Friday, 22 February 2013

Links to this blog...

This blog was recently mentioned by Richard Levick in his post for Forbes on the fallout from the announcement that the US Department of Justice is bringing civil charges against Standard & Poor's.

I also wrote a guest editorial some time ago for Nutmeg about if and how credit rating agencies can remain relevant in the future.

It's Finally Happened - Moody's Downgrades the UK

Moody's finally confirmed market rumours this evening and downgraded the UK's government bond rating from AAA to AA1. It cited several factors, including the sluggish growth outlook for medium-long term, anticipating that weak growth will last into the second half of the decade, posing challenges for the government's fiscal consolidation programme. The consequences of this include the government's "high and rising debt burden" which reduces the capacity for shock absorption on the government's balance sheets. Importantly, because of the extended time frame of the fiscal consolidation plans, taking them into the next parliament, the level of risk involved has increased. Now, instead of peaking in 2014, Moody's expects the UK's gross general debt to GDP to peak in 2016 at 96 per cent, which is up from just over 90 per cent now.

Despite these problems, Moody's stresses that the UK still retains high creditworthiness, due to its competitive, well-diversified economy, previous and future fiscal consolidation and robust institutional structure. It's favourable debt structures, bond maturity lengths, and the resulting reduced interest rate risk on UK debt are all additional factors in the UK's favour. Moody's seems to believe that the government's fiscal consolidation plan will, in time, be fulfilled, given the UK's underlying economic strengths. The ratings agency does mention that the UK's exposure to the Eurozone is an issue that may become more urgent depending on how the crisis in that area progresses, however the contagion is stated to be mitigated by the UK's independent monetary policy and the status of sterling as a global reserve currency.

Moody's had changed the outlook from stable to negative in February 2012, however today's downgrade shifts the outlook back to stable. Speaking this evening in response to the downgrade, UK Chancellor of the Exchequer George Osborne took the news as a "stark reminder" of the troubles being faced by Britain, and vowed to "redouble" his efforts to reduce the deficit and maintain historically low interest rates for families. Interestingly, the downgrade comes less than a month ahead of the Chancellor's budget on March 20th in which he will outline fiscal policy for the coming months. 

But will the downgrade actually make any real difference? 

The short answer to this is, well, economically no, but politically, maybe. For a start, bond markets are usually a couple of months ahead of ratings agencies when it comes to anticipating difficulties and slow growth prospects, and sterling has fallen significantly against the dollar over the past few months. This has the advantage of making exports cheaper, helping the UK economy, but it tends to signal that all is not well for economic outlooks (regardless of rumours of currency wars). More to the point, rumours have been circulating for some weeks - some even publicly - that the UK is on the verge of a downgrade. The announcement tonight by Moody's should not have surprised anyone. Will bond yields increase dramatically when the markets open on Monday morning? Unlikely. And considering the role call of countries who have been downgraded over the past few years, the UK is simply the latest to join the list.

But the political issue is slightly trickier. Like other political leaders across the western world, Osborne staked a good deal of political capital on maintaining the AAA rating. I recently posted about the French reaction to their downgrade from AAA. But it's loss in the UK may prove to be a double-edged sword. While it may force reappraisal of fiscal policy, it might also give the Chancellor some room to breathe and reassess his options.

Undoubtedly it marks a recognition by a CRA that the deficit reduction plan is not working as successfully as planned, and that plans for growth haven't produced the desired results. Fiscal policy to get Britain moving after the recession focused around shifting from domestic consumption to an export-oriented base. But as nearly 40 per cent of UK exports are destined for Europe, the ongoing recessions there are less than encouraging. You simply cannot build growth by exporting to contracting economies. The good news is that the markets still appear to have faith in the political and economic ambitions of the UK government. Bond yields remain persistently low, despite some warning of a collapse in the bond markets as seen by Greece. The economic reputation of the UK remains intact, but questions are likely to be asked over the coming days about the political will to stick to austerity, especially given the backlash against pure austerity in other parts of the world, notably Japan and France. It will be interesting to see, therefore, if the Chancellor's "plan A" will be "tweaked" slightly to take account of the latest developments, and shift slightly away from austerity towards growth.

Monday, 4 February 2013

S&P confirms Justice Department is to bring civil action

The credit rating agency Standard & Poor’s has just confirmed that the US Justice Department will bring a civil action against it claiming that model used to rate mortgage-backed securities was inadequate. The Justice Department claims that inflated ratings of securities directly contributed to the housing bubble and in turn the financial crash.

Commentators have been pondering the question of why S&P is the only agency to face a law suit, and why now. Many have been swift to point to the fact that S&P has been the only CRA to date to downgrade the US, lowering the rating to AA+ with a negative outlook in August 2011. Whether this theory holds any water, I suspect we will never know, however if this is successful it is almost certain that other suits will follow (if parties don't settle first). On news of the action, shares in S&P’s parent company, McGraw Hill, fell 13.8%, the largest one day fall since the stock market crash of 1987. Shares in Moody’s were also down 10.7%, as investors anticipate a ripple effect throughout the ratings industry if the action is brought. 

The case could signal a change of approach to the rating agencies, which have so far remained untouchable, shielding themselves (in the US at least) by the First Amendment to the Constitution under which ratings are deemed to be “opinions”, protected as free speech. However, the civil action threatened by the Justice Department has a lower burden of proof than previous criminal prosecutions.

Negotiations between the US Justice Department and the CRA broke down when the Department demanded a settlement of $1 billion from the agency. S&P state the action is “without legal merit and unjustified”, and in a statement lists the steps taken by the agency to enhance systems, governance, analytics and methodologies since 2007. The page of the agency’s website explaining changes brought in by the company also highlights a handy link to a plain-English explanation of what ratings are, and what they are not, in case there was any doubt still. The statement by the agency stresses that ratings were provided in good faith by S&P in the "unprecedented" housing market of 2007. It points out that collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBSs) that were awarded AAA ratings also received similar ratings from rival firms.

It states that the Department of Justice’s plan to use the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 would be unprecedented, and would have no legal merit.
Consequently, despite the fact that the agency “deeply regrets” that it failed to anticipate the extent of the downturn in the market, it claims that this was not foreseeable, and that when doubts were raised, the agency took immediate action to reassess the relevant ratings.

The proposed action has reignited debate over the best ways to effectively regulate CRAs. Due to their position as gatekeepers to the markets, both for private issuers and sovereign states, agencies hold a great deal of power within the markets. Owing to the current way in which ratings are requested, paid for and issued, numerous conflicts of interest have been highlighted, many of which have been discussed in earlier posts. The possibility cited above of a previous downgrade being the reason for the current action stresses even further the inter-dependency of nation states and CRAs when dealing with access to international markets and international regulation. The fact that this action could represent any kind of "pay back" on the part of the US Department of Justice and Securities and Exchange Commission (SEC) is a frightening prospect. Issues that are this important for the security and stability of the economy must remain above the "tit for tat" of politics and retribution. 

Since the financial crash, CRAs have responded by separating braches of their operations and repeating that ratings are assigned in good faith. Regardless of regulation, however, the issue remains that the job of assessing risk and assigning a rating to a debt has to be performed. It provides a quick source of information that remains vital to the markets, despite claims by the agencies that investors should rely on their own research rather than simply a rating. As CRAs have come to occupy such positions of power within the markets, it seems likely they will continue to fulfil this role. Questions of effective regulation that deal with conflicts of interest, therefore, will continue to occupy policy makers, market leaders and academics for some time to come.