Tag Archives: Italian Bonds

Should hedge funds be allowed to short a country’s debt?

A few weeks ago, I wrote about how credit rating agencies had cut their outlook for Italy, and how this was being blamed for Italy’s borrowing costs going up. Well, Italy’s borrowing costs continue to rise, and this time it’s being blamed on the hedge funds. Whenever I see an article like this make the rounds on social media, I invariably see some of the same comments come up: “hedge funds shouldn’t be allowed to bet against a country like that, they’re making money on other people’s suffering.”

First, I think the moral arguments are misguided. When two companies compete with each other and one drives the other out of business, the successful company could be said to be making money on the other’s suffering. But our capitalist system accepts this as the price we have to pay for an efficient economy, and so I don’t see the big difference between that and countries. Should people not have been allowed to short Lehman Brother’s because its collapse would likely harm the American economy? Surely not, so why should Italian government debt be protected in this way?

Secondly, it’s important to realize that the process of shorting is a mutually beneficial arrangement for both the entity doing the shorting and the one lending them the bond. In order for a bond to be sold short, it must be borrowed, then sold, then repurchased and handed back to fulfill the borrow. The borrowing of the bond generates interest, which must also be repaid by the entity doing the short selling. So bond-holders have an incentive to lend out their bonds to short-sellers because this lets them generate interest and therefore income on their bond. If they were not allowed to generate this income, then the bond would be worth less to them and they would not be as willing to purchase it. This would reduce the demand for a nation’s debt and thus would increase borrowing costs, which is something we’re trying to avoid by outlawing short selling.

Third, how would such a short-selling ban be implemented, and what would that affect? The processes that go into a short sale: the borrowing, selling, and purchasing of a bond, are all legal on their own. You would have to write a new, more complicated set of laws therefor to outlaw short selling but not also outlaw these individual practices which seem good and legal. So once you add this new complicated regulation to the market, how many entities will decide that it’s no longer worth it to invest in Italian debt (which has these complicated regulations attached to it) and will instead just invest in German debt (which doesn’t have these complicated regulations). And even if you could ban short-selling EU-wide, then many organizations would just pull their money out of EU bonds and park it into American, British, or Japanese bonds. People think that countries have all the power in the bond market, that they can set the rules because financial institutions need to buy bonds to make a profit. But countries’ bonds are competing with each other, there’s always another bond market people can invest in, and if you want to save Italian borrowing, then scaring money out of the Italian bond market doesn’t seem like the right way to do it.

Finally, short selling is a necessary part of price discovery. Without short selling, markets would not so easily discover the true price of bonds, and so would operate far less efficiently. Again, let’s say you banned short selling throughout the EU. Empirical evidence has shown that banning short selling only increases trading costs and lowers liquidity. That means that if you banned short selling, there would be less money in the market to buy bonds anyway, which again is counter-productive to Italy’s current predicament. In terms of Price Discovery, the failure of price discovery would mean that all prices would tend to converge together, as there is no strong discovery mechanism to discern them. That means the price of Italian debt and German debt would likely converge because investors would not be able to discern their true prices. This would be good for Italy, in fact it is exactly what some people want to accomplish by banning short selling, it might make it easier for Italy to finance it’s debts.

…but it would be bad for Germany. Germany currently enjoys a distinct position as having perhaps the most highly regarded debt in the Eurozone. That makes its borrowing costs very cheap and makes it easy for Germany to finance its obligations. Now, if the EU wanted they could always ask Germany to help out Italy, in fact years ago there was a call for Common European Bonds aka Eurobonds. This proposal would mean that member states could take out bonds which were to be paid back by all members of the EU together, making it easier for states like Italy to get cheap loans (because they were leaning on the German economy) while making it more expensive for Germany to get loans (because they were propping up the Italian economy). It is important to note that this Eurobonds proposal was soundly rejected by the EU and by the Northern EU member states in particular. Absolutely no one was willing to make Germany’s borrowing more expensive for the benefit of Italy.

So with that said, banning short selling would only accomplish what has already been deemed unacceptable. It would cause liquidity problems in the Italian borrowing market, and it could only help Italian borrowing if it also hurt German borrowing due to obfuscating price discovery across the EU. So why even do it? If Italy truly truly needs help financing its debt, the idea Eurobonds would accomplish exact what is desired without harming the bond market.

Did credit rating agencies make Italy’s borrowing costs go up all on their own?

Yesterday I discussed how credit rating agencies work and why they are a healthy part of a mature bonds market. To recap: credit rating agencies like Moody’s, Fitch, and S&P rate the creditworthiness of nations based on economic and political indicators, and publish those ratings to investors. Investors in turn pay for these in-depth credit ratings to decide exactly what bonds they should invest in and how much. Investors are willing to invest in lower credit-worthy bonds, but will only do so if they can get a higher interest rate due to the higher risk involved. That’s why it is big news when a ratings agency cuts their rating of a country’s bonds, such as Italy. This should directly translate into the market seeing Italy as a riskier investment and thus demanding higher interest rate to buy Italian bonds, forcing the Italian government to spend more and more money servicing its debt and deficit.

That’s the simple part but it doesn’t always work like that. Here for instance is the “spread” between Italian bonds and German bonds, it can be seen as how much more Italy has to spend to service its debt than Germany does. Germany’s bonds did not have any cut in outlook so they should be fairly stable, while Italy’s outlook was cut so it should have even more expensive bonds, right? Well not in this case, Italy’s outlook was cut on August 5th and since then Italy’s borrowing costs have gone down relative to Germany’s. Now I don’t want to ascribe too much to any one thing, analysts have a tendency to over-analyze market moves, but there is a sort of pattern that is often called “buy the rumor, sell the news.” In this case, investors expected Italy’s credit outlook to be cut, so they expected Italy’s bonds to get more expensive. They thus invested in such a way that the price of Italian borrowing went up prior to the actual cut, and then went down after it happened. Regardless, even with this messy pattern it’s hard to say that Moody’s alone was responsible for any increase in Italian borrowing cost, there’s clearly more to it than that.

And that’s an important caveat to the bond markets, Information from Moody’s and other ratings agencies are of course used by investors to inform their decisions, but they aren’t the only thing used. Indeed, Moody’s can sometimes seem reactive rather than proactive, it cuts a country’s credit rating after the country’s borrowing cost has already gone way up due to other economic or political news. Moody’s and the credit agencies are I think a big easy target for financially illiterate commentators because they’re easy to blame. The big bad American ratings agencies cut our credit score and made it more expensive for us to borrow. But these agencies are just one cog in the much larger bond market, and the individual actions of thousands of investors big and small is what causes the change in borrowing costs. If no one trusted Moody’s they wouldn’t have any effect on the bond market, and if they weren’t seen as trustworthy raters of bonds then no one would trust them. But Moody’s doesn’t have the kind of power and authority that its detractors ascribe to it, and Italy’s borrowing costs are expensive for many, many reasons that would not be fixed by Moody’s giving them an Aaa credit rating.

Do credit ratings agencies have too much power?

Recently, the credit ratings agency Moody’s reduced its outlook for Italy from “stable” to “negative”.  For those of you who don’t remember, ratings agencies were some of the key “villains” of the Eurozone crisis of the 2010s.  A ratings agency is simply a company who does research into the creditworthiness of people, organizations, or governments and then sells this information to lenders and investors.  Moody’s is one of the “Big 3” ratings agencies and so its ratings carry a lot of weight, whenever it cut its rating of Italy, Spain, or Greece, lenders would take notice and would consider those countries to be less creditworthy.  This in turn made it harder for those countries to borrow money to cover their expenses, just as an individual with a low credit rating has a harder time getting loans and has to pay higher interest on what loans they can get.  And for countries that were already saddled by high debt, this could be catastrophic.

Whenever Moody’s or another ratings agency cuts its ratings for European debt, the cries arise from various places that these ratings agencies are bad actors who must be reigned in.  People say that they are untrustworthy, they are profit-seeking, and worst of all they are American.  Because of all these things, they should not have this much power over the borrowing costs of European countries.  I think that while there are multiple criticisms to be made of ratings agencies (and I will try to address them later), at least some of this criticism comes from a place of ignorance and I’d like to address this.  

Let me first give a very brief explainer of how a ratings agency like Moody’s works in the context of government bonds.  A bond is basically a loan to a government, when you buy a bond you hand the government some money in exchange for their promise to pay you back over time.  So in a bond market you have the bond sellers such as Italy, and the bond buyers such as the banks and money funds.  Like any loan a bond has an inherent risk, a country that is more likely to not pay back its debts is seen as a riskier investment and must pay higher interest rates in order to sell its bonds on the market.  A government might confidently believe that there is zero risk in their bonds and thus they should only give the absolute minimum of interest rates, but if the market disagrees then no one will buy that government’s bonds and they won’t be able to raise money this way.  But how do the bond-buyers know which governments are less or more likely to pay back their debts?  Ratings agencies like Moody’s look at both the political and economic situations of the governments and come up with a rating, that rating says how risky the bond is and thus how likely it is to be paid back.  That in turn informs the market actors, who will demand higher interest rates for riskier bonds then for less risky bonds.

First of all, ratings agencies aren’t evil entities who make borrowing expensive for the lols, they are simply an element of the division of labor of modern finance.  Financial organizations, be they banks or pension funds or what have you, want to invest in stable, high quality bonds.  But if every bank and fund needed an entire team of analysts to assess exactly which bonds were high quality and which were not, there would be a lot of wasted labor as competing banks paid different people to find the same information.  Instead, banks outsource a lot of this investigation to the ratings agencies like Moody’s, then buy the information provided by Moody’s and use it to understand which bonds they want to invest in.  That in turn is a money saver and so the expenses of the bank or fund are a lot lower than they otherwise could be.  This division of labor is a godsend to modern finance, and to remove it for no reason would not be wise.  Moody’s provides a genuine service, it researches the economies and outlooks of almost every major government and investible corporation, and it has built a reputation of trustworthiness over its long history.

Second of all, ratings agencies have a lot of power in part because the market gives it to them.  Market actors such as banks and funds trust Moody’s and the rest of the Big 3 because of their long history of accurate ratings, or at least being more accurate than their competitors.  Those market actors use the information Moody’s provides to inform their investments, but Moody’s isn’t forcing anyone to raise the price of Italian borrowing, the market actors demand higher costs for Italian bonds in part because they trust Moody’s ratings and Moody’s says Italy’s outlook is not as good as it once was.  If you create a new organization, it wouldn’t necessarily change anything because a new, unproven organization would not be trusted.  The market would still trust Moody’s ratings more and thus Moody’s ratings would inform the price of bonds, this new organization wouldn’t.  You can’t really force every market actor to not use information from Moody’s.  I mean you can try, governments can always write laws, but enforcement of this kind of information ban would be a nightmare and would probably only cause bond-buying entities to flee from the EU bond market altogether because they wouldn’t want to fall afoul of new laws but also don’t want to buy a bond that they don’t know if it’s trustworthy or not.

Thirdly, trying to replace Moody’s is not an easy task and I’m not sure most of the detractors are up to it.  As I said, they only have power because the market gives it to them, so let’s say you put together a “European Moody’s” let’s call it Euddie’s (pronounced YOO-dees), then what?  Euddies won’t have the long track record of Moody’s, it won’t have the trust of the market, and so no one will buy their ratings or use their ratings to inform decision makings.  Instead they’ll just keep using Moody’s ratings and there will be no change to the borrowing price for European countries.  Furthermore, who will run Euddies?  If it’s a private company like Moody’s then you run into the exact same criticisms that people have for Moody’s ie it’s profit focused and shouldn’t have this much power over governments.  The only difference would be the nationalist complaint that Moody’s is American and Euddies wouldn’t be.  On the other hand if Euddies is an EU-level government entity, then who outside the EU would trust them?  EVERY government in the world says it is perfectly creditworthy up until the moment it defaults, so why would investment organizations trust an entity that is controlled by the very governments it is supposed to be rating?  In all likelihood without stringent ring-fencing between Euddies and the governing bodies of the EU, it would be seen as just another government agency like the ECB, without the trust that Moody’s has.  Finally, I don’t think Euddies will solve the problems that Moody’s detractors think it would, nations like Italy are still heavily indebted with poor economic outlooks, any reasonable credit agency will not give them AAA credit rating no matter where the agency is based or who runs it.  There is every reason to believe for instance that Moody’s ratings are as much reactive as proactive, oftentimes borrowing for a country will get more expensive before Moody’s even cuts their outlook.  So I don’t think that a Euddie’s organization giving preferential treatment to European government bonds would really change their borrowing costs when Japanese, American, Chinese, and all non-EU investors will continue to believe that those governments are not as creditworthy as they claim to be.

In conclusion, Moody’s and other credit rating agencies are not bad actors in the market, they are performing a legitimate service for other financial institutions and cannot be simply removed or replaced without serious consequences.  Tomorrow I will try to touch on the differences in borrowing costs between Italy and Germany, and how Moody’s ratings have fit into that.