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.