Wednesday, 30 November 2011

The Lawsuits Keep Coming

The case against Standard and Poor's finally got underway on October 7th in Australia. Thirteen towns were sold AAA-rated Constant Proportion Debt Obligations (CPDO's - also known as "Rembrandts" by the Australian firm Local Government Financial Services in 2006. According to Standard and Poor's, who rated the synthetic derivatives, there was less than a 1% chance of failure. Within two years the products had crashed, resulting in losses of $15 million for the affected councils. Standard and Poor's has been charged on two fronts. Firstly, as the  CPDOs were new products, they did not have sufficient information to accurately rate them. Secondly, they are charged with bowing to pressure from the issuing bank, ABN Amro, to issue a favourable rating.
In responses, Standard and Poor's has rehearsed familiar arguments, stating that "rating is an art, not a science", and reminding us of recent US judgments declaring ratings no more than "predictive opinions". See previous posts on the Ohio case here.

These may be revisited, however, as on September 30th a judge sitting in Albuqureque denied rating companies' requests to have claims brought against them dismissed. The case is being brought against all three big ratings agencies (Moody's, Standard and Poor's and Fitch) by Maryland-National Capital Park & Planning Commission Employees’ Retirement and the Midwest Operating Engineers Pension Trust Fund. They are representing investors who lost $5 billion in Thornburg Mortgage Home Loans Inc. mortgage- backed securities which were rated AAA.

Developments will be posted here.

Monday, 14 November 2011

S&P Revised Bank Ratings Criteria and BICRA Methodologies

Standard & Poor's has just released revised bank ratings criteria. The new criteria aims to provide greater insight into how banks are rated, and claims that the new approach is more 'intuitive'. It builds on existing methodology but aims to simplify and incorporate what has been learned over the past few years throughout the financial crisis. According to Standard & Poor's, the stresses of the crisis have forced banking to reinvent itself. There has been, and continues to be, a potential shift in the balance of power between banks in the west and those in BRICs nations, and while recovery in the former is not a foregone conclusion, neither is sustained growth in the latter. Moreover, there has also be a shift in business volumes away from the formal banking sector towards the shadow banking sector. This is somewhat due to heavier regulation of banks following the crisis and the more stringent capital and liquidity requirements. Restrictions on higher risk activities have also forced these operations elsewhere, meaning that profit margins on regulated banking activities are likely to be reduced over coming years. Moreover, government support for banks is also less certain, with moves by many governments to support certain activities, sectors, and institutions, or in some cases to make it clear to the markets that no institution is too big to fail. The new criteria are designed to reflect the changes that are taking place, and keep pace with current market practice.

The new criteria also aim to establish a greater degree of global consistency across the ratings frameworks and - interestingly - in so doing to sustain market confidence in the ratings.

The revised BICRA (Banking Industry Country Risk Assessment and Assumptions) methodology results from consultations carried out throughout 2010 following a request for comment back in January 2010. According to the feedback from this request, Standard & Poor's report that one of the most often cited complaints was a lack of clarity about the criteria and how it was applied. Consequently, Standard & Poor's appears to be on something akin to a PR drive at the moment to publicize and more importantly explain how the methodology works.

So what is new?

The criteria take a revised approach to investment banking, with elements allowing for a greater differentiation of risk. This can now be taken into account with the business profile. Credit risks of banks operating in different business lines are also more clearly differentiated, meaning that risks pertaining to a specific sector can be more accurately expressed.

Secondly, criticism was levelled in replies to the 2010 request for comments that no account was taken of stronger liquidity of institutions in funding analysis. Under the revised criteria, "funding and liquidity" is a discreet factor. Now, when this is above average (strong liquidity and above-average funding), the standalone credit profile can be raised by one notch.

Thirdly, criticism was also directed at the practice of using capital standards globally. Under this system, the RAC (risk adjusted capital) ratio of banks operating in higher risk countries would be assessed in the same way as banks operating in lower risk countries. However, the capital standards one would expect to be achieved by a bank operating in a high risk country would, on average, be less. Under the revised criteria, country profiles are taken into account, and therefore for a bank operating in a higher risk country with a standalone credit risk anchor of BB or B-, slightly lower RAC ratios (moderate amounts of capital) falling just short of the usual 5-7% will not automatically see a rating reduced by one notch, as was previously the case. Risk adjusted capital frameworks (bank capital methodology) remain unchanged.

Finally, the BICRA methodology, while retaining its original structure, has been tightened somewhat. The criteria has been integrated more sovereign analysis in an attempt to make ratings more consistent. The BICRA methodology itself is designed to allow for evaluations and comparisons between global banking systems, with the system being given a BICRA score between 1 and 10, with 1 comprising the lowest risk groups and 10 the highest. A BICRA analysis for a country includes both rated and unrated financial institutions that take deposits and/or extend credit within a particular country. The new methodology takes a macroeconomic approach, looking at the entire financial system of a country and considering the relationship between the banking system and financial system as a whole, including the impact of non-bank market participants. The macroeconomic approach also assesses the influence of government supervision and regulation of the banking sector, including emergency support mechanisms, although note that targeted government intervention for systemically significant institutions is reflected through ratings uplift rather than BICRA.
The methodology remains divided into the two main areas of economic risk and industry risk, which are each further subdivided into three. Standard & Poor's claim that this will not only make the analysis easier for the user to assess, but will make bank ratings more consistent with their sovereign counterparts. Each factor is assessed for an economic and industrial score for each country - the BICRA score. The rating methodology for banks uses the economic and industrial profiles produced by the BICRA analysis to give an anchor which then acts as the starting point for determining the bank's stand alone credit profile (SACP). Following this, factors such as support from a government or parent group are considered before an overall rating is assigned.

The guidance notes go on to state that the creditworthiness of a sovereign and its banking sector are closely related, and that many of the factors underlying a sovereign rating are relevant in determining a BICRA score. Also, the sovereign rating methodology is applied in assessing sub-factor such as "economic resilience" and "economic imbalances". The methodology also recognizes that the influence of a sovereign's creditworthiness on the related BICRA is more pronounced when the sovereign's creditworthiness deteriorates.

In a paper written last year I suggested that greater amounts of end-user due diligence could be encouraged to relieve some of the excess reliance on market 'opinions' produced by credit rating agencies. The revision of analyses to enable users of ratings to more readily understand the methodology certainly goes some way towards increasing the transparency of the methods used and analysis undertaken by the agency and should be applauded. However we should be careful. The methodology is certainly more accessible, and Standard & Poor's are clearly aware that greater transparency of process is necessary for market trust and maintaining reputational capital. But we are still none the wiser as to the quality of information that goes in to the algorithms, or indeed what institutional and economic assumptions these latter are based on.

The new criteria are due to be applied in November/December 2011, and Standard & Poor's claims that the impact of the new methodologies will be less than previously feared, with 90% of new rating anticipated to remain within one notch of their previous rating. The agency claims that around 10% of A1 ratings will fall to A2 as a result of the revisions.

All criteria documents can be accessed online, and each has a straightforward explanation of the function and purpose of the criteria.

Friday, 11 November 2011

France downgraded due to "technical error"

Standard and Poor's mistakenly downgraded France yesterday due to a "technical error". This was at the expense of France, who, along with the rest of Europe, are still incandescent over the episode. It appears that a message was sent out to some subscribers stating that France's sovereign rating had been downgraded. However less than two hours later the agency withdrew the statement and reconfirm the country's AAA/A-1+ rating. The erroneous announcement caused a surge in French 10-year bond yields by up to 28 basis points, up to 3.456 per cent, although these fell again following the retraction.

Last month, Moody's stated that France was - financially speaking - the weakest economy in Europe to still cling on to its AAA credit rating, and put it on a three-month review period (see earlier post here). French bank exposure to Greek and Italian debt means that this situation has not changed.
The technical error prompted French Finance Minister Francois Baroin to ask market regulators in France and Europe to investigate the "causes and potential consequences" of Standard and Poor's actions. France's stock market regulator, AMF, subsequently opened an investigation into the incident. France's fiscal policy is premised on its AAA rating, and Nikolas Sarkozy has effectively pinned his re-election hopes on retaining the rating. A second package of austerity measures in three months was announced this week by the French prime minister, Francois Fillon.

A downgrade for France would almost certainly entail a downgrade of the EFSF, which could pose big problems for the rest of Europe. However, considering that the Fund is unlikely to be able to cover significant bail out for larger European economies a modest increase in interest rates is unlikely to derail its use for smaller loans. However, the unhappy incident does prompt questions about the internal controls and screening mechanisms in place in the big three ratings agencies, not least how it could take nearly two hours for the CRA to realize its error.

While there is no press release or statement on Standard and Poor's website regarding the mistake, reactions in Europe indicate that the matter is not likely to die down soon. Speaking today, Michael Barnier, European commissioner for the internal market stated how serious the error had been. He emphasized that it was imperative that market players exercise discipline and a special sense of responsibility. Mr. Barnier is due to unveil a new regulatory regime for credit rating agencies on Tuesday.

In other developments, the Isle of Man was downgraded one notch to AA+ from its AAA credit rating by Standard and Poor's today. The agency cited reasons that the economy was small, undiversified and focused on financial services, all of which left it vulnerable to market shocks. The agency stated that by diversifying the economy of the crown dependency, the Isle of Man could regain its AAA rating.

Wednesday, 26 October 2011

The Mystery of the Triple A rating and the Reincarnation of the CDO

Speaking last month, Christine Lagarde stated that if banks could raise sufficient funds on the open markets to meet their liabilities and Basel III requirements within the certified time (between 7 and 9% of capital to risk-weighted assets) then governments should step in and lend to the banks. No-one, it would seem, wants this outcome. The banks retaliated with claims that they were not in need of a second "bail out", and there aren't many taxpayers who would be happy with another round of bank bailouts.

But it's not just banks. At the end of last year, Ireland needed a bailout. Greece and Portugal swiftly followed, and now Italy and Spain have joined the list of those 'giving cause for concern'. The European Financial Stability Facility was set up following the Irish bailout as a means of dealing with the problem. At the time, no-one expected, and likely intended, for the fund to be used. It was intended merely as a 'back up' plan that would encourage the market to lend to Ireland. But this never happened, and now - unable to fulfil the government guarantees of banks - Ireland cannot raise money on the markets. Estimated interest rates of 7% on Irish government bonds being unsustainable, Ireland had to look elsewhere, and the EFSF was the remaining option.

The EFSF, it is anticipated, will borrow €750 trillion from the markets and will lend to countries in need.The means of the EFSF are combined with loans of up to € 60 billion coming from the European Financial Stabilisation Mechanism (EFSM), i.e. funds raised by the European Commission and guaranteed by the EU budget, and up to € 250 billion from the International Monetary Fund. In other words, the fund is a special purpose vehicle (SPV) set up to lend money to countries that can't issue bonds on the markets. Investors who won't lend to Ireland and Spain because of their poor economic situations are being asked to lend to the EFSF, which will in turn lend ot Ireland and Spain. The core countries of the Eurozone have agreed to guarantee the fund, though, so each are liable for the defaults of others. Germany, France and Italy are the largest contributors, making Germany, France and Italy liable in large part for the debts of countries who borrow from that fund. So far so good.

All of the big three ratings agencies were asked to assign the fund a triple A rating - the highest possible, and each agreed. This was justified on the basis that those countries guaranteeing the loans could afford to honour their guarantees. But the fund is essentially supplying loans to people who can't borrow anywhere else because it is unlikely they'll be able to pay the loan back. It's also guaranteed by countries who aren't solvent either (Ireland, Greece, Portugal, Spain and Italy are all guarantors too). Put this way, the triple A rating assigned seems surprisingly optimistic - reminiscent almost of the CDOs that came to symbolise the worst of the sub-prime mortgage crisis.

Of course, the CRAs have defended their actions, citing Germany's surplus and the structure of guarantees involved. Indeed, Scott Mather, Pimco fund manager, has stated that if the EFSF just loans to Ireland then the fund appears to be a fairly safe bet. The problem comes if and when more countries need to borrow from the fund. By guaranteeing Ireland's loan from the EFSF, Spain, for example, will have to set aside assets to cover the guarantee, leaving less room for manoeuvre should anything go wrong, and making it more likely to need to borrow from the fund itself. The more countries that borrow, the fewer guarantors there are, and the rating assigned will drop. In the worst case scenario, Germany, and to a lesser extent France, will be left lending to the rest of Europe, and most likely writing off a significant part of any loan. This - as we are all well aware - is well after the point at which politics steps in and marks the end of the single currency experiment - and is the worse case scenario.

It is worth noting a couple of final points. The AAA rating for the fund was necessary because the investment it is seeking to attract is mainly funds. Pension funds and other investors who usually look for low(er) risk vehicles that are investing the life savings of teachers, postal workers, etc. Ireland had its first bail out nearly one year ago. It followed IMF advice and introduced strict austerity measures. The economy has shrunk by 20%, unemployment is in the high teens and debt to GDP ratio has soared to over 100%. IMF advice hasn't solved anyone's problems, yet it is still being offered as the solution, in the form of a second bailout package. Greece is in the same situation. It is estimated that Greek debt will rise form €270 billion to €340 billion in four years time. This is predicated on the assumption that Greece follows IMF advice by introducing strict austerity measures. The problem is that Greece can't afford to service its current debt levels, let alone increased levels. Massive write offs are the only way that Greece is going to be able to default 'gently', although it does bring the wisdom and the function of the EFSF into question even further.

For more on this see NPR's Planet Money podcast on the issue. An FAQ factsheet on the EFSF is available here.

Monday, 24 October 2011

... and the downgrades continue

And so the banking crises and the sovereign debt crises rumble on, with endless meetings in Brussels that have so far achieved stupendously little given the time already devoted. We are being reassured that progress is taking place, so perhaps just a little longer...

In the meantime several more European downgrades have been occupying the rating agencies. On the 18th October Moody's cut Spain's sovereign credit rating, making it the last of the big three rating agencies to take such action, lowering the rating from Aa2 to A1. A couple of weeks before, Fitch had cut Spain's sovereign rating to A minus from double A, followed closely by a similar move by Standard and Poor's. Considering Spain's sovereign rating was triple A status until September last year, recent downgrades mark the latest turn in a significant drop. Moody's cited reasons of political uncertainty (further elections could see the conservative People's Party make huge gains in elections on November 20th), unrealistic deficit reduction plans (from 9.2 per cent of GDP last year to 4.4 per cent in 2012) with equally unrealistic growth figures (forecasts of 1.8 per cent growth have been estimated by Moody's to be closer to 1 per cent). Further reasons cited include the government debts of Spain's 17 autonomous regions, and the willingness of these to curb their spending.

Moody's have also downgraded both Belgium and Italy, the latter following a similar move by Standard and Poor's last month. Standard and Poor's have also downgraded three large Italian banks although it confirmed the ratings of 18 large banks - including the largest by assets. 21 regional banks were also downgraded. However concerns have been raised by the head of Italy's banking association and chairman of Monte dei Paschi, Giuseppe Mussari, that EU bank recapitalisation plans being discussed in Brussels could do more harm than good in Italy by forcing banks to hold 'unnecessary' amounts of capital and exacerbating the sovereign debt crisis. Italy's 10-year bond yield rose 7 basis points to 5.867 per cent on Tuesday, the highest close since before the European Central Bank began buying Italian bonds on August 8 to try keep down borrowing costs.

As negotiations to bail out Greece and the Euro with it continue in Brussels, Moody's has announced that it may change the outlook on France's triple A rating from stable to negative in the next three months. As is customary in such situations, a downgrade is neither forthcoming or imminent, but the mere prospect of such sends shivers through the markets and French banks' shares fell following the announcement. Moody's praised France's 'very high economic strength', its 'ample capacity to absorb shocks' and its 'favourable public debt maturity', along with political efforts aimed at fiscal consolidation. However, the global financial and economic crisis had, according to the rating agency, led to a deterioration in French 'government debt metrics'.

The agency stated that France's finances were now among the weakest of those countries which still had a triple A rating. France's public finances are not only looking vulnerable but French banks are heavily indebted to Greece. Standard and Poor's last week downgraded BNP Paribas by one notch from double A to double A minus citing exposure to Greek debt. What's more, major consequences could follow for France if Greece defaults on its liabilities and markets react poorly, or if there are any further defaults. Add in the fact that France has been gradually becoming less competitive for businesses over the past years - in contrast to neighbouring Germany - and it becomes easy to understand why Sarkozy might be worried. Moody's isn't alone, however, as Standard and Poor's included France in the role call of countries likely to see further downgrades in the case of a double dip recession - alongside Spain, Italy, Ireland and Portugal. France's public debt is approaching 90 per cent of GDP and so a downgrade could prove extremely painful, even though this figure is set to fall as France's budgetary deficit is brought down from 5.7% currently to 3% in 2013. These figures are - as most Eurozone projections - based on optimistic growth forecasts. France anticipates 1.75% over the next year. Most commentators doubt this will materialize, either making deficit reduction a longer-term goal, or necessitating further austerity measures in the run up to the election next year.

France is already committed to €158.5bn ($217bn) in guarantees for the new eurozone rescue fund, the European financial stability facility, which is equivalent to 8.5 per cent of GDP. It has also just agreed to guarantees for the failing Franco-Belgian bank Dexia. Now these don't matter much unless and until one of these fails, at which point the government is bound to step in. But it does mean that France has much less room for manoeuvre on its balance sheets than it did three years ago, leaving it vulnerable to further financial shocks. It is also limited in the resources it can supply to the European Financial Stability Fund (EFSF), and Germany's peas for a greater Greek write-off followed by French re-leveraging of banks is, as a consequence, increasingly difficult. Politically, at least, Sarkozy has hailed the AAA rating as 'untouchable', and while rating agencies take political direction into account, it will no doubt take more than a statement of intent to preserve France's rating.

Friday, 7 October 2011

UK financial firms downgraded by Moody's

The credit rating agency Moody's has downgraded the senior debt and deposit ratings of twelve UK financial firms, including RBS (down two notches from AA3 to A2), Lloyds TSB (down one notch from AA3 to A1), Nationwide and Santander UK. Nine Portuguese banks were also subjected to the same. While the agency stated that it did not believe that conditions had deteriorated, it attributed the downgrades to the belief that the UK government was less likely to bail out any of the institutions should they get into difficulties.
The removal of implicit government support for the banking sector was welcomed by Lloyds as necessary for the sector in the UK at least to stand on its own once again, however the news prompted falls in all the share prices, including for Barclays whose share price fell in accordance with the other banks despite the fact that it was not downgraded.

The Chancellor George Osborne stated that British banks were among some of the best capitalized in the world, and that the government were taking steps to address the "too big to fail" problem. Of course, detail is scant, and heralding capitalization levels and stress test successes should be taken, one feels, with a Dexia-sized pinch of salt. Moody's split the downgrades into three categories - those institutions still with a high likelihood of government support, a moderate level, and a low level of support. Unsurprisingly, the large banks including RBS and Lloyds fell into the first category, while the smaller institutions were split between the second and third.

While most UK banks have exposure to Irish sovereign debt, they are not exposed to other Eurozone countries in the same way as some of the European banks. There's more on this point, along with discussion of some interesting calculations carried out by French bank Natixis here.

New Zealand soverign debt downgraded

Standard and Poor's and Fitch both downgraded New Zealand's sovereign debt a few days ago. The ratings agencies cited increased government spending after the earthquake along with high levels of household and agricultural debt. Fitch also stated that New Zealand's high level of external debt was 'an outlier' among comparable developed nations.

The Standard and Poor's rating was cut from AA+ to AA, however Moody's rating remains unchanged at AAA. New Zealand's debt to GDP ratio has fallen over the past year following government efforts from 86% to 70%, and while most commentators agree that several years ago the country would have escaped attention from the CRAs, the sovereign debt crisis has prompted a more cautious approach.

Wednesday, 5 October 2011

Moody's downgrade Italian bonds

Moody's, the credit rating agency, has been busy. The agency cut Italy's government bond ratings yesterday, this time by three notches to A2. Reasons cited include long-term funding risks for states in the Eurozone and high levels of public debt. While this is the first downgrade of Italian bonds for many years, the move parallels recent activity by Standard and Poor's who recently downgraded Italian sovereign debt to single A. The ratings from the two CRAs now equate with each other, and both have a negative outlook, meaning that further downgrades could follow. While the downgrade from Standard and Poor's comprised a thinly veiled warning about the political leadership of the country, that of Moody's appears to focus less heavily on the antics of Berlusconi and more on the Eurozone banking and sovereign crises.
Many large French and German banks are heavily exposed to Italy, and the downward revision of that country's sovereign debt will only fuel fears that the sovereign debt crisis in Europe is morphing into a second banking crisis.
Also on Tuesday, Moody's placed the ratings of seven Hungarian banks (OTP Bank NyRt, OTP Mortgage Bank, K&H Bank, Budapest Bank, FHB Mortgage Bank, Erste Bank Hungary and MKB Bank) on review for possible downgrade. The move follows the approval of a law in that country that would allow foreign currency mortgage borrowers to repay their loans in full at exchange rates falling well short of current market rates. Moody's cites that this will add potential stress to a banking system "already under significant pressure". Around 80% of Hungarian banks are owned by foreign banks.

This morning, Moody's has also placed on review for downgrade the standalone bank financial strength ratings (BFSRs), the long-term deposit and senior debt ratings and the short-term ratings of Dexia Group. The liquidity position of the Group, along with wider concerns about the state of the market is cited as reasons. Further details are available here.

Sunday, 2 October 2011

SEC Staff Report on Credit Rating Agencies

This Report brings to the fore many of the issues that commentators have been citing for a long time about problems inherent in the ratings market. This (long) post summarizes the Report and discusses briefly the findings, but future posts will most likely draw more on this Report and what it is likely to mean for US and EU regulation in the future.

Staff of the SEC have issued a report on the ten Nationally Recognized Statistical Rating Organizations (NRSROs) registered in the United States. These include the "big three" of Standard and Poor's, Moody's and Fitch, and the report - required by the Dodd-Frank Act - makes for some interesting reading. The Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 requires the SEC to examine each NRSRO annually and report on findings. The aim of the increased oversight was to ensure compliance with the new reporting, disclosure and examination requirements as set out in Dodd-Frank. The CRAs, which were criticized for issues of inaccurate ratings relating to mortgage-backed securities leading up to the financial crisis, still have "apparent failures" in following their own methodologies and procedures, the report found.

One CRA, which is not identified (more on this later), apparently allowed some "dissemination" of a pending rating before it's public release. The report also notes apparent failures in some instances to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest. The Report itself splits the ten CRAs into two groups, the first comprising the "big three" (Standard and Poor's, Moody's and Fitch), and the seven smaller CRAs operating as NRSROs. The Report notes that the larger CRAs are mainly financed along the lines of the issuer-pay model. While some of the smaller agencies have traditionally kept to subscriber-pay models, these are now beginning to explore more issue-pay models, in particular with respect to the rating of asset-backed securities.
The report also notes that since the 2008 Public Report, the larger agencies have taken steps to address the concerns raised. That report had examined operations relating to ratings given to certain Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) and had highlighted concerns about the sufficiency of resources devoted to ratings and surveillance, the adequacy of disclosures, documentation of the rating process and management of conflicts of interest. The 2011 report states: "Each of the three larger NRSROs appears to have devoted notable resources and effort to responding to the concerns and recommendations outlined in the 2008 Public Report". Further detail on this point is notably absent, although conclusions can be drawn from the number and breadth of concerns raised in the Report.

The Report's essential findings also show that one larger CRA failed to follow its methodology for certain asset-backed securities, applying the wrong methodology to one class of securities which have now been put on review. This was reported to the Staff during the period of the review, causing concerns to be raised about the speed with which the error had come to light, been disclosed, and then remedied. This, according to the Report, led the Staff to express concerns about the extent to which lack of resources - a criticism of the 2008 Report - remains a factor, making the lack of detail about the extra resources put in place by the "big three" even more frustrating. The CRA in question apparently has greater resources devoted to the surveillance of ratings of asset-backed securities, yet the error still took months to come to light. The Report questions if this means that the CRA is following its own published criteria for the review of asset-backed securities ratings. Interestingly, the Report cites market share as one of the possible factors that led to a delay in discovering and disclosing the error and further delays in taking remedial action.
The Report further found that one of the smaller NRSROs was slow to disclose changes to its rating methodology for certain asset-backed securities and how those changes would apply to its ratings, and slow to apply those changes to outstanding ratings of affected asset-backed securities.

It is the issues highlighted by the Report in relation to management of conflicts of interest that is perhaps the most illuminating. The Staff identified "troubling weaknesses" in two of the smaller NRSROs with regards to their securities ownership policies and procedures, and the implementation of these. It was found that a lack of adequate documentation made it impossible to verify that the procedures had been adhered to, and that one key employee in particular had violated the policy by failing to adhere to securities trading pre-approval requirements. Moreover, it would appear that this same key employee held securities related to a business sector for which he participated in criteria development, in clear violation of the policy. In other of the smaller NRSROs, the securities and ownership policies, including monitoring and enforcement were found to be "haphazard and inconsistent" and one instance was identified where a key analyst may have directly owned a security of a company that was subject to a rating action in which the analyst participated, contrary to Rule 17g-5(c)(2) Dodd-Frank. Even more surprising is that the Report states that the Staff made recommendations that each enhance its policies and procedures, including documentation and enforcement, and presumably hope to find progress in the next annual report. The Report does stress that employee securities ownership policies play a crucial role in preventing the misuse of material non-public information, before stating that this area will comprise a focus of future reviews.

Issues raised with regulation of conflict of interest continue with a focus on the larger NRSROs, two of which were found not to have specific policies or procedures in place for managing potential conflict of rating issuers that may be significant shareholders in the NRSRO itself or a parent company, a situation the Staff found could give rise to a conflict of interest. Indeed, the Report states that two of the larger agencies issue ratings for companies that "may be" significant shareholders of the NRSRO or the NRSRO parent company. The Report recommends that the agencies establish procedures for managing these conflicts of interest where they arise, and this may include complete separation of such functions within the firm, although the Report makes no suggestions. This conflict of interest parallels that of the subscriber-pay business model, which the Report highlights as providing potential for conflicts of interest in three smaller NRSRO which appear to have weaknesses with regard to their policies and procedures to manage this. According to the Staff, the subscriber-pay model is more likely to see the subscriber exert pressure on the NRSRO in order to obtain a more desirable outcome.

Two of the smaller NRSROs were also found to have weaknesses in policies and procedures concerning the disclosure and management of conflicts of interest associated with certain ancillary business. This latter is defined in the Report as "any services which an NRSRO may provide which are not core credit rating services". Again, detail here is scant, and the Report does not specify the services referred to, but it is likely that some of these were product design and financial advice. The financial crash highlighted the practice of CRAs effectively advising on the market, assisting in financial product design, and then assigning these a rating. While separation of such functions was present prior to the crash, standards have been tightened since.

The Report goes on to examine internal supervisory controls, and found that in three of the smaller NRSROs these are "weak", including one firm lacking any internal audit function and having limited compliance personnel. The Report also found that of three of the smaller and one of the larger NRSROs, "the procedures for disseminating a pending rating action appeared to allow for limited dissemination of a pending rating action in some instances prior to public dissemination".

The Report notes in Part C that disclosure by one smaller NRSRO regarding certain rating methodologies appears "weak", while public descriptions of its committee process and details about the number of analysts working on credit ratings appear to be "misleading". Overall disclosure could be improved, according to the Report. However, as no NRSRO is named in the Report, it is difficult to see how the market can react to these findings. Admittedly, with only three larger players, and a total of ten NRSROs in the US market, it may be unrealistic to call for complete transparency in the hopes that the markets will respond by punishing those CRAs with poor documentation procedures. Indeed, transparency is not the focus of Dodd-Frank. But the trend in the Report does appear to be to call for increased disclosure from the NRSROs themselves. It seems a missed opportunity for this to be the same in the Staff Reports.

Finally, the Report gives no guidance on how to solve the interminable, and by now infamous, question of conflicts of interest in the ratings industry. Whether the issuer is a shareholder in the NRSRO or not, whether the rating is funded on the issuer-pay or subscriber-pay model, and whether the NRSRO employee holds securities in the issuer (or pays into a pension which holds them) all give rise to potentially material conflicts of interest. The latter is perhaps the simplest to address, but answers to all three remain tricky - and the subject of a future post.
The report notes that the staff made various recommendations to the NRSROs to address the staff’s concerns and that in some cases the NRSROs have already taken steps to address such concern, but the SEC believes that working with the CRAs without disclosing bad practices is the best way for these issues to be resolved. The report stresses that the "essential findings" set out are those of staff members who conducted the examinations, and do not constitute any expression of the Commission per se, nor do they constitute any "material regulatory deficiency", although they may form the base for such in the future.

Wednesday, 28 September 2011

Standard and Poor's, Moody's and Fitch win dismissal of case

Standard and Poor's, Moody's Corp., and Fitch Inc., have won dismissal of a case brought against them in the Ohio courts by five public employee pension funds. The funds claimed that the ratings given to certain mortgage backed securities were faulty and caused them to lose money.

US District Judge James L. Graham, throwing the case out yesterday, agreed with previous case law that the opinions were mere "predictive opinions", and without specific intention to defraud by the ratings agencies, there was no liability. Former Ohio Attorney General Richard Cordray, who filed the suit in 2009, and who has since been replaced by current Ohio Attorney General Mike DeWine, claimed that the ratings assigned to the securities - all AAA or equivalent - were assigned because of payments made by the issuers. Further action by the current Attorney General has been promised.

As stated, the case confirms previous rulings in the US regarding the legal status of ratings, which are considered to be public opinion, protected under the First Amendment to the US Constitution. This was first clarified in 1999 in the Jefferson County case where a suit against Moody's was dismissed. The Jefferson County School District had sued Moody's, claiming that ratings assigned to bonds issued were unfair, causing financial distress to the County. Dismissing the case, the US Court of Appeals of the Tenth Circuit found the statements too vague to be "provably false".

In a similar case in Orange County, also in 1999, a Santa Ana judge also found that without proof of actual malice, Orange County would not be able to succeed in an action against Standard and Poor's. Orange County claimed that ratings ascribed by Standard and Poor's had been too high.

The result? Ratings assigned by CRA's are "public opinions" protected as such under the First Amendment to the Constitution, and therefore without proof of actual malice are not open to legal challenge. For a more detailed overview of the US case law see this post. For the time being, all suits brought against rating agencies have been in the US. It is, however, unlikely that any result in Europe would vary.

Saturday, 24 September 2011

Bank of America - Too Big To Fail No Longer?

Can a bank ever be too big to fail?

After a three month review the rating of long term Bank of America debt has been downgraded a couple of notches from A2 to Baa1. Moody's have cited the reduced chance of a full-scale bailout by the US government should the bank run into difficulties, although the rating agency concedes that should trouble occur, it is still likely that some government help would be likely. According to Moody's, allowing a troubled bank to fail is now more likely than previously because of a realisation that this approach reduces the risk of contamination. Citigroup's long term rating and Wells Fargo's rating have also both been downgraded.

So are taxpayers safe from future bailouts? Are the big banks now no longer "too big to fail"? In its report, accessible here, Moody's states:

"Moody's continues to see the probability of support for highly interconnected, systemically important institutions as very high, although that probability is lower than it was during the financial crisis. During the crisis, the risk of contagion to the US and global financial system from a major bank failure was viewed as too great to allow such a failure to occur -- a view borne out in the aftermath of the Lehman failure. This led the government to extend an unusual level of support to weakened financial institutions and Moody's to incorporate the expectations of such support in its ratings. Now, having moved beyond the depths of the crisis, Moody's believes there is an increased possibility that the government might allow a large financial institution to fail, taking the view that contagion could be limited."

So Moody's believes that the worst of the financial crisis is over and that we are emerging into the sunny uplands of recovery? Maybe not, however there seems to have been a shift in perception that contagion can now be stopped not by bailing out huge financial institutions, but by letting them fail. There are obviously political implications in protecting the taxpayer from more massive bills (more on this later), however provisions in the Dodd-Frank Act that work to reduce interconnectedness among financial institutions can also explain this. Under rules recently finanalized by the Federal Deposit Insurance Corporation (FDIC), the orderly liquidation authority set out in Dodd-Frank sets out a clear intent to impose future losses on bond holders in the event that a systemically important bank - such as the Bank of America - was nearing failure.

However, as yet the parts of Dodd-Frank that would serve to reduce interconnectedness among financial institutions, such as resolution plans or changes to over-the-counter derivatives markets, are still pending. It would therefore be extremely difficult for an orderly liquidation of an institution the size of Bank of America to occur at the present time, and consequently Moody's believes that for this reason, should disaster strike, the government would still be compelled to provide some financial support. Reliance on the ordinary liquidation authority to resolve a systemically important bank would prove too disruptive to the marketplace and wider economy, leading to a situation almost as undesirable as those Dodd-Frank was designed to avoid.

Bank of America, according to Moody's is still exposed to "potentially significant" levels of risk related to both residential mortgages and home equity loans that are still languishing on its balance sheet. Moreover, while Bank of America has taken steps to improve its capital and liquidity positions, and while Moody's believes that it has an ample buffer to absorb any losses that might occur as a result of bad debts, a deterioration in the economic environment or adverse legal rulings on claims against it might serve to tip the balance against the bank's long term financial stability. Of course, these latter are not within the direct control of management of the Bank, meaning that short of further increasing their "modest" capital and liquidity, there is little more the Bank can do except weather the storm out. Of course, following a downgrade of long term debt by the CRA, this one option available to the Bank of America is now just that little bit harder.

So can a bank ever be too big to fail? The obvious answer has to be yes, however the political climate in which a financial crisis materializes should not be underestimated. Is Moody's taking into account the rise of the Tea Party movement in the US? Considering Obama's difficulties in raising the debt ceiling, and the way in which a left-leaning congress balked at previous bailouts, the increasingly vocal right wing in American politics is likely to signal the end for taxpayer support of financial institutions.

Tuesday, 20 September 2011

Moody's praise Italian Austerity Budget for Securitizations

As stated in the previous post, the recent downgrade of Italian sovereign debt by Standard and Poor's has prompted a few raised eyebrows at Moodys' unchanged rating of the debt. Moody's weekly report available here praised the Italian austerity measures as "surprisingly positive for term securitizations". The measures abolish the 20% surcharge on the cumulative amount of interest that has accrued on bonds that amortise in their first 18 months. The measure is credit positive for securitization because they no longer will bear negative carry. Negative carry results from lower interest earned on retained principal than interest paid on notes, according to David Bergman, analyst at Moody's. By removing the surcharge, there is no longer a need for a lock-up period, thereby saving negative carry costs.

By contrast, the consensus at Moody's appears to be that the other austerity measures expand on earlier measures but will have little effect. The latest round of measures aim to eliminate government deficit by 2013 as opposed to the earlier 2014. The measures contain the usual you'd expect to find in deficit reduction plans - increased taxation and reduced spending, and again, as in Greece and much of the rest of the Eurozone, a crackdown on tax evasion forms a significant element of the anticipated increase in tax revenue. A further one point increase in VAT to 21% will come into effect on 17th September, and an extra levy on those earning over €300,000 is also being introduced.

More here when Moody's reappraises Italian debt this week.

The austerity measures are included in law decree 138/2011, which in Italy is popularly called “Manovra Bis”.

S&P Downgrade Italian debt

Standard and Poor's yesterday downgraded Italian sovereign debt to A with a negative outlook. This means that further downgrades are still possible. This means that Italy's Standard and Poor's rating is now 3 notches below that assigned by Moody's, which announced last week its intention to review the Italian measures brought in to deal with the debt problems.

As is usual with these things, the base rate of borrowing rose, leaving yields on 10 year Italian bonds at 5.80% this morning, the highest since the European Central Bank started buying Italian and Spanish bonds in August, according to the FT. By contrast, 10 year German Bund yields this morning were at a low of 1.75%.

Standard and Poor's cited Italy’s “weakening economic growth prospects” and the difficulty of the “fragile governing coalition” being able to “respond decisively” to the crisis, however Berlusconi responded by calling the downgrade political. The Italian government passed an an austerity package just six days ago, however Standard and Poor's has clearly not been much reassured. It would appear that concerns surrounding Italy's ability to deal with the debt crisis are as much about political capability than fiscal stringency.

The Eurozone may be preoccupied with an imminent Greek default, and while this would be tricky and painful, Greece's economy could - just about - be propped up by the rest of the Eurozone, should it choose to do so. However the larger Italian economy is not in this position, and as such any prospect of Italian default should signal something akin to a "save yourselves" policy turnaround. And then there's Spain...

The European institutions have, predictably, reacted angrily to the news, and have threatened a third round of regulation of CRAs, setting up a wholly independent European rating agency. Commentators have largely been skeptical about this threat, but more here if and when the plan is taken forward.

Wednesday, 14 September 2011

The American Downgrade

This is an interesting post on modeled behaviour and the eponymous downgrade:

Downgrade of French Banks

Moody’s has downgraded by one notch top French banks Societe Generale and Credit Agricole while leaving BNP Paribas on negative watch. The agency said that during the review, Moody's concerns about the structural challenges to banks' funding and liquidity profiles increased, in light of worsening of refinancing conditions. Moody's cut SocGen's debt and deposit ratings by one notch to Aa3 from Aa2. The outlook on the long-term debt ratings was negative. For Credit Agricole, Moody's downgraded its BFSR by one notch to C from C+, and cut its long-term debt and deposit ratings by one notch to Aa2 from Aa1.
Credit Agricole and Societe Generale have seen their share prices fall 60% and 65% respectively since February, while BNP has fallen 53% over the same period.
Analysts have welcomed this move as the Moody's rating was slightly elevated compared to other agencies.