The Reality of Brexit: Farewell to the UK's last AAA rating

Moritz Kraemer, chief ratings officer for S&P Global Ratings (the new name for Standard & Poor’s), stated today that the UK’s AAA rating was no longer “tenable” under the circumstances and would be downgraded at least one notch “within a short period of time”. While it is unclear what effect this downgrade will have, the only certainty is that it will heap insecurity upon insecurity, adding to the markets’ troubles and further raising the cost of government borrowing.

Other leading CRAs, notably Moody’s and Fitch, had already downgraded the UK prior to the start of the referendum campaign. Moody’s, which currently assigns the UK a rating of AA1, one notch below a AAA score, had previously warned of further downgrades following a vote to leave the EU. Moody’s has also warned that a UK exit of the EU could also see downgrades of UK businesses, impacting on their ability to borrow and, consequently, reducing their ability to invest. The referendum outcome is “credit negative” and could “increase the risk of political fragmentation within the EU if popular support for the bloc fades among member states”.

Fitch had also downgraded the UK prior to the Brexit debate, and has assigned a rating one notch below AAA since 2013. However it has also warned of short-term disruption and long term risks for the UK. In less dramatic language, Fitch Ratings described Brexit as “moderately credit negative” for the UK, and expects knock-on downgrades for UK entities to be relatively limited in the short term.

All three CRAs, while repeating the negative effect of the vote, stress the importance of the deal that Britain can strike with the EU as a principal factor in determining mid to long term ratings, both for the sovereign and entities. 

EU downgraded by S&P's but UK rating affirmed

On 20th December, Standard & Poor's, one of the 'Big Three' credit rating agencies, downgraded the European Union's long term rating to AA+ from AAA, citing reasons of contentious budget negotiations. This signals a slight heightening of the risks that the EU's borrowing capacity on the international markets will not be supported by its Member States. However, S&P's states that the stable outlook on the rating indicates that there are still highly rated sovereigns within the EU who are prepared to support the supranational organisation. The short term credit rating on the EU is affirmed at A-1+ with a stable outlook. 

The deteriorating credit conditions within the EU have also played a role in the downgrade, with weaker credit positions among several of the Member States. This economic appraisal is accompanied by the more political assessment that cohesion across the Union has weakened, elevating the risk profile. The long term rating on the EU was revised to a negative outlook in January 2012, however since that time the average ratings of the net contributors to the EU budget has decreased from AA+ to AA. Also, the downgrade of the Netherlands in November 2013 means that there are now only six Member States with AAA ratings. Moreover, since 2006, S&P's claims, the revenues contributed by AAA-rated sovereigns as a proportion of total revenues contributed, has nearly halved to 31.6 percent. 

Currently, 80 percent of EU loans to Member States that are outstanding are to Ireland and Portugal. The CRA believes that the chance of the EU being unable to access credit markets to extend these loans is "remote". However many of the other reasons stated for the increase in risk of long term EU supranational borrowing is notably political. S&P's notes that the willingness of Member States to contribute to meeting the EU's financial commitments on a pro rata basis could be tested in future. Added to this is the proposed referendum in the UK about continued membership of the Union, which the ratings agency describes as an unprecedented step for a sitting Parliament to take, and which could - by implication - have ramifications both for the UK and the EU. 

The EU is currently rated AAA by Moody's with a negative outlook.

A couple of days later, S&P's affirmed the UK's AAA/A-1+ (unsolicited) rating, which apparently sits on the back of "exceptional monetary flexibility". However, the negative outlook is retained as the sustainability of the recovery - built on private consumption and property investment - is of questionable sustainability.

Sovereign Risk and Bank Ratings

This post discusses the interplay between ratings assigned (principally by S&P's) to sovereigns and their banks. Bank Industry Country Risk Assessments (BICRA) ratings are the starting point for understanding risk in the banking industry. There is a previous blog post on BICRA methodologies here. BICRA ratings are relative measures of the industry risk and economic risk of a country's banking system. For BICRA, analysis of economic risk is based on similar indicators to those used by sovereign ratings experts. In sovereign ratings, CRAs look at economic structure, growth prospects and macro policy flexibility to assess the sovereign's ability and willingness to repay its public debts. For banks, the same factors are important in helping to form assessments about loan growth, asset quality and borrowers' ability to repay. The relationship between sovereigns and banks is a relationship that goes both ways - banks play an important role in channeling savings into investment, while operating in a financial system that is regulated by governments. At the same time, the embedded risk from the banking system can be important in gauging the contingent liability of a sovereign. So the relationship is an important one for the resulting ratings of both banks and sovereigns.

The impact of sovereign risk is most clearly seen in the economic risk assessment part of BICRA. Four out of the five analytical areas of sovereign analysis factor in to the 'economic resilience' assessment. The fifth sovereign factor, which is about external performance, features in the 'economic imbalances' score. Sovereign stress can also be factored into the assessment of credit risk in the case where a sovereign rating is falling sharply. At the same time, a sovereign in distress can weigh on the assessment of system wide funding within BICRA if it causes a negative feedback in the wholesale or cross border funding mechanism or the conditions for banking in a particular country. 

Some banks can be directly affected by a change in the sovereign rating. This can be the case where banks receive extraordinary government uplift in their ratings (if the government has provided a solid guarantee to the bank -it is "too big to fail") then a change in the rating of the sovereign may see an immediate change in the rating of the bank. At the same time, for banks whose SACP is at or above the sovereign rating, (there are not many of these but they do occur) there is a direct relation between the sovereign and the bank and once again, ratings can change very quickly on news of a downgrade. There can also be a more indirect impact in cases which involves evaluating how the new conditions in which the banks are operating affect the BICRA. At the same time, if the economic risk score changes, this can impact on a bank's capital position. Similarly, if asset quality worsens, it may also affect the bank's risk position and capital and risk position are some of the bank-specific factors in S&P's analysis. 

Bank Ratings and the Role of Government Support

The credit crisis changed the way S&P's factors government support into its bank ratings. Going back to 2008 at the height of the credit crisis, it is fair to say that many people were surprised at the level of support given to banks not just in the US but globally. Until that time, government support of US banks was not explicitly incorporated into the ratings given to those banks. But towards the end of 2008 and following a series of government bank support initiatives, the extraordinary support given to the large, systemically important banks was included in the ratings. 

In November 2011 new bank rating criteria was introduced, making the criteria more transparent, and including for the first time explicit reference to government support. The Stand Alone Credit Profile (SACP) was also revised and tightened and altered to include either group support or government support. Governments were identified as 'high support' or 'supporting' (as in the US) in certain instances and banks were defined as being of high, moderate or low systemic importance. 

The potential for extraordinary government support continues to be factored in to the ratings of high systemic importance banks in the US. This is because despite progress made under the Dodd-Frank Act with regards to liquidations, S&P's believes that a crisis today would still require some form of government support to minimise contagion risk. However, there is the possibility that support could be removed from the ratings of the banks' holding companies and depending on how regulation evolves on resolution, support may be removed from the ratings of high systemic importance banks. Government support is not set to be removed from the ratings assigned to operating companies though.

2013 round up

During 2013 there have been 18 downgrades and only 8 upgrades, which has mirrored the preponderance for more downgrades since 2011-12. The balance of outlooks hasn't really changed - about 2/3 are stable, and of the remaining 1/3, most are negative non-stable outlooks. In Europe, there are now - at the end of 2013 - far fewer negative outlooks than there were at the beginning of the year, although some of these are due to downgrades having taken place. There are a few more positive outlooks at the end of 2013 in Europe than had been the case in January. The opposite has occurred in the Asia-Pacific region, where there are more negative outlooks at the end of 2013 than the beginning.

There have been drives by both S&P's and Moody's to make their sovereign rating methodologies more transparent and generally clearer, as global bond yields showed that investors actually ignored 56% of Moody's and 50% of S&P's rating and outlook changes last year. This was in particular when the CRAs said the governments were becoming more or less safe. The revised methodologies haven't seen vast alterations in sovereign ratings, and are readily accessible. The CRAs state that they want their methodologies to be so transparent that investors can use them to estimate their own version of a sovereign rating that should be no more than three tranches away from the rating assigned by the CRA.

This poses questions, not least surrounding the changing role of CRAs in the sovereign bond markets. By making their methodologies so transparent that any investor can use them to assign their own rating, have S&P's and Moody's become simple providers of a list of pointers investors should consider when summing up the risks of investment? Moreover, when using the CRA methodology, the CRAs claim that investors should be able to estimate "within a three notch alpha numeric range" the likely rating assigned to a sovereign. But this indicates three notes above or below, which covers quite a wide variation in rating. The difference between three notches - according to the alpha numeric ranges set out by any of the Big Three agencies - encompasses a substantial variation in the level of risk. Added to this, once an investor has taken the time to use the methodology for herself to estimate the sovereign risk rating, she then finds a potential three notch divergence between her result and that assigned by the CRA. And there appears to be little she can do to square this circle. In short, the transparency ends here. 

The state of Europe after the Eurozone crisis - a round up of developments

The longest recession in 40 years in Europe appears to have stabilised, but the search for recovery continues. Greece is taking delivery of a third bailout from the Eurozone, albeit tiny in comparison to previous loans. However, exports, consumer spending and corporate investment are still low, hinting that a recovery is still some way off. 

In the banking sector, Basel III minimum leverage ratios are being welcomed, having been recognised as a buffer against future crises. In the US, for example, minimum leverage requirements well in excess of 3% have been proposed, hinting that the Basel requirements are still seen as inadequate. It does also hint that the implementation of a globally comparable leverage ratio - as set out in Basel III - is unlikely to be met with uniform regulations around the world. 

In the EU, an agreement reached between the Member States on June 27th 2013 on a proposed directive states that in future financial crises, bank and financial institution bail-ins will be the default position, preserving depositors' money and sparing the taxpayer. Bail-outs are not ruled out, however, as the agreement gives national governments substantial flexibility to determine how best to resolve a situation. As such, governments can still determine that a taxpayer-funded bail-out is the best solution, and considering that the agreement on bail-ins is not likely to come in to force until 2018, there is still plenty of time for taxpayers to be left firmly on the hook.  Moreover, S&P considers that EU member governments with sufficient financial capacity will continue to support major creditors of systemically important banks, at least until balance sheets recover, and banks are made more resolvable through structural reforms. 

While mortgage agreements and real estate sales are increasing again in the US, the same is beginning to take place in the UK. US new home sales were up 7.9% in August, and were up 13% on the year. (Source: Census Bureau, from S&P Ratings Direct). Lower interest rates in the UK have been partly responsible for the increase in lending, along with the Bank of England "Funding for Lending" scheme which aims to target lending to the real economy, in particular SMEs. Moreover, the govenrment-backed mortgage scheme, has also aimed to boost lending to those who could otherwise not afford to get on the housing ladder, although this has been met with accusations that it will only fuel, rather than address, the housing bubble.

This all sounds remarkably positive, given the travails of the past few years. However a recent report by S&P on the state of the Eurozone is less optimistic. The report concludes that slowdowns in emerging markets, and an economic rebalancing in China, may "start to reduce the credit support provided by global diversification in recent years". The mantra that a diversified economy will weather economic storms better may prove little use should China - along with other developing economies - slow down their consumption, leaving demand stagnant throughout the global economy.

China's growth has slowed noticeably and perhaps more significantly, expectations for China's growth have also fallen. The consensus is that forecasts have fallen by one percentage point over the last year to 7.5%, however this continues to decline. This compares to a GDP of over 9% in 2010-2011, and although the Chinese leadership seems comfortable with current figures, their focus will be on balancing internal demand and consumption with international trade. 

A Eurozone slump, along with negative US fiscal policy developments, slower growth in China or a disorderly reduction in quantitative easing are currently the top risks for global credit conditions. This has had implications for European sovereign creditworthiness, along with corporate credit ratings above the sovereign. Corporate trends in Europe are still mainly negative. Fifty-six percent of S&P rating actions in the second quarter of 2013 were ratings downgrades, while over two-thirds of industry sectors carry "stable-to-negative" or "negative" outlooks. Moreover, S&P expects the Eurozone to remain in recession for the rest of 2013 and has downgraded its real GDP forecast from minus 0.5% to minus 0.8% for this quarter. The ratings agency expects a weak recovery in 2014 with a GDP of 0.8%, but expects that potential growth will remain impaired long in to the future. Furthermore, according to S&P, there is still a one in three possibility that the Eurozone could experience a sharper and deeper recession in the remainder of 2013 that could last into 2014, seeing the recovery pushed back even further into the future. Owing to the structural nature and depth of the Eurozone crisis, the agency estimates that it is unlikely for a recovery to occur earlier, or for GDP figures to improve substantially in the short to mid term. 

A recent report by Moody's affirms the provisional AA1 rating of the European Financial Stability Fund (EFSF) based on the contractual elements, including the "irrevocable and unconditional" guarantees by the Eurozone member states, as well as their creditworthiness and commitments to the EFSF. The strong political commitment of Eurozone member states to the Fund is also important, as Moody's assesses that any default would entail "significant pecuniary and political costs" for Europe. However, the rating is subject to a negative outlook, reflecting the negative outlooks on euro area sovereigns that are guarantors to the Fund. The three largest shareholders in the fund, Germany, the Netherlands and France, all have negative outlooks, with Finland being the only eurozone country with a stable outlook currently. 

Diverging Opinions: S&P refuses to follow Moody's, instead reaffirming the UK's AAA

A few weeks ago, Moody's downgraded the UK one notch to AA1, depriving it for the first time of its top AAA rating. It was roughly a month before the Chancellor was due to deliver his budget, and we wondered what Moody's knew that we didn't. Well, maybe not a great deal. In a counter move, Standard & Poor's yesterday announced that it would be maintaining the UK's AAA rating, albeit with a negative outlook and a one in three likelihood of downgrade over the next 18 months. The agency expects the UK economy to grow by 1.6% per year for the next three years - below estimates provided by the Office for Budgetary Responsibility. It also states that any easing of the austerity program may precipitate a downgrade. Fitch Inc has altered the UK's status from "negative outlook" to "negative watch", indicating that a downgrade may yet be imminent, but allowing the UK to cling on to the top rating for a little longer.

So why did the largest two ratings agencies come to different conclusions about the UK economy?

I discussed the downgrade by Moody's in a previous post, and will focus on S&P's decision here. 

S&P's reaffirmed the UK rating because “the Government remains committed to implementing its fiscal programme, and has the ability and willingness to respond rapidly to economic challenges”. This is despite the fact that the national debt as a percentage of GDP in 2016 is expected to rise from 85% to 95% while the deficit falls to only 4.2%. While this clearly remains within the 'acceptable' limits of fiscal consolidation according to S&P's, the agency warned that should the pace slow any further, a downgrade will follow. The top rating was apparently spared on the back of the UK's wealthy and diverse economy, the flexibility of fiscal and monetary policy, as well as flexible and adequate product and labour markets. These were taken into account by Moody's as well though, indicating perhaps that S&P's has placed slightly more weight on the willingness and political commitment of the government to stick to its austerity plans, come rain or shine.

Standard & Poor's also made mention of the EU referendum promised to UK voters by David Cameron. The agency's assumptions are based on the premise that corporate sentiments are unaffected by the uncertainty created by the referendum. In other words the CRA acknowledges that the referendum creates uncertainty - that businesses are cautious in uncertain climates - but goes on to conclude that this is not the case here. Why? Much of the literature on investment emphasises the role of certainty and predictability in creating a suitable investment climate to attract businesses and long-term investment. Uncertainty surrounding the future of the UK within the EU, and a potential end or alteration to the free movement of goods, people, services and capital across British borders within the European Union could seriously harm the UK.plc's outlook. Not that there is much Mr. Cameron can do about this now, having made the promise to the electorate. S&P's does state that should it's assumptions about business here prove wide of the mark - and investment does suffer as a result of uncertainties - a downgrade could follow.

Oddly enough, having chronicled this, the next question is 'does it matter'? Well, in short, not really. Even the downgrade by Moody's had been factored in by the markets prior to its announcement, and the expectation that S&P's and Fitch will follow suit is widely assumed. Will it cause markets to reappraise their levels of risk associated with UK bonds, now the AAA has been confirmed? Unlikely. Besides, the AAA rating is becoming an increasingly rare specimen these days. The stigma of suffering a downgrade has been severely diluted by the sheer quantity of downgrades that have taken place over the past few years. 

But this state of affairs does lead to another - perhaps more important - question. If the markets are regularly factoring in risk assessments to their operations weeks (usually) before any announcement on downgrades by the CRAs, and if the impact of a downgrade has been reduced to the extent that sovereigns are no longer worried by an announcement, are we witnessing the slow demise of the role of CRAs in international markets?