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.