of the real estate decline and because of its dysfunctional state government, in which spending restraint appears to be almost impossible.

This year, investors should turn to Illinois, where the recession has been severe, producing a current unemployment rate of 10.4%. Here the quality of state government is indicated by five of the last nine governors having served prison sentences (not counting ex-Gov. Rod Blagojevich, who's currently on trial).

Illinois just borrowed $900 million in a bond issue that was very well received, being priced at a yield 0.15% lower than expected. However, that is much more a function of the high yield offered – nearly 7%, or 4% above equivalent US Treasuries – as well as the excessive liquidity in bond markets right now. Much of the demand for the bonds came from foreign institutions, which have a strong preference for government over corporate financing, because they don't understand the risks involved.

In reality, the $900 million bond issue was borrowed to make Illinois's required contribution to its state employee pension fund. This came in addition to a $2.4 billion bond issue earlier this year to fund previous contributions to the pension fund, and an earlier issue of as much as $10 billion in 2003 – for this very same purpose.

Meanwhile, on the spending side, Illinois state spending has risen from $56 billion to $80 billion in the four years since 2006, according to National Review's Kevin Williamson, who has been following this case.

There has been neither a state moratorium on payment since Arkansas in 1933, nor a full default since Pennsylvania in 1841. Nevertheless, the combination of poor-quality state governments, reckless overspending during the boom years, state pension systems that are totally out of control and a deep-and-prolonged recession following a severe housing downturn have lined the stars up for one or more state defaults in the next few years, unless the U.S. economic recovery really gains strength.

Some states, like New Jersey under new Gov. Chris Christie, may be able to drag themselves back from the brink – but it will require Herculean efforts to do so.

Nevertheless, it seems hopelessly unlikely that all the vulnerable states – and there are perhaps a dozen with considerable degrees of vulnerability – will be able to save themselves this time around. Only a few states – such as North Dakota, which is conservatively run, and which has oil-shale and mineral resources cushioning its recession – seem completely invulnerable at this time.

This will all come back to bite investors. With interest rates at historic lows (the U.S. Federal Reserve continues to hold the benchmark Federal Funds rate target down near 0.00%), investors have been searching for – and often reaching for – higher yields to boost their returns.

Last year, for instance, investors in that predicament poured $7.8 billion into high-yield municipal bond funds, pushing assets to a two-year high. But they may pay for that aggressiveness this year as default risks grow.

"People are starving for yield because rates are at zero," Paul Tramontano, co-chief executive officer of New York- based Constellation Wealth Advisors, which manages about $4 billion, told Bloomberg News. "They're taking [on] more risk than they think."

As we mentioned earlier, just because brokers say that the muni bonds they're trying to sell you are "safe" because they were rated as such by the credit-rating agencies, those are the same agencies that got it wrong on the subprime-mortgage sector.

They're getting it wrong again on states and municipalities.

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The (Not Global) Double-Dip Recession

And the double-dip recession nominees are...

LAST WEEK INVESTOR fears of a global double dip recession created a meltdown in the stock-market, says Martin Hutchinson of moneymorning.com.

However, the chance that recession may return is only high in several countries: those who have serious inflation and those who have experienced massive monetary and fiscal stimulus.

The rest of the world is recovering just fine.

One country where the chances of future recession are substantial (though its economy never had much of a first dip) is India. Indian consumer price inflation was 13.9% in the year to May, while its three-month interest rate is only around 5.6%. That's a recipe for bubble creation every time. Add in a public-sector deficit totalling around 10% of gross-domestic product (GDP) – when state budgets are included – and you see a system clearly headed for a sharp slowdown in the future, as the authorities battle monetary and fiscal chaos.

Closer to home, the US economy looks likely to suffer a "double-dip" recession, or at least a very severe growth slowdown. The excessive fiscal "stimulus" injected into the economy since 2009 has failed to produce much job growth, while private-sector lending, particularly to small business, is being crowded out of the market: Bank lending to companies is down fully 25% since that particular market peaked in September 2008, according to US Federal Reserve statistics.

The current position is unsustainable. After all, the US savings rate has fallen back down near its 2007 level, the payments deficit is once again widening, and the US budget deficit is at record levels and showing no signs of being brought down. Either the current levels of debt will be artificially shrunk by a burst of inflation (very possible, given the inflation in India and China), or the US economy will experience a second, severe "dip".

Or perhaps both will occur.

It is this wobbly US position that is most familiar to traders, which is why it exerts the most influence over global stock markets.

The European Union (EU) is fashionably derided in the United States. That's partly because – in the eyes of most US investors – "Greece" has become synonymous with "Europe".

To be sure, Greece's level of public debt is also so high that it is doubtful whether the country can escape without a partial or total debt default. And some other countries inside and outside the Eurozone – including Bulgaria and Romania – have allowed their cost bases and public sectors to get out of line with economic reality.

Some other European Union countries are in great shape. Germany, derided by Keynesians because of its cautious budget policies and by Wall Street because of its lack of a hedge-fund culture, is once again demonstrating what can be achieved through a commitment to cost-cutting and a devotion to quality.

Thanks to the weak euro, Germany's current account surplus has swelled to 5.5% of GDP, while industrial production in the first half of 2010 was up 13%. The Germans are referring to this as the "blitzschnell" (lightening-quick) recovery. Readers suffering through the current US recession can be forgiven for thinking that we could do with a bit of blitzschnell here, too.

In Asia, blitzschnell recoveries are a way of life, as their economies catch up with Western living standards. Commentators are worrying that China may overheat, but I don't see it.

Modest monetary tightening by the People's Bank of China has caused property prices to drop 20% in the last few weeks, taking much of the air out of what had undoubtedly become a bubble. Meanwhile, wages in the fast-growing Southeastern portions of China are growing rapidly, with the giant electronics manufacturer Foxconn International Holdings Ltd. (PINK ADR: FXCNY) raising its entry-level wages by as much as 60%.

These cost increases will cause inflation in Western economies, as the now-cheap Chinese goods become less so. And these increases will also reduce China's payments surplus, as well as the pressure on its currency.

At the same time, however, the higher wages will also inject a massive amount of purchasing power into the domestic Chinese economy. That will finally rebalance it by allowing consumption to rise from its current, abnormally low level (of less than 40% of GDP) to a level that is representative of a normal, middle-income economy. This, in turn, will stimulate demand for Chinese domestic manufacturers, igniting continued expansion of the economy.

China may be in for a burst of inflation. But with a growth rate that's unlikely to drop much below 8%, China is a long way away from a double-dip recession.

In the remainder of East Asia, the growth prospects for Korea, Taiwan and Singapore also appear excellent. Only Japan remains sluggish; there its outlook depends on the success of the new government of new Prime Minister Naoto Kan in finally reining in public spending and the budget deficit.

Finally, the prospects for the better-run parts of Latin America appear excellent, as high commodity prices continue to improve those countries' terms of trade. I wouldn't touch Venezuela or Argentina. And in Brazil I'd wait until after the October election. But the prospects for Chile and Colombia – and maybe even Peru – look excellent.

Overall, therefore, last week's downdraft appears overdone. In most global markets, a double-dip recession appears very unlikely, and future growth will probably be vigorous as the recession is left behind.

Given that reality, investors should look for buying opportunities in East Asia (outside Japan), in Germany, and in the small Latin American markets of Colombia and Chile.

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Europe to Rebound?

Austerity could set Europe and the US apart as Washington continues to build debt...

EUROPEAN COUNTRIES – both inside and outside the Eurozone – are slashing their budget deficits, writes Martin Hutchinson, contributing editor to Money Morning.

Greece, Portugal and Spain – three of the so-called "PIGS" – have to do so, of course. But Germany – generally reckoned to be in excellent shape – is also cutting its deficit, as is France, which hasn't run a budget surplus in 40 years. Britain, too, with no need to protect the Euro (it's not a Eurozone member) just introduced a budget that cut the deficit by $140 billion over four years.

US President Barack Obama and other Keynesians warn that Europe may push its own economy – or even the global economy – back into recession.

But here's the surprising reality: Europe may gain from its fiscal pain – and its deficit-trimming actions offer the best hope for a lengthy recovery.

The Keynesian theory of economic "stimulus" rests on the flawed fundamental belief that government spending can create wealth. The fact is that just the opposite is true. In reality, the money the government spends has to come from somewhere. So any jobs "created" by government spending are matched by other jobs – possibly more of them – lost somewhere else in the economy. It's part-and-parcel of the so-called "crowding-out" effect.

If financing is plentiful and state budgets are in surplus – or only experiencing small deficits – a burst of "stimulus" may offset a recession. If budget deficits are already large, or financial conditions are tight, the government job-creation may be more than offset by job destruction in the private sector – generally the small-business private sector – that is then starved of funding.

The considerations aren't merely financial – there are also "confidence" concerns. The decline in value of subprime mortgages and other bubble-era assets accelerated sharply when confidence in those assets collapsed. Once that occurred, mortgage lending became much tighter and home mortgages might have become impossible to obtain for a period – had the government not intervened with guarantees.

Similarly, when confidence in Greece collapsed, that country's cost of borrowing escalated rapidly. It wasn't long before Greece was no longer able to tap the capital markets, forcing it to obtain a bailout from its rich friends in the European Union (EU).

If that can happen to Greece, it can happen to anyone elsewhere. Very large budget deficits disproportionately increase the chance of a collapse in confidence in the country concerned. It becomes impossible to raise money for viable private sector projects. The Keynesian "multiplier" theory – which holds that unemployment itself reduces consumption and investment – shifts sharply into reverse.

The ultimate impact: Once a deficit gets beyond a sustainable point, its long-term costs far outweigh any potential benefit that the "stimulus" was supposed to create.

So where does that leave us with Europe? Well, in this seemingly paradoxical reality, as European governments rein in their budget deficits, they may actually increase the strength of their economies.

For those countries with large debts or deficits – such as Spain, Portugal, Italy and Ireland – the deficit reductions are necessary in any case to restore confidence in the economy and reopen the flow of funding to the private sector. With Greece – admittedly the most extreme case – this may not be possible: The combination of a feeble economy and a corrupt, kleptocratic government may simply make the place unattractive for many years to come.

For Germany, the reduction in borrowing is less necessary, but the weakness of the Euro should prove hugely beneficial for Germany's major exporters. Thus even if the transfer of resources from Germany's relatively efficient public sector to its private sector does not boost output directly, the surge in Germany's exports should further strengthen that already-strong economy.

The two intermediate cases are Britain and France, where the combination of debt and deficits is alarming, but not immediately threatening. In both countries, the main problem has been the inexorable growth of the public spending – to 52% of gross domestic product (GDP) in Britain and 56% of GDP in France.

In Britain, the massive cuts in public spending now announced should revivify the economy, although the overhang of excess capacity in financial services remains worrisome.

In France, moves to raise the state-sector-retirement age to 60 – still nowhere near enough for long-term fiscal balance – can only help output by removing a little of the drain on the private sector.

For US-based investors like us, the course is clear. Quite apart from investments in the growth economies of Asia and emerging markets, you should look more closely at Europe – for at least the following three reasons:

• Europe's oversized state sectors are being trimmed;
• The region's growth may now accelerate somewhat;
• And – in contrast to the United States – Europe is reversing the mistaken "stimulus" policies of recent years.

Germany, in particular, is attractive, and no portfolio should be without some German shares in my opinion.

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