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Thomas Piketty: Le Monstre Sacré

Over the last few weeks, much ink has been spilled in an attempt to refute, undermine and marginalize the book “Capital in the 21st Century” by Thomas Piketty, a French economist. In some, unsurprisingly British quarters it has even reached the level of “the lady doth protest too much, methinks.” You cannot convince people of your viewpoint by just silencing the opposition. It’s a safe bet that, had a British economist said the same things or reached similar conclusions, no British institution would have attacked him so publicly. But who knows, perhaps “Le Monde” would have done so with gusto and joie de vivre! It’s clear that the Financial Times is not a proper forum to argue about economic time-series with any seriousness. Although one can find fault with the Mona Lisa, doing so does not take anything away from its value as a work of art.

anzac_gallipoli_map_01

Where are the Quants?

Historical Preamble

Around April of 1915, the Western Allies of WWI embarked on a campaign that would quickly turn into one of the costliest mistakes in modern warfare: the Battle of Gallipoli. This fiasco was largely motivated by a legitimate desire on the part of the Western Powers to resupply their ally Russia, as always cut off from the main European theater. Under the leadership of (First Lord of the Admiralty) Winston Churchill, the Allies decided to attack the Gallipoli peninsula on the edge of the Aegean Sea with some of the less capable warships in the British Navy’s then considerable arsenal. However, when combined Anglo-French naval forces proved unable to break through Ottoman defenses lining the Dardanelles, land forces were called in, ultimately with catastrophic results in terms of both material and human losses.

This was carnage of hitherto unseen magnitude, whereby casualty rates routinely hovered around 90% on the Allied side. It was also the series of engagements via which Mustafa Kemal, himself a commander at Gallipoli, emerged decisively as the undisputed leader of modern Turkey, and during which he gave what is arguably the most celebrated order in military history: “I do not order you to fight. I order you to die.”

L’affaire ALCATEL: enfin, le complot est démasqué. Translation: how to stiff the French with bad assets when you don’t work for an I-Bank

Introduction

Have you followed the strange fate of the $14.8 BN merger involving ALCATEL, the French telecommunication conglomerate, and ATT’s now-defunct spin-off, Lucent Technologies Inc.? That mythical transaction, which has been shedding red ink ever since it closed, was consummated on December 1, 2006, and with much fanfare, we might add. At last, ALCATEL had a pied ä terre in the USA. What could be better than this?

Actually, bankruptcy would have been better.

While the deal was effectively a take-over of Lucent by the French giant, it turned out, most likely for political reasons, that the former CEO of Lucent Technologies, the American Patricia Russo, was duly nominated as the first post-merger CEO. She did not last too long, as was to be expected from someone attempting to run a quintessentially French company-cum-government bureaucracy who doesn’t speak French.

The last happy day for shareholders of the “new” ALCATEL was the day the deal closed. Meanwhile, former Lucent shareholders have been ecstatic ever since. The smartest guy in the room was probably the ALCATEL CEO Serge Tchuruk, who bowed out gracefully after the deal was sealed. He has been thanking God ever since that he wasn’t around to see so much value destroyed so quickly, by so few people, without a single shot being fired. During the last quarter of 2012, led by the Dutchman Ben Verwaayen, the company wrote off another $1.9 BN, bringing total write-offs post-merger to a staggering $16 BN. Frankly, weapons of mass destruction couldn’t do any more damage.

Are Credit Ratings Different from Bond Valuations?

Widespread confusion appears to exist among the investing public as to the potential distinction between ratings and valuations. Are they the same? If not, how exactly are they different, and is one more “useful” than the other as a financial measure? Even the SEC is now confused, something quite surprising in light of the fact that they are supposedly regulating rating agencies. Given the importance of this practical distinction, it’s worth spending a few minutes dispelling rumors, lies and innuendos.

At a fundamental level, both ideas are identical and the issue of their supposed kinship or difference makes no sense at all. It is equivalent to asking about the difference between degrees Fahrenheit and degrees Centigrade: both are temperature-measurement systems. The only difference is that one system is used in America while the other one is used in Europe and elsewhere. (Should we call this “l’exception Américaine?”) If someone now living in Paris suddenly woke up in New York, confusion would reign only until he learned the new system, which would take less than a day, or even faster if he headed to the beach when the thermometer read “30 degrees.” The point is that a self-consistent system is always usable but only makes sense within its own context. No harm will be done by using either system as long as it is used appropriately. Since a simple transformation function exists between them, any confusion on the part of a user can be cleared up immediately with a mapping function.

Leadership and Value Creation: Alan Mulally

Our title is but a thinly veiled allusion to the hero of the namesake novel [Герой нашего времени] by the illustrious Russian novelist and poet Mikhail Lermontov who, on the death of the legendary Alexander Pushkin, assumed the role of Russia’s leading poet.

The hero in question (Pechorin) is not the kind of heart-throbbing, virile, impeccable stud personified by a fictitious character, like James Bond. On the contrary, Pechorin is a deeply flawed, some would even say amoral, man. It may surprise you that the quintessential hero of 19th Century Russian literature is not someone we would want as Santa Claus.

Rating Ford’s Bonds

When an airplane crashes, people always die, which is not normally the case when a car crashes.

Compare these outcomes to what happens when a structured deal crashes, a now unremarkable event during which no one has ever died. The point is this. The average intellectual ability that can be reasonably expected of senior executives in any industry is directly proportional to the severity of the empirical consequences of a crash in that industry. The aerospace industry is arguably the most demanding, sophisticated and rigorous of all simply because amateurishness cannot be tolerated there for the same reason it is so commonplace in finance.

A case in point is the fate and fiscal health of Ford Motor Company, which of course makes cars. As a CEO, Mulally professes expertise only on the left side of Ford’s balance sheet. By contrast, most of us in attendance that evening claim expertise on the right side. Thanks to his relentless work, Ford’s asset side now seems to be in great shape, but what can be said of its liabilities? According to Wall Street, not much except the perennial and naïve buy recommendation. Much more could be done by research analysts to benefit Ford directly and significantly, at literally no expense to Ford or the investor public.

Sylvain Raynes at CapitaLand

I just spent two wonderful days in Singapore teaching a risk-management and valuation seminar to managers at CapitalLand, a leading Asian real estate and property management concern. CapitaLand has a strong knowledge culture, and Singaporeans are also consummate hosts–at least, my hosts were. Dr. Boaz Boon (head of CapitaLand’s corporate research department), John Pang (Managing Director of CapitaLand Financial) and Wen Khai Meng (CEO of CapitaLand Financial) made

Can you Snatch the Pebble from my Hand, Grasshopper?

Dear Students, past, present and future:

At this very moment, many of you are probably struggling with decisions that will affect your career over the next twenty years and beyond. The capital markets are in total disarray while most investment bankers have been reduced to glorified Maytag repairmen at best. Most of them have no choice but to believe that the future will look very much like the past, and in so doing are not completely wrong. Yes, the past is still the best predictor of the future, but this only means that somehow, deals will be done next year or the following. That’s true, but how will they be done, and by whom? This is no mere speculation. The rest of your life may hang in the balance.

The fate of American finance, the one we know and love, depends on finding solutions to such seemingly unsolvable riddles.

A Dialogue concerning Two Rating Systems

The following is a hypothetical conversation between Constance “Connie” de Boudinville, the dashing and attractive spokesperson for the US credit rating industry, and Axel Raskolnikov, an eastern European banker on a fact-finding mission in the United States aimed at improving the practice of banking in his native land by emulating the American model. The setting is October 2009 in sunny Miami, Florida, on the last day of the annual ASF securitization conference at which Ms. de Boudinville had just delivered the closing address, a sort of Platonic apologia for the rating agencies:

Axel

Madame de Boudinville, may I have a few words with you?

Connie

Well, you could call me Baroness, but just call me Connie! I’m feeling good today; and after all, this is America!

Axel

Well, Connie then, I noted that, in your address, you failed to define what a credit rating really meant. Please excuse my ignorance, for I am new to the term and to the world of finance. Could you define what is meant by a credit rating in words a mortal like me can understand?

Connie

Actually, it’s quite simple. May I call you Axel?

Axel

Конечно! Of course, I mean.

Connie

A credit rating is a measure of the probability with which a corporation or legal entity will fulfill its financial obligations, assuming it has any.

Axel

What would happen if a company had no debt at all and wanted a credit rating?

Connie

Well, if it paid us a fee, it would get a rating of course, but here and now, I can’t tell you what that would be.

Axel

But wait, if a company has zero debt, the probability with which it will fulfill its obligations is 100% by definition! In that case, its credit rating has to be the best there is, right.

Connie

I can see you’re new at this game Axel! That’s not exactly how the system works, but let’s just say you’re right for now.

Axel

So, let’s assume I owe you 100 Rubles, Dollars I mean, and the rating agency estimates that the probability of my paying it back is 90%, my rating will be 0.9 right.

Connie

Yes, that would be nice Axel but in fact, we are much less precise than that. Instead of using numbers everyone can understand, we use letters of the alphabet, like A, B and C.

Axel

You mean like in high school.

Connie

That’s right Axel, just like in high school!

Axel

So, I imagine that the best rating is ‘A’ then.

Connie

You’re coming along wonderfully well Axel. In fact, the best rating is not A, but triple-A. The second best is double-A, and so on.

Axel

But if the ratings are probabilities of repayment, why don’t you just use the numbers themselves? Wouldn’t it be much easier to understand than letters?

Connie

I know Axel, it’s weird, but most people in America prefer the letter system; it’s much easier to remember than numbers. There are only fifteen or so letter-ratings and most investors have no trouble with that number.

Axel

But wait Connie, if I owe you 100 Dollars on Friday and I can only pay you on Monday, that’s not the same as if I paid you on Friday, is it not?

Connie

Obviously not, because you might need that money on Friday to pay someone else on Friday. Money today is not the same as money tomorrow. No argument there Axel!

Axel

So, how can there be only one kind of rating then?

Connie

I never said that Axel. In fact, there are many kinds of ratings, and each of them means something slightly different. For instance, take where you work, a bank. Banks have financial strength ratings, short-term ratings and more, and one of them addresses the Friday issue you just mentioned.

Axel

Amazing! How does one measure financial strength then?

Connie

We use ratios of various financial variables, more or less the same ones people use to tell the government about their own accounts, and then decide what that means in terms of a rating.

Axel

OK, got it! Speaking of banks: how do you account for corruption inside the bank?  In my country, the absence of corruption is a major sign of “strength,” if not financial, at least moral.

Connie

Axel, in America corruption is exceedingly rare, and when it happens, we usually find out too late anyway. Besides, we can only go by what other people tell us. It’s their job to tell us the truth about the company. We are not policemen Axel, only judges.

Axel

The truth, ah yes, that ingenious concoction of desirability of appearance. The truth is that the probability of payment can be any number between zero and one. Therefore, there could be thousands of credit ratings, not just fifteen. If you use letters to express ratings, some companies will have different payment probabilities and yet have the same letter rating, and unscrupulous people might take advantage of that misinformation to make money. I think they call it arbitrage or something, but I wouldn’t pretend to teach you French Connie!

Connie

Axel, you wanted to know how it works. Please leave the truth alone!

Axel

I’m sorry Connie; I just get carried away. I won’t do it again, promise! How do we know credit ratings actually work Connie?

Connie

Finally! It’s quite simple Axel: we have bond defaults studies!

Axel

Что это? What’s that Connie?

Connie

Well, that’s the proof that credit ratings really do work. Over the last 100 years or so, we have accumulated data on the default of corporations in the United States, so we now know what the ratings mean in terms of default frequency.

Axel

Default frequency?  Please explain Connie.

Connie

OK, here we go, Axel. Instead of expressing the rating as a payment probability, we use the non-payment, or default probability, because the numbers are much more manageable that way. You see, default probabilities are very small anyway, so it’s easier to quote them than the corresponding payment probabilities that would all be essentially equal to one. No one would see any difference between all these ratings, and we can’t have that, now can we Axel?

Axel

What’s a default Connie?

Connie

Basically, a default is a bankruptcy, although we also include “mini” bankruptcies and special situations, and call them defaults too.

Axel

You mean like what Mother Russia did in 1998?

Connie

That was a scandal Axel, not a default. OK, it was a default.

Axel

So a hundred years ago, rating agencies did not know what ratings really meant since they did not have any default data. What did people do then?

Connie

I don’t know Axel, but somehow the Republic survived!

Axel

So then, rating agencies only have ratings for the United States right. You said that the default data were for US companies only.

Connie

Actually Axel, we have ratings for most large countries and most large companies in the world.

Axel

But how do you know that the default probabilities associated with those ratings are the same as those for the US companies of the same rating?  Life in Europe is quite different from life in the US Connie; you know that.

Connie

It does not matter Axel, because we are the worldwide arbiters of credit. As long as we say it’s OK, it’s OK Axel. See what I mean. One day, we will know what these European ratings really mean, but in the mean time (please excuse the pun) there can only be one referee in any game. Can you imagine a soccer match with two referees?

Axel

No, I really can’t. However, I can imagine a biased referee in the game Connie. Many European companies are now competing with US companies and if the default frequencies of two companies are in fact the same it wouldn’t be fair to give the US company a higher rating than the European one, now would it?

Connie

No it would not, but we are fair, Axel, that’s why we’re in charge.

Axel

This is great Connie! May I trouble you some more?

Connie

Of course Axel, the rating business is an open book.

Axel

I also noted that you spoke of senior secure and senior insecure ratings. What are these things Connie? Where I come from, everything is insecure.

Connie

[laughing] I said “unsecured,” not “insecure” Axel. This means that corporations can have securities with different priorities of access to cash should they go bankrupt, and we feel that investors who own the securities with the higher priority will lose less of their investment than those who own those with a lower priority. We assign a lower rating to the second type of securities to reflect that belief, which belief, I might add, is also verified in practice.

Axel

Loss? You never said anything about loss before. I thought credit ratings were about default frequencies, not losses. Even if I lose less than the next guy, the company still defaulted, right Connie?

Connie

But how then are we going to tell investors that they will lose more money if they invest in unsecured than in secured bonds? We have to make a difference, Axel dear.

Axel

Certainly, Connie dear. However, the place to introduce the concept of loss is where it makes sense, i.e. not in the definition of default frequency but rather in your estimate of recovery. You should simply state that unsecured investors would experience higher loss upon default than secured investors, but that the ratings are the same since the default frequencies are obviously the same. Right now, people who price loans using the current system are clearly overpricing since they are double-counting the reduction in recovery.

Connie

Touché Axel. I’ll have to bring this up at the next steering committee meeting. Tell me Axel, would you be available to come out and tell our management that they have been wrong for the last hundred years?

Axel

Now, now, you wouldn’t want me to subvert the American way of life Connie! Communism is really and truly over, you know!

Connie

Don’t worry Axel! Americans truly respect honesty, especially in foreigners.

Axel

So…how does it work, Connie? I need a rating, so I go see a rating agency, pay them a fee and get a rating. Is that it?

Connie

That’s about it. See how simple it is!

Axel

What if I don’t like it? Can I pay more and get a better rating?

Connie

Axel, this is your second warning! One more and you’re on watch! Of course not! If you could do that, everybody would do it. Then, credit ratings would lose their meaning and the country would be in utter chaos.

Axel

That’s amazing Connie! In my country, everything has a price. I can see a situation where someone would borrow money from the government to look good for the rating contest and then give the money back afterwards. This way, they would get the rating they want.

Connie

That would not work Axel, because as soon as they gave that money back to the government, we would lower their rating.

Axel

But wait a minute, Connie, are you saying credit ratings can change?

Connie

But of course, Axel: They can change at any point in time.

Axel

Do they?

Connie

Actually, they don’t because most of the time, corporations don’t borrow money from the state, or from anybody else for that matter, just to get a credit rating. If they did, that would be fraud, and that’s illegal. Most of the time, their financial condition is like our method, an open book. Credit ratings are more or less the same all the time. Of course, every now and then, something awful happens and we have to lower the rating. We call it downgrading. Or else, something very good happens and we can raise it; we call that upgrading. Credit rating is quite a sophisticated business Axel, one where angels fear to tread.

Axel

But things happen all the time in this world Connie, so ratings should really change quite often. Why don’t they?

Connie

Well that’s just it Axel! Our clients: investors, corporations and bankers that is, really don’t like it if we downgrade too quickly, or upgrade too quickly for that matter. They say it creates uncertainty because companies borrow money at rates largely determined by their credit rating. Can you imagine if ratings could change every day? CFOs would never get any sleep! Unless things are truly bad out there, we leave it alone. Besides, if we had to monitor all the companies we rate our analysts wouldn’t get any sleep either! This way, everybody is happy.

Axel

Yes, but if you downgrade only if things get really “bad”, as you say, everyone will be taken by surprise, except of course those that already knew it. How can you say that a default probability has suddenly increased tenfold overnight? Is it not likely that all that bad “stuff” was there all along for everyone to see? If you slowly reduced the rating as things unfolded over time, would this not be a better way to tell investors about it. In fact, would this not avoid having to do the very thing you seek to avoid, i.e. a catastrophic downgrade?

Connie

Perhaps so, Axel, but you have to pick your poison. Either a credit rating is a long-term view of the company, or it is a current view of the same company. It can’t be both! As long as everybody knows what we do, it’s really their fault if they misjudge the rating! Moreover, as I explained to you ten minutes ago, credit ratings really do work. On average, they do express the default probability of the obligors. It’s not our fault when some investor out there owns the one corporation that actually defaults.

Axel

That’s strange, because in my country, people don’t care if someone else loses money, only if they lose money. Wouldn’t it make more sense to tell people that they are about to lose money rather than telling them that they are just fine on average? To say the least, it seems to be misleading. Could you not provide timely ratings instead of long-term ratings? No one really cares what happens on average, if they are dead now!

Connie

Axel, this is your last warning! Don’t you remember what the greatest writer of all time, Voltaire, once said: the more things change, the more they stay the same! Well, that’s our policy in credit ratings Axel. That’s all I have to say.

Axel

I do remember Voltaire, but the greatest writer of all time was Dostoievsky, not Voltaire! Joking aside, you mentioned something about structured finance ratings in your talk. What is structured finance anyway?

Connie

Glad we changed the topic Axel! Structured finance is a way for people who can’t get money to get it anyway. You can imagine how popular that might be!

Axel

And how does that happen? We’d really like to use it in Russia if possible.

Connie

It all starts with a special purpose company or an SPC as they say. Then, you sell your assets to the SPC and it borrows money, not you. This way, the people that give you the money don’t really care if you go bankrupt, since they have your assets locked up in the SPC. They get comfortable with the situation and let you have their money.

Axel

So, all I need is an SPC and assets for sale?

Connie

That’s right Axel!  However, make sure you really sell those assets, and not just pretend to sell them. Otherwise, it’s not structured finance but corporate finance.

Axel

That should be easy. It must be obvious when you are selling something, is it not?

Connie

In fact, it’s not Axel; and that’s why we’re on top of things in that department. Darling, don’t you now see how useful rating agencies are?

Axel

I have so much to learn Connie. What about structured ratings then?

Connie

Structured ratings are different from corporate ratings because structured securities are specifically constructed to have a default frequency of zero, so we can’t give them normal ratings now can we.

Axel

If they all have the same default frequency, i.e. zero, what do these ratings really mean then?

Connie

Remember the loss discussion from a few minutes ago? That’s the key. Structured ratings are loss estimates, not default estimates, and we express that loss in basis points, which is banker-talk for percentage Axel. Unfortunately, some of us in the industry are still not convinced and insist on using default frequency as the measure of structured ratings. I’ll have to talk to them about that someday [sigh].

Axel

But how can this be? Isn’t everybody looking at the same deals!

Connie

Yes Axel, but that’s politics. Please don’t tell me you don’t know about that!

Axel

Politics is one thing, money quite another. One of these people is clearly wrong. Can’t the other guys talk to him and work out a uniform definition of structured ratings?

Connie

Actually, it’s more or less already happened. As far as I know, everybody now looks at losses.

Axel

Thank God, Connie! You scared me for a split second! Come to think of it though, it wouldn’t be so bad after all to have two incompatible definitions. We Russians have lived with a split-brain for centuries and we are doing just fine, right?

Connie

Yeah, right!

Axel

Well, if structured ratings don’t mean the same as corporate ratings, there is no reason why they wouldn’t change all the time right, or is Voltaire making magic here too?

Connie

Yes, I’m afraid that most illustrious of world scholars is right on again! Structured ratings are different from corporate ratings in their definition, but they are still supposed to remain the same forever. Just like for corporate ratings, if we find out something nasty is going down, we can downgrade the bonds. In fact, even if we only believe something is going to happen, we can take preemptive action, just like the US army, Axel!

Axel

But how do you find out what people are up too if you don’t monitor the deals?

Connie

We do monitor the deals Axel!  However, we are not responsible for other people’s crimes, just our own. If we know what’s going on, we adjust the rating for sure. Otherwise, our policy is: Don’t ask, don’t tell.

Axel

But if structured ratings are loss estimates, isn’t it true that one knows more about losses four or five years after closing than one year after, and so the rating should change to reflect that increased knowledge, should it not? After all, deals can also get better, not just worse. How does it go again? The sun sets, but the sun also rises!

Connie

I see you read a lot of books. That’s quite unusual for an investment banker. Axel really! Even if we did know more about a deal, and I’m not saying we do, what’s the difference? After all, investors are still in as good a shape as they were four years ago. There’s nothing new in that. Who cares if the rating is really better than before? You can’t lose less than zero right. If the issuer has too much capital in the transaction, big deal! We are an investor-service Axel, not an issuer-service.

Axel

You do have a way with words Connie!  If structured ratings are already different in one respect, why can’t they be different in another? Why can’t structured ratings be dynamic instead of static?

Connie

Because we are already on record as saying they don’t change. Don’t you hate it when people keep changing their mind? I surely do. This way, everything is just fine. Of course, every now and then we make a mistake. To err is human Axel, and to forgive divine, remember that!

Axel

I agree with you Connie. Consistency in spite of overwhelming evidence is truly a virtue. What I now see so clearly is that the problems of two people like us don’t amount to a hill of swaps in this crazy world! If they change that rating, they’ll regret it, maybe not today, maybe not tomorrow, but some day! This way, they’ll always have plausible deniability (intense gaze)!

Connie

Axel, this could be the start of a beautiful friendship (longing look)!

Axel

But wait Connie, if rating agencies believe structured ratings are dynamic, then what’s the problem telling investors the truth?

Connie

It’s not about the truth Axel, it’s about deal flow. At any rate, before one can tell the truth, one has to know it!

Axel

Amazing! It’s starting to look more and more like Russia. My boss is going to love this!

Connie

You’re quite a fast learner, Dear. Make sure you let me have your resume when we’re done.

Axel

Thanks Connie! By the way, I couldn’t help reading about what those horrible people at Enron did! Apparently, they used structured finance to get money they shouldn’t have. However, you said that’s what structured finance is all about Connie. So what did they really do wrong?

Connie

You put your finger on the problem Axel! What they did was not structured finance at all, but something that was made to look like structured finance. Investors were all fooled because structured finance is really a good thing. These wretched individuals used the good name of structured finance to get money from unsuspecting investors. That’s what went wrong!

Axel

Isn’t there something that could have been done to see what was going on, like following the rules of structured finance for instance?

Connie

That’s easy to say Axel!  Have you ever tried to find out what is going on inside a small company, let alone a big one? We can do nothing about fraud, Axel!  We trust that what accountants are telling us is true. If it’s not, we are off the hook anyway, and we simply move on. Of course, there’s a bad apple in every barrel Axel, but we’re still the only game in town. In fact, we are protected by the first amendment to the US constitution because we are only offering our opinion, nothing more. Like ABC News or something! We have no liability for that opinion. If we mess up, we just say buyers beware and that’s it. It’s a very solid business plan.

Axel

It’s getting better all the time it seems. Coming back to Enron, were the rating agencies not watching these bad people in action Connie? If it was not structured finance, and the rule makers of structured finance, i.e. the rating agencies, were reviewing the deals, then how could they make it look like it was?

Connie

But Axel, structured finance is complicated nowadays. We are not Gods, although you might think we are. In many cases, our people are simply overwhelmed and just can’t cope with these complex structures.

Axel

What do you mean by a structure Connie?

Connie

A structure can be many things but essentially, it’s a set of rules that determine who gets the cash that comes into the deal. Much like a financial “auto pilot” you might say. It works like Aeroflot, except that these structures don’t crash all the time. Come on Axel, I was just kidding!

Axel

That’s great! Because Russians know a lot about rules, in fact, we practically invented the rule business. You know, like chess and all! Wouldn’t it be easier to cope with all these rules by putting them inside a cash flow model and letting the chips fall where they might. That way, you wouldn’t really have to worry about how complicated the interactions between the rules might be, for they would simply come out of the wash naturally. All your analysts would have to do is keep a stable of models for the various types of deals associated with the assets, and Voilà! Isn’t this a better way to go?

Connie

Perhaps it would be in the end Axel, but as surely as I’m standing here today, it would also destroy the romance of the old ways, when a seasoned analyst could simply eyeball a deal and guesstimate the required enhancement at a glance. Everybody’s just talking about the good old days, but at the rating agencies, we are truly living them. Don’t you feel like our society has lost too much of its charm with all that financial wizardry? Enron is just another example of why we should move backward, not forward.

Axel

Yes, technology does dehumanize Connie, but in my opinion, losing money is much worse. On the other hand, I freely admit that romance is hard to give up.

Connie

Axel dear, don’t you think we’ve talked shop long enough? Why don’t you buy me a drink, and then maybe you can show me your e-bit, da?

Axel

Ahhh, Constance, ma Chérie! Détente can be beautiful. Пошли!

Dr. Strangeloan: How I learned to Love the Bond And Not to Worry

I would like to tell you about the recent Unites States long-term credit rating downgrade by S&P.

Now surely, the Republic will stand regardless of the doom and gloom the S&P minions may see in their crystal ball. Rather than piling in right away with Hegelian negativity on steroids, please allow me to indulge in one of my most cherished childhood memories. Beware, though, for I’m about to tell you a cybernetic story, so if you have better things to do right now, please stop reading. Despite my best literary efforts, what follows is likely to be about as exciting as reading the Wall Street Journal, although Rupert seems, of late, to be doing his best to “raise the bar,” so to speak.

Many years ago, I was addicted to a TV show called Kung Fu. It was a typical 60-minute weekly drama set in the old American West and relating its myths, lies and fantasies. The hero (David Carradine) was presumably a Chinese immigrant whose early childhood had been spent as a pupil at a Buddhist monastery somewhere in China, where he had received extensive training in self-control, martial arts and philosophy. He was kind and merciful and would spend approximately 55 of the 60 episodic minutes preaching peace, understanding, self-abnegation and friendship among men of good will. He would then spend the remaining five minutes beating the living hell out of everybody else on the show. The moral of the story, at least it seemed to me at the time, was that in some cases peace and love just don’t cut it.

The episode I most vividly remember is one during which two young novitiates, one of whom (Cheng) is our hero, the other (Chang), are given cash to travel to a nearby village to buy food for the entire household. On the way, they encounter a nice-looking old man who inquires about their journey. They tell him the truth, as young boys are wont to do, whereupon he proceeds to tells them about a secret shortcut to the village that will save them about half an hour. They thank him and happily take the shortcut. Unfortunately, this was a con job. In the middle of it all, they fall prey to an ambush and lose the cash. They return to the monastery, clearly with their tails between their legs, and are immediately asked to join a woodshed meeting with the Master in residence. It went something like this:

Master: Tell me, Chang, what did you learn from this?
Chang:  Not to trust strangers!
Master: Tell me, Cheng, what did you learn from this?
Cheng: To expect the unexpected.
Master: Chang, you will be leaving us soon.

And the rest, as they say, is history. Why am I telling you this?

For openers, let me tell you why I am not telling you this. Not because I expect you to spend your early years in China learning martial arts and philosophy at a Buddhist monastery, and not because I think violence is an acceptable way to resolve problems, for it obviously is not. On the other hand, even if you did hang out in Chengdu for the next ten years, you would probably not even miss a beat on Wall Street, and would most likely be able to resume right where you left off. Voltaire said, plus ça change, plus c’est pareil: The more things change, the more they stay the same. Can a Frenchman really be totally wrong, especially a self-maid man? But no, I have a more mundane goal in mind today, one I already warned you could only be reached indirectly and painstakingly.

Are you still with me? Please don’t quit now, for the worst is yet to come.

The world of credit ratings does not exactly connote Hollywood-style sex appeal. Historically, the average credit analyst was usually someone with a social profile lying half-way between a misfit and a nerd, very much like me, I’m afraid, going about his business with the naïve certainty that the world is better off because he exists, defending the human rights of widows, orphans, institutional bond-fund managers and other defenseless creatures. When the alternative is something as profoundly rewarding as clearing & settlement or custody, one can easily understand the attractiveness of a job in which recognized business leaders actually return your phone calls and call you by your first name, apparently because deep down, you’re such a pal. If only it were true. The only occupations with more ego-stroking potential are probably journalism, movie stardom and fashion design.

With the advent of structured finance, though, a market solely predicated on the existence of primary market ratings and thus, on the prior possibility of value, credit analysis acquired an exalted, quasi-mythic status, the moral equivalent of the Oracle at Delphi. Ordinary mortals with ordinary jobs had suddenly been made into rock stars. A formerly inconsequential human being was now referred to as a Bodhisattva, while invitations to Louis Vuitton cocktail parties were no longer unthinkable, or infrequent. Credit analysts went from limp losers to Latin lovers in one easy step, and their financial exploits were now recounted in hushed and respectful tones. Their new issue reports got more web-views than Paris Hilton, and seven-figure salaries went from unattainable to lived experience. At Midas Mufflers, you were just a “somebody,” but at S&P, you, erstwhile unacknowledged toiler of the netherworld, had suddenly turned into a big swinging you-know-what, literally a general of the capital markets. Now clearly, every man is a general to his dog, hence the popularity of dogs.

Is this not the quintessential American dream, the faint but still non-zero probability that every US citizen can one day become a hero and marry a fashion model? What’s wrong with a little Yankee self-actualization, with getting that proverbial piece of the action? After all, isn’t it true that no man is an island, in itself entire? Apparently, reciprocity is the key to every lucrative relationship. So, cooperation with Wall Street was obviously the right thing to do.

What’s wrong, of course, is that it was just that, a beautiful dream.

One day, you had to wake up and realize that, when all is said and done, you never understood a thing about finance, that Warren Buffett is not really your high-school buddy, and that the captain of the swim team is still more likely to wed the fashion model you were ogling so fondly just a few moments ago. At some point, it had to dawn on you that you never were the master of your own power; that you commanded without authority, attempting to live your life in reverse. In the end, you were still just who you had always been, only less so because you actually believed the dream. If only investors would forgive your trespasses while punishing those who trespassed against you, all would be well in the quiet countryside, to say nothing of the not-so-quiet Countrywide.

Mea culpa, mea culpa, mea minima culpa!

Dear repentant credit analyst, finance is an analysis of time, of non-linear time that is, i.e., of something apparently beyond your ken. Mind you, the same type of fiasco would have happened had anyone else been in your shoes. Wall Street bankers, self-proclaimed former masters of the universe, are actually glad they have someone else to blame but themselves, for the truth is they would have done exactly the same thing, and most likely worse, given that the average investment banker has as much self-control as Bill Clinton at a Playmate convention. As that famous playwright would surely have said, “The fault, dear trader, lies not in your deals but in yourselves.”

But wait, say you, what about the S&P downgrade? I know what you’re thinking right now. “Can’t this guy say something nice for a change? Can’t he say something righteous, and loving? These are beautiful people!” In the end, isn’t it just easier to shoot the messenger simply because you don’t like the message? Ah yes, the downgrade. What about it? Essentially, S&P said there is too much politics in Washington, and that $2.4 trillion is not enough; it needs more. I’ll bet Monica Lewinski said that too.

First, to say there is too much politics in Washington is like saying there is too much “greed” on Wall Street, too much reckless driving at the Indy 500 or too much sex in a brothel. This shocking news is neither shocking nor news. Second, just a week ago, S&P admitted publicly that it had a bug in its CMBS rating model, most likely for the past 20 years or so, and canceled all future CMBS deal ratings until further notice. Goldman was impressed I’m sure. But that’s not the best part. Just a few months ago, it also admitted not understanding the waterfall-distinction between pro rata and pari passu. I guess S&P can speak neither Latin nor Excel correctly, which may go a long way towards explaining its reluctance to rate Latin American countries AAA.  On its face, this downgrade-thing is chutzpah taken to the limit, akin to a priest downgrading God, or a husband telling his wife, “Honey, this time I’m putting my foot down!” Basically, it’s a joke on many fronts.

On the political front, S&P no longer has the moral authority to downgrade an entire country after the fact, when this is precisely what they are accused of having done, no doubt coincidentally by that very same country, just a couple of years ago. If anything, the downgrade is way too late, not to mention way too smug and convenient. In a self-respecting sport like football, late hits will get you a big fine. What will this get S&P? God knows! But that’s the whole point, gentlemen. God is now dead, and S&P is responsible.

A famous Russian proverb says: После боя кулаками не машут. Don’t swing your fists after the fight. When it’s over it’s over, guys.

Perhaps S&P ought to use its credit-rating principles on itself and apply its outrage at the nefarious influence of politics to its own pathetic situation, contemplating the countless lawsuits it is now defending, suits that arose directly as a result of S&P’s mammoth incompetence and inability to know when to downgrade something much less problematic to grasp than Beltway politics. Yes, it is wrong to shoot that oh so Standard, but decidedly not Poor, messenger arbitrarily, but this is someone who’s been walking around for years with a bull’s eye on its forehead.

On the technical front, the thorniest issue is the fact that the US credit rating is the ground, the basis of all other ratings, the equivalent of zero in mathematics. Moving the zero on the scale, apparently without a Plan B, makes as much sense as switching from Fahrenheit to Centigrade in temperature reporting, and then claiming it is “colder” in New York this summer. At this juncture in world history, please tell me who is more creditworthy than Uncle Sam? Do they have nuclear weapons? Do they have cruise missiles? Do they own the Internet? Does their currency also count as international money, in addition to gold? Viewed in the proper context, the S&P downgrade is a meaningless, exculpating, cynical and naïve move that can only result in the immediate focus of the nation’s attention on how badly these people behaved, and continue to behave, despite clear pronouncements to the contrary and innumerable acts of contrition. A savvy US president once remarked that if you’re not part of the solution, you must be part of the problem. Sadly, S&P seems to have crossed that thin red line.

The last bump on the road to righteousness in this S&P saga is likely to be the inconvenient fact of the sovereign ceiling. As you all know, no corporation can have a credit rating higher than that of its sovereign for the simple reason that the sovereign has an implicit, if not explicit call on its country’s assets via taxation and other legal mechanisms. So far, no one has denied this. Therefore, in a few days or so, S&P will have to either downgrade every American AAA-rated corporation, presumably telling them they are sorry, because to such companies a downgrade is not just politics, or else do nothing, thereby covering itself with additional vainglory and demonstrating once again that it is better to remain silent and pass for an idiot than to speak and prove it.

Finally, what about Chang and Cheng from Kung Fu?

You will recall how Chang was fired from the monastery for failing to understand the principle that whatever happens to you should not always be ascribed to others, and that taking responsibility for your own actions and their consequences is the origin of all wisdom, not to mention of all wealth.It is painfully obvious to most observers that S&P needs to take a good look in the rear-view mirror and ask itself, in addition to the army of lawyers now on its payroll, whether it still likes what it sees, or whether, as most of us have already concluded, this sad reality-TV episode wouldn’t be a great excuse to spend some time in a Chinese monastery. From what I know of S&P analysts, I think they might just love it. And who knows, China might begin to love them back!