S&P Looks at Temasek Part II

The S&P criteria for evaluating investment holding companies (IHC’s) has the potential to move Temasek from a AAA rated credit firm to Greece as the headlines have noted.  While this headline does accurately capture the potential impact, too many have focused on the outcome and a misreading of the its implication and not enough effort focusing on how the proposed methodology arrives at the new rating.  In fact, the potential outcome of the S&P proposal rests on much more technical reasons than a sudden belief that Temasek is a low credit quality firm.

The biggest proposed change is the importance S&P gives to liquidity in their risk assessment of IHC’s noting that “we propose to give a greater weight to our assessment of asset liquidity than to our assessments of asset diversity and asset credit quality.”   S&P stresses the importance of liquidity “…because the ability to sell assets quickly is the ultimate source of debt repayment if an IHC cannot refinance maturing debt.  Our assessment reflects how quickly we expect the entity can liquidate assets at a reasonable price.”

There are solid financial reasons, especially for a firm like Temasek, to accept higher liquidity risk by holding lower liquidity assets.  Studies have found that asset liquidity is valued so that financial firms, such as hedge funds, willing to hold lower liquidity assets receive a premium for bearing that risk.  University endowments have targeted lower liquidity investments given longer investment time horizons and the ability to sell at their discretion.

The second major proposal is to use “spot prices” rather than some “average price over n trading days – to value listed assets.”  Related to but also distinctly different from liquidity, this focuses on what price could assets be sold to cover debt payments.  This debate has raged for how banks should value their loan portfolios in what is typically called “mark to market” by valuing a bond or loan at the market price the bank could expect to sell it at or at some other less potentially volatile rate such as a long term average or expected stream of cash flow basis.

There is reasonable and straightforward logic as to why spot prices should not be used.  Let’s use a simple scenario to illustrate why.  Assume the market price of an asset declines and a financial institution reaches a level where they have to sell the asset to cover their debt payment.  When they sell an asset this further depresses the market price potentially causing other firms to be forced to sell.  It is also possible to recreate this scenario in reverse when prices are going up.  Fundamentally, there is a solid argument that using market prices can increase volatility.  It should be strongly emphasized that reasonable people have reasonable disagreements on this very tricky issue.

While these two concepts need to be considered separately, they also need to be considered jointly.   S&P is proposing that we ask the following about credit risk as it pertains to IHC’s: if an IHC needs to sell assets to repay a debt, how easily can it sell its financial assets and at what price?

How do these concepts apply to Temasek specifically?  Temasek can reasonably be considered a somewhat less liquid IHC for two reasons.  First, Temasek asset holdings are relatively concentrated.  Temasek holdings are concentrated with significant stakes in key firms like Singapore Telecom, DBS, Standard and Chartered, and China Construction Bank.  As one article noted, approximately 50% of Temasek assets are concentrated in ten firms.  If Temasek needed to sell some of these stakes, given the large size of the holdings, this would reduce the liquidity by pushing down the price if Temasek needed to sell a significant amount or if the market found out Temasek was selling a sizable block.  Also, if Temasek ever needed to sell its entire stake in a major holding, this would significantly reduce companies with the ability to finance large acquisitions.

Compare this to Norges Bank Investment Management (NBIM) which manages the Norwegian sovereign wealth fund.  They have limited themselves to 2% of outstanding equity of any company they hold.  While this essentially turns them into an index fund as they hold 1-2% of most every listed company, this also means that they remain very liquid.  NBIM is able to easily sell stakes in entire companies in relatively short periods of time or in many companies when needed.  In short, there is elevated liquidity risk due to the concentration of Temasek’s portfolio.

Second, there is what I will term political liquidity risk.  Look at the major holdings in Temasek’s portfolio and you will see politically strategic firms like Singapore Telecom, DBS, and Singapore Airlines.  Those are for all practical purposes completely illiquid investments where Temasek depends on dividend cash flow for debt repayment.  Removing firms from the Temasek portfolio that are for all practical purposes illiquid, reduces Temasek liquidity to cover debt repayment even further.  The S&P concern over liquidity risk has a significant impact when focusing on Temasek.

Turning to the question of what price Temasek might be able to secure for its assets under different market conditions returns us to the issue of asset concentration and political risk.  Not only is the Temasek portfolio concentrated within its portfolio, it is concentrated by industry and geography with an increasing allocation to higher risk assets like financial and natural resource firms.  For example, three of the top four holdings are in financial firms and Temasek remains closely linked to Singapore and surrounding countries.  This implies a high degree of correlation among their holdings.  If the market is declining, then Temasek would need to price any significant asset sale at an even larger discount.  Conversely, in a rising market Temasek might be able to extract a sizable premium for one of its strategic stakes.  However, given the concern about debt coverage from asset sales, we should focus on down markets and again there is cause for concern.  There would be significant pricing pressures on any significant asset sales by Temasek.

There would also be pricing pressure due to potential political risk.  Let’s assume for one moment that Temasek decides to sell a significant stake Singapore Telecom, DBS, or Singapore Airlines.  Given the long historical record, key personnel through each firm, and political significance, any buyer would be enormously concerned about undue influence exercised after the sale.  The same could also be said about most Asian holdings for instance in China Construction Bank or Bank of China.  The Chinese government would most likely have a strong opinion about Temasek selling its holding to anyone else.  Political risk is likely to impact the final sales price and not positively.

The primary risks the S&P is proposing to increase in its credit model for IHC’s are the ability to sell and the price it will receive for selling.  I believe there is a fair and reasonable case to be made that when Temasek is narrowly analyzed against these two criteria, it does have an elevated risk level.  There is good reason to have some concern over liquidity and asset pricing risk should it need to sell assets to cover debt repayment.

As noted at the beginning of this article, while the S&P frameworks does raise the risk profile of Temasek, it is important to note the reasons why.  Their reasoning focus on specific and technical issues and not due to a new belief in the underlying quality of Temasek assets.

Note:  Part III will cover the Temasek response, whether they should be considered as risky as Greece, and other bigger picture issues.

S&P Looks at Temasek and Sovereign Wealth Funds Part I

Somehow I missed the November release of the credit ratings agency S&P asking for comments on its proposal for updating standards of investment holding companies (IHC) and government related entities (GRE).  This is both a somewhat technical exercise and discussion by credit ratings agencies that takes place to reassess their standards for evaluating credit risk but also has very tangible impact on Singaporeans and can be explained in ways that make sense.

Before beginning to analyze the proposed S&P standards and Temasek’s response, let me try and provide some background to better understand the overall situation.

  1. S&P is one of the three major global credit ratings agencies along with Moody’s and Fitch.  Their market dominance stems primarily from their oligopolist position conferred by the US government within the American market.  Less than 10 credit rating agencies in the United States are recognized as “nationally recognized statistical reporting agency” which allows a privileged position for instance in rating investment grade debt held by a large variety of institutions.  The big three are estimated to control approximately 95% of the credit rating market in the United States which they leverage into dominant positions throughout the world.
  2. S&P, in putting forth generalized standards, is trying to create a clear, transparent, framework that they can use to compare different companies rather than make every analysis unique.  To take a simple scenario, they might state that companies with a debt to equity ratio of greater than 3:1 will receive a B rating while a company under than will receive an A.  Framework standard sacrifice detail and uniqueness, which individual analysts will provide later when researching companies, for broad standards than can be applied throughout the world.
  3. The broad framework standards used by every credit ratings agency can be used to disguise the true risk.  Frameworks to assess credit risk are generally solid guidelines but like all rules can be used to manipulate the overall system.  During the global financial crisis, many mortgage linked products met the technical guidelines to receive a high rating even if it clearly masked the true level of risk for that financial instrument.  Guidelines laid forth by ratings agencies should be considered fallible frameworks that attempt to capture common risk factors but they absolutely should not be considered final and perfect assessments of individual risk.
  4. Credit rating agencies are riddled with group think and conflicts of interests, but at the same time historical data reveals a very clear relationship between defaults and ratings.  The riskier the rating the higher the probability of default (PDF).  Credit ratings are imperfect by any measure with a systematic downward risk bias, but they should be ignored at your peril.  There is a strong relationship between both initial rating and adjusted rating and default probability.
  5. Credit ratings rarely change so consequently, there is a lot more interest in the framework or the rules that allow firms to receive top credit ratings.  Unlike credit default swaps (CDS) which trade daily and can be used to predict default probability, bond ratings typically go years without a ratings change so the initial rules of the game matter a lot more.  According to S&P, the last time it changed its IHC framework was May 2004 when it was entitled “Rating Methodology For European Investment Holding And Operating Holding Companies.”  The “European” in the title should giveaway how outdated the S&P framework is.
  6. Every firm that does not receive the rating they feel they deserve will loudly protest that there are factors unique to their situation that the ratings body is not accurately weighing.  Most of the time, but definitely not always, firms arguments that the ratings agencies fail to accurately understand their industry or firm are poor attempts to gain a better ratings.  Credit ratings by the large agencies on average accurately assess the credit risk associated with firm issued debt.  If anything, credit ratings agencies on average understate rather than overstating the risk associated with debt products.
  7. S&P in its framework creation rarely deals with the type of issues I raise such as accounting or corporate governance problems but rather on much narrower concerns focused on whether debt can be repaid and potential stress concerns.  For instance, two issue which S&P raises which may seem technical are liquidity and mark to market vs. trailing average over some period.  Again, these are broader framework issues narrowly focused on repayment rather than the specific corporate concerns.

So as not to turn this into an excessively lengthy post, I am going to limit this post to the broader framework and background surrounding this issue.  This is a very important issue that has very real ramifications for Temasek, Singapore, and everyday Singaporeans.  I want to make sure the background and broader issues are understood so that when I turn to analyzing S&P’s proposal and the Temasek argument, everyone is aware of what is unfolding.

This may seem somewhat technical and boring but let me assure you it is vitally important and will be very important.

Revisiting Chinese Consumption

In my last post, I expressed significant skepticism over the supposed rapid rise of consumption in China to bolster GDP growth.  Given wide spread reporting of declines or slowing of Mainland revenue by both Chinese and foreign firms, it seemed incongruous that that official consumption data was significantly accelerating.  While some heralded the GDP data as proof of the rising Chinese consumer in the face of slowing investment, it appears the truth source of consumption growth is again the Chinese National Bureau of Statistics.

Gordon Orr at McKinsey China was also puzzled by the consumption data and not only stumbled upon the source of consumption growth but uncovered very large data gathering change by the CNBS.  Looking at the data he noticed that urban consumption growth slightly outpaced income growth but not enough to be responsible for the required consumption growth.  However, when examining  rural consumption growth he noted that official YoY consumption grew at 27%.  Let me repeat that: according to the China National Bureau of Statistics rural consumption grew 27% from between 2013 and 2014.

Even for an economy growing at 7.5% this seem large so he asked the CNBS for an explanation.  The CNBS responded that they “expanded the coverage of their rural survey in 2014, and that the (higher) 2014 data is not comparable to prior years.”  This is a stunning revelation if true and raises many issues.

First, China has been a serial data methodology reviser over the past decade and all revisions have made significant upward revisions to GDP.  Just this past January, China made additional revisions that added the GDP of Malaysia on top of 2004 and 2008 revisions to GDP that added approximately 20% to GDP.  Given the enormous problems with other economic data such as unemployment which remains virtually unchanged over the past decade and inflation which claims that urban housing prices grew only 8% in total from 2000-2011, the supposed concern over statistical with regards to GDP that is only revised in one direction seems inconsistent.  Maybe if inflation and unemployment were both revised upward, as is the CNBS pattern, some credibility might be established.

Second, the CNBS apparently stresses that there is a break in consumption data and 2014 is not comparable to previous years.  Assuming this is true, 2014 GDP then is not comparable to 2013 GDP.  Given the inconsistency in Chinese GDP data, it seems nearly impossible to compare any year to any year with their self admitted data issues.

Third, if this data methodology revision is not included into 2014 GDP, official GDP would be at least 1% lower doing some basic back of the envelope math.  Conversely, if this new method is applied historically, this would increase Chinese GDP by approximately 1% annually.  These are not insignificant data revisions.  One mistake commentators make when tracking Chinese GDP is comparing GDP across time when it is clearly not comparable across time by even the NBSC’s own admission.

Fourth, though the CNBS announces or lets other uncover the new methodology, there is never any detail provided about the revised methodologies.  Others who have studied similar type of data on Chinese consumption the NBSC uses to revise GDP upwards have found that GDP in recent history has been significantly overstated.  The scientific method relies on others being able to replicate the results from similar or identical data and methodology.  The NBSC refuses to release the data or methodology it uses to justify these upward revisions and others using similar data an widely accepted GDP accounting methodologies find strikingly different results.  This should concern people.

Fifth, there is the supposed sampling error raised by Gordon Orr himself.  If the NBSC expanded its survey of Chinese households to better account for rural consumption the most logical step is that they would improve sampling of poorer and more remote areas with lower consumption.  Take this simple scenario.  Assume that previously, the NBSC collects samples from all villages over 10,000 people and extrapolates this for villages under 5,000 people.  Under the new methodology however it samples both groups of villages.  It would seem unlikely that the large majority of wealthy high consuming rural inhabitants are in under sampled areas like villages under 5,000 people, as described in this scenario.  This basic phenomenon would result from relatively extreme abnormal population distributions.  In other words, the NBSC is asking you to believe that the only people it didn’t sample before or extrapolate their data to previously are a group of previously hidden Mercedes driving farmers living large who consume so much as to swing national GDP data by more than 1%.

Having been writing about Chinese economic data for years, I am not sure which surprises me more: the obvious and blatant manipulation of data or that people still give it any credence.