RSS FeedCredit rating agencies as courts of international finance
As I am writing this, President Obama announced a deal to avoid default on US government debt. If lawyers think in terms of courts, then what would be the legal consequences of the US default? While the legal issues of government’s failure to pay its debt to domestic lenders are unique and complex, the default in respect of foreign nation-state lenders such as China is probably even more interesting. There are no courts of international jurisdiction that can declare the US bankrupt, administer its assets, or enforce their judgment. The US is an independent country subject no one’s will despite the international law. But since the international law is a legal system, there must be some consequences for the US. One such factor is international rating agencies. You could hardly hear about the debt crisis in the US without learning that its excellent credit rating would likely suffer as a result. Apparently, private international rating agencies are filling some of the void in the international legal system that courts usually occupy within nation-states.
The three most important international credit rating agencies are Standard & Poor’s (S&P), Moody’s, and Fitch Group. S&P and Moody’s are American, and Fitch Group is controlled by a French corporation.
The biggest difference between credit rating agencies and courts is that rating agencies do not adjudicate disputes. But under the surface this difference is not so important. We can view events affecting credit ratings as disputes between the debtor and the lending community. Such events include defaults, budget deficits, and so on. The lending community wants some objective basis, for example, to charge a different interest rate as a result of one of the events above. And the debtor government wants to minimize its borrowing cost. Often these interests would come into conflict giving rise to the need for a third party to establish an objective basis for new lending terms. It sounds awfully like adjudication.
In theory, credit ratings are such independent, impartial, and objective assessments of the most optimal relationship between lenders and a borrower in accordance with generally accepted rules. Credit ratings basically result from applications of such rules and principles to a given debtor.
In practice, credit agencies are hardly accountable to anyone. They are for-profit, private organizations whose decisions are final and are not subject to review. The ratings’ impact is fast and powerful, and it usually directly affects interest rates available to the borrower. There is a good overview of other criticism of rating agencies on Wikipedia.
When countries, which desire to keep as much of their independence as possible, fail to establish formal and binding international governance and adjudication bodies, private organizations fill the legal void. It’s not necessarily a bad or a good thing, but it’s important to recognize the legal and enforcement role that these organizations play. Their existence also supports the view that international law exists.
Pulat Yunusov is a Toronto litigation lawyer.
(Post sponsored by AdviceScene)
And you think you have student debt?
The expense of a professional school education to study law represents a significant investment. For many of us, that investment has required substantial aid in the form of student loans – both public and private. Yet, we take on that debt with the understanding that 1) it is important to have legal professionals, and that 2) practicing law should enable us to meet our obligations.
Consider then the case of poor Robert Bowman: the 47 year old recently lost an appeal to a decision denying his application to the New York State Bar on Character and Fitness concerns for his approximately $480,000 student debt.
The Post-Mortem Legal Battles of Michael Jackson
When the king (of pop or otherwise) dies, all the courtiers usually start scheming on how to get pieces of his estate.
Brian Oxman, the family’s lawyer, said,
We will have to see how that plays out in a court of law. I suspect that the death of Michael Jackson is only the beginning of the legal battles over not only his property, but also his children.
Jackson supposedly recorded over 100 songs for his kids that were only supposed to revealed after he died.
But after all of his debts are paid, there may not be much scraps left to fight over. His death may signal an end to confidentiality agreements, especially around his legal settlements, and there will be a lot more stories revealed.
Then there are the disputed reports that he converted to Islam recently. Some have indicated that removal of his body wrapped in white sheets may signal an Islamic funeral, something that some of his family and friends may object to given denials by his publicists of the conversion.
One thing that is not disputed is that his music reached the entire world, and everyone will be watching the trials to see what happens.
Flexibility, Please
Blame the current economic crisis on too much debt taken on with too little research.
Nobel Prize winning economist Myron Scholes lectured at the University of Western Ontario’s Faculty of Law on March 19, packing the faculty’s largest classroom to overflowing with students, professors and businesspersons curious to know what the Professor (Emeritus) of Finance from Stanford University had to say about today’s financial doldrums.
Scholes, who won the Nobel Prize in 1997 for work on the Black-Scholes Options Pricing Theory, was speaking as part of the Torys LLP Business and Law Pre-Eminent Scholars Series.
When financing operations, business organizations can choose between raising equity by selling shares, or taking on debt. Often they prefer debt financing because interest on debt is tax deductible.
Leading up to the crisis, financial institutions leveraged debt heavily, which means the outcomes, whether positive or negative, would be magnified.
One of the main problems with the current debt market, Scholes suggested, is the debt rating system. Under the current regime, debt that is considered high quality is low risk for investors. By comparison, debt that is rated lower is considered more risky — and with that weighting comes a greater promised rate of return.
Scholes offered several criticisms of the rating system.
First, he suggested that rating agencies use too little data in making their assumptions. The agencies used data from only the last few years and assumed – incorrectly, as it turned out – that housing prices wouldn’t fall. Had agencies used older data, they would have seen different long-term trends.
Secondly, rating agencies assumed that any losses on housing prices would occur idiosyncratically. In other words, their models did not have a built-in contagion or domino effect.
Thirdly, the current rating system suffers from a “cheapest to deliver” problem. Scholes compared the problem to buying wheat. If wheat vendors are only allowed to put up to X amount of sawdust in their wheat, then those vendors will put exactly X amount of sawdust in their wheat. Likewise, when rating agencies specify precisely what criteria will achieve a high rating of, say, AAA, then companies will do just enough to pass that test and no more. Indeed, they will keep pushing the envelope to get away with doing less.
In the future, Scholes said our economies will need a design with more flexibility. Flexibility refers to the ability to protect oneself with financial reserves.
During prosperous times, keeping reserves, such as money in the bank, instead of investing is seen as costly. However, a policy based on the preservation of some flexibility will signal to people that having options is a part of life. By example, carrying an umbrella when it does not rain is burdensome; not carrying an umbrella when it starts to rain is more burdensome. As people become afraid, they build up excess amounts of reserves and money stops flowing through the economy.
Ultimately, Scholes argued that the cost of being reactive is gigantic. Financial and political leaders should think about developing proactive solutions that build flexibility into our economy.
The Torys LLP Business and Law Pre-Eminent Scholars series is one of Western Law’s most popular courses. Each month one of the world’s top legal and business scholars presents a paper in his or her area of expertise to Western law students.
Cross-posted from the Financial Post Executive Blog and the UWO Law site.
