Canary In The Coal Mine

In the good old days, miners did take a canary to work with them in coal mines. If dangerous gases such as carbon monoxide collected in the mine, they would kill the bird before killing the miners. Thus providing a warning to exit the mine immediately and stay alive.

In an ideal world, the rating agencies would play the part of the canary and send out a warning, that a financial disaster is imminent. In the real world, the rating agencies are always too late.

They miss to warn investors before the asian- and russian financial crisis in 1997, respective 1998.

2001, In the case of giant energy trader Enron – a company with 20’000 employees that reached dramatic heights, only to face a dizzying collapse – Moody’s, S&P and Fitch kept their ‘investment grade’ rating until four days before the bankruptcy. Enron affected the lives of thousands and many pension funds.

Where is the canary, when you need one?

Inexcusable, in my view, is the role the rating agencies played 2007 in the run-up to the Lehman Brothers collapse and the subsequent global financial crisis. It’s important to know, that the ‘Big Three’ have an ‘issuer pays’-model, whereby an private issuer, a Wall Street bank for instance, pays for the initial rating of a security.

Customer friendly, the agencies rated hundreds of mortgage-related structured products ‘AAA’ during the housing boom. That’s exactly what the paying clients needed (or demanded?) to sell the junk to unaware investors.
In essence, the ‘Triple A’ was a bought marketing tool that misled thousands of investors and inflated the real-estate-boom even more.

When the housing prices in the real world collapsed, S&P and Moody’s had to downgrade their fantasy-ratings. Again, too late – and the sudden mass-downgrade of hundreds of mortgage-related securities triggered the worst financial crisis in decades.

The inability of credit rating agencies to anticipate debt-crises and the tendency to overreact once financial difficulties have piled up, was confirmed at the scene of the next accident: They missed to anticipate the Eurozone credit-crisis.

But the bond market doesn’t have to wait for the sleepy rating agencies. He has other instruments to trade risk. During the Eurozone crises with the looming default risks of Greece, Spain, Portugal or Italy, the market relied on ‘credit default swaps’ or cds.

Very, very basically – a holder of a bond, who seeks protection against a possible default, can buy a cds as an insurance and thereby trade the default-risk to the cds-seller. The higher the anticipated risk of a default, the higher the annual premium, reflected in the trading level of a cds.

The cds indicated the default-risks much faster and more accurate than the credit agencies. In the case of Italy, Spain and Portugal it took 19 (!) months on average before credit ratings were equivalent to the cds.

The cds were playing the role of the canary in the coal mine.

———
China’s yuan has joined the IMF’s elite club of currencies. Why does it matter? Answers in the next chapter: http://www.theleader.ro/welcome-to-the-club/