Rating Agencies Unfairly Give Turkey Short Shrift

There has been considerable talk in Turkey about how Basel II requirements will raise the financing costs of Turkish banks and firms. This worry is mainly due to the idea that the below investment grade sovereign rating of the country of Turkey will force an increased capital requirement on the part of lenders to Turkish banks and firms, thus raising their costs of borrowing.

I believe that the Turkish economy faces various risks and I’ve been vocal about them. However, I am of the opinion that Turkey has historically gotten (and still gets) a lower rating than it deserves from credit rating agencies. I’m not going to go into a lot of detail as to why I think so, but you could get a clue into my line of thinking here.

Unfortunately, these credit rating agencies missed the risks of many once-favored securities while rating them AAA or AA, hence playing a part in the current financial meltdown. Let’s remind ourselves of the fact that Iceland too had a rating of AAA (or Aaa if you ask Moody’s) not too long ago.

The title of the report released on July 19, 2005 is “Moody's Reports: Iceland's Low Government Debt and Flexibility Support Aaa Rating."

Of course, we know how that worked out. By the way, Iceland is still an investment grade country due to its “medium level of economic strength and very strong institutions”.

Hmmm… I smell some bias here. Of course, how could a country like Turkey possibly have “medium level of economic strength and very strong institutions”? More importantly, what makes an institution “very strong”? Being Western, perhaps?

A few years back, a Moody’s analyst came out to reiterate her distrust of the Turkish economy, and her main punch line was her belief that the Turkish education system was “weak”. This person was not Turkish nor did she speak the language. Of course, why bother learning anything meaningful about Turkey or engage in meaningless hours of due diligence regarding its economy when you can just stereotype an entire 70 million people as “poorly educated” in order to defend your investment thesis AND get paid the same regardless?

By the way, this was when Turkish economy was growing and Turkish sovereign bonds in all currencies were performing well AND they were about to perform even better. Talk about the “heuristics bias” on the part of the analyst who needed to rely on deeply formed biases and clichés to make investment (or grading) decisions…

Here’s a look at what Moody’s thinks about Turkey at this point:

Turkey's economic resilience is only medium, its debt affordability is low, and its susceptibility to political and financial event risk is assessed at high.

Wow. Am I under some delusion or could this sentence be equally valid for many “developed” world economies as well? The sentence above basically says nothing and everything at the same time.

But I like to look at the glass half full here. At least she is not insulting all of us (including myself) who have depended on the “weak” Turkish education system at some point in our lives or who currently teach in it.

Okay, now that I got the rating agencies’ poor treatment of Turkey out of my system, I want to come back to some serious investment issues here.

I don’t object to Iceland’s current investment grade status. Although the worst may be over for Iceland, the country is not getting any of my money despite its investment grade status. The problem is that during the time frame from 2005 to the present, you would have been much better off being invested in Turkish sovereign bonds. If you don’t want the Turkish currency exposure, you have the option of investing in sovereign bonds denominated in U.S. dollars or euros.

Now, if a rating agency has a proven history of giving sky-high ratings to mortgage securities or countries and it turns out that those ratings were miserably wrong because they depended on certain “rules of thumb” and did not look beyond accepted investment stereotypes including some deeply rooted cultural biases, why should we take anything these agencies say as gospel? Why isn’t their competence (or lack thereof) part of the discussion here as much as risk management tools have been?

I’m not sure why rating agencies should have any independent authority over valuing risk. I’m even less comfortable with how Basel II rules have determined capital adequacy requirements of lending banks. Among other things, those requirements also depend upon credit grades given by “independent” rating agencies to the borrowers.

Jon Danielsson has written a well-received post entitled “The Myth of The Riskometer”. (Hat tip to Yves Smith here.) For the record, I find the post quite pessimistic and I think people who critique risk management tools definitely engage in some overkill.

Yet Danielsson makes some great points in the piece, one of them alluding to the abuse of the tools in the section called “The Financial Engineering Premium”. He mentions how the so-called “risk-based capital requirements” set forth by Basel II have been manipulated by banks in order to increase leverage and still look well capitalized on paper.

One thing we have learned in the crisis is that banks that were thought to have adequate capital have been found lacking. A number of recent studies have looked at the various calculations of bank capital and found that some of the most highly capitalised banks under Basel 2 are the lowest capitalised under the leverage ratio, an effect we could call the financial engineering premium.

As Philipp Hildebrand (2008) of the Swiss National Bank recently observed “Looking at risk-based capital measures, the two large Swiss banks were among the best-capitalised large international banks in the world. Looking at simple leverage, however, these institutions were among the worst-capitalised banks."

Did I have an epiphany while reading this part or what? Talk about how Turkish firms and banks get the short end of the stick YET again. Basel II risk-based capital requirements make banks who choose to lend to Turkish banks (categorized as “below investment grade”) look less capitalized because of the way investment grade and below investment grade securities get weighted in their portfolios! Hence the feared increase in the borrowing costs of Turkish banks and firms.

The irony? Because Turkish banks are a lot better capitalized than their European or U.S. counterparts, they are less risky at this point in time. In fact, Turkish banks have been affected significantly less than their European or U.S. counterparts during this crisis mostly because they did not have any mortgage derivative assets in their portfolios that were once rated AAA by the highest “authorities”. In other words, Turkish banks were on the periphery of the systemic risks engulfing these global institutions.

The moral of the story is this: Both the credit rating agencies as well as Basel II requirements caused distortions in the markets that created and exacerbated systemic risks. The “system” has created such a façade that otherwise creditworthy guys got a bad rap, whereas those who did not deserve anything got good ones.

Maybe this explains my general cynicism and explains why I’m so suspicious of blaming risk management tools. Again, it’s not their use I’m worried about, it’s rather their ABUSE that caused many of the problems.

Portfolio Disclosure: This is even more complicated than writing an essay. But because I have written extensively on the Turkish economy, I feel obliged to go into this detail. For the record, I do not hold a position in the Turkish stock market, but I think it would be a great bargain at the current levels IF the Central Bank decreased its rates further even if it meant allowing for some more currency devaluation. I have absolutely no idea what the CBT will do next, as they remain an absolute mystery to me. But interest rates still remain high especially given how a lot of Central Banks have joined in the new global game of slashing rates.

Coming back to the Turkish stock market, I believe it would react very positively to further decreases in rates, and it would start following fundamentals rather than blindly following global markets day in and day out. (Valuation ratios remain cheap as well.)

There’s now the question of how much markets have been pricing an IMF deal. Although that’s a valid uncertainty, it does not change my long-term view above. So the Turkish stock market remains too tricky for me at this point because I still don’t see a friendly enough macro environment despite the recent interest rate cuts. As long as those factors are not there, for me the Turkish stock market remains a high beta play on the world markets.

Yet, I’m certainly entangled in the Turkish economy in various ways. I have a significant position in TL related instruments, so I also got caught in the TL devaluation like many others, which is funny since I’ve been writing about how “overvalued” the TL had been. Of course, all markets except American and Japanese experienced devaluations.

I’d decided to sit on some T-bill positions with some duration and lock in what then seemed to me to be a “good” rate of 23.50%. I just didn’t want to keep the money in a lower interest bearing yet ready-to-fly overnight account like I had done earlier. My position, while losing to the U.S. dollars, made considerable money in TL when the Central Bank unexpectedly slashed rates. Of course, that rate looks awfully good now – albeit retrospectively.

I have written extensively on the Turkish Central Bank, and if I had the foresight that it would start surprising us the way it did, I would have announced the durations of my positions in Turkish T-bills.

I recently got out of that position and entered a long Turkish sovereign Eurobond position maturing 2017. I decided to increase exposure to euro because my portfolio has been overexposed to both Turkish Liras and US dollars (that in US stocks and cash – more on that later). Also, the dollar has gained so much value, so this may be a good long-term euro entry point. I still have (and will continue to have) a portfolio position in Lira-denominated T-bills, but it’s part of a retirement package and I have no control over its duration or trading.

To make the long story short, currency devaluation risks aside, I do feel that credit rating agencies are flat out wrong in their evaluation of the Turkish sovereign risk. I have had (and will continue to have) significant exposure to sovereign Turkish risk via bills and bonds (denominated in TL and Euros).

Comments

[notsosmart:]

who can believe the rating agencies about anything? well its your money.

Jan 28 05:40 PM

[Atakan:]

Well-said Suna. The ratings agencies seem to be enjoying some sort of a "reserve currency" type of privilege perhaps b/c of the lack of a competing model/approach. From a strict resource allocation perspective it is somewhat understandable why a country making up 0.17% of the world equity market is not getting red carpet treatment. As the Turkish market matures and the major Turkish corporations float more than what on average amounts to a laughable % of ownership to the public this balance of opinion should shift favorably. Until then, for the believers there is a mid-term market inefficiency here.

Jan 28 11:36 PM

[Suna Reyent:]

The markets don't necessarily "listen" to rating agencies either which is a good thing. But still there is an apprehension to reduce General Electrics's AAA rating (which is totally undeserved by the way), because there are other consequences of reducing debt grade as well. So why don't we all pretend that the emperor has clothes on as long as we can.

As far as Turkish sovereign debt is concerned, it has in the past been priced a lot better than its official grade, which is a clue as to how little rating agencies are valued in the markets. However, there are other issues here that have to do with various regulations (a lot of buy-side funds are simply not allowed to buy below investment grade instruments, for instance), and Basel II capital requirements that create valid concerns for borrowers that are ranked below invesment grade. That rating agencies fail miserably in this job and create uneven grounds for borrowers is another reason for my "outrage" as well.

In regards to my decision to buy a medium duration eurobond, of course spreads may widen given the uncertainties and the global crisis, but I generally tend to believe that analyst expectations lag the actual events, meaning that they are most of the time behind the curve. So the fact that I'm NOW hearing so much doom and gloom regarding Turkish economy is more of a bullish indicator for me. Also from my perspective I'm just locking in a yield. If an American feels the US treasury is unable to default, why would a Turkish person feel differently especially given the fact that the Turkish treasury has never defaulted in its history?

Of course there is more of a fight with people's perceptions here: Cliches, stereotypes that are hundreds of years old. You are never going to convince a biased person who has already made up his/her mind. On the other hand, if investors end up losing all their investment because they trusted the AAA rating of a country which turned out to be miserably wrong, then there is something quite alarming and uneven going on in here, and it's more than the good old injustices of life.

Also, I've generally had it with all the "boo!" I'm hearing in general about certain great American companies that actually produce something and add real value to society. But they get pulled down with the financial firms that in the end produce nothing. Yes, this is a financial crisis that also has consequences in the real economy, but let's try to separate the good from the bad.

Jan 29 05:32 AM

[iyamwutiam:]

Dear Suna:
I would be interested to hear your perpective on what the future entails as more and more informed people in other nations come to the same conclusions. Particularly in the 'third world'. As you are aware there is an anti-Davos meeting n South America and wonder why the GCC countries, Russia, etc do not do the same.

It has been obvious to many for decades that the rating of soveriegn debt is frighteningly skewed (especially when you look at broader indices -like Debt/GDP etc). Do you envision -the splitting of the world -so to say. Where more and more nations refuse to participate in the on going financial colonization of their countries futures? This seems an opportune time considering the tremendous amount of foreign reserves held by so called 'third world' countries like China, Russia, Brazil, etc.

Jan 31 12:33 PM

[iyamwutiam:]

www.iht.com/articles/2...

Jan 31 12:37 PM

[Arik:]

Great article !

Feb 16 03:55 AM

[Suna Reyent:]

:)))

Feb 18 03:17 AM