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

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

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

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

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

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

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

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

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

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

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

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

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

The Politics of Ratings, and the Politics of Avoiding Ratings

A while back I wrote a post about the muddling of finance and politics. The Eurozone crisis had seen France stripped of its AAA rating, and the move hadn't been taken well in France or the rest of the Eurozone. In particular, there was a significant, and very public, "answer back" from the French government and central bank, claiming that the UK should be downgraded first. 

These downgrades, along with those of Italy and Greece, had been notable for the significant political rhetoric behind the ratings. As was plainly cited at the time, the lack of political leadership and consensus was one of the main factors behind the downgrades, making the CRAs political commentators as well as risk assessors. This has never been denied by the CRAs. In their sovereign rating methodologies, each of the Big Three provide for political risk factors to be included in the assessment, along with "other factors" that the analyst might deem relevant. (Standard & Poor's sovereign rating methodology can be found here, and Moody's methodology is here. Interestingly, Moody's is currently seeking feedback to proposed "refinements" of its sovereign rating methodology. More on this in a later post).

The problem now, though, is that the US is facing the same. The fiscal cliff negotiations that played out in the final minutes of 2012 displayed to the world how divided the US legislature really is when it comes to solving the fiscal problems facing the US. Maybe "problems" is an understatement? 

In August 2011, Standard & Poor's downgraded the US one notch from AAA to AA+. This was the first downgrade in US history and stunned Washington. S&P cited - unsurprisingly - the large debt burden, but also the political stalemate that made tough decisions to tackle the deficit nigh on impossible. It seems that Moody's and Fitch, however, are looking very closely at their top ratings in the US. Fitch, speaking during the negotiations, reminded us that failure to raise the debt ceiling would exacerbate uncertainty over US fiscal policy and send the US into an unnecessary recession. It stated that this could erode medium-term growth potential and financial stability, leading to an increased likelihood that the US would lose its AAA status. Moody's, taking a similar line, has also expressed concern about the lack of political consensus to come up with a credible long term debt reduction plan. It stated that the current AAA rating will only be confirmed if current negotiations lead to a long term strategy that reduces debt to GDP ratio. 

The political aspect of downgrades of Berlusconi's Italy centred on the lack of credibility of the leader. But in the US, the political agenda is not the issue, so much as the lack of ability to reach a suitable agreement. Politics may not be the issue, but it got in the way of finding a solution to the real, underlying problem. The fiscal cliff may have been avoided, but the issues surrounding debt levels remain. It is estimated that without action, the US debt will reach $25 trillion by 2022. Moody's statement that only a reduction in the deficit will lower the likelihood of a downgrade seems rather trite considering the figures. For now, the country remains on "negative outlook".

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.

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.

... 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.

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.

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.