Moody's downgrade of Spanish regions should be a signal for Rajoy to request aid

Spanish regional downgrades should not have been a surprise. After all, regional credits are generally tied to the national rating in most rating agencies' methodologies. As the central government bonds got downgraded, regional debt was sure to follow - this was discussed in some detail here.

Moody's: - The ratings of the following five regions have been downgraded:

- Junta de Extremadura: long-term issuer rating downgraded by one notch to Ba1 from Baa3; negative outlook;

- Junta de Andalucia: long-term issuer and debt ratings downgraded by two notches to Ba2 from Baa3; negative outlook;

- Comunidad Autonoma de Murcia: long-term issuer and debt ratings downgraded by two notches to Ba3 from Ba1; negative outlook;

- Castilla-La Mancha: long-term issuer and debt ratings downgraded by one notch to Ba3 from Ba2; negative outlook;

- Catalunya: long-term issuer and debt ratings downgraded by two notches to Ba3 from Ba1; negative outlook;

Note that none of these bonds are now investment grade based on Moody's, which may ultimately impact their eligibility for the ECB collateral. What's troubling is that Moody's is basically looking beyond the internal rescue fund (called the FLA) set up by Spain to bail out the regions (see discussion).

Moody's: - Moody's decision to downgrade the ratings of the four Spanish regions of Andalucia (to Ba2 from Baa3), Castilla-La Mancha (to Ba3 from Ba2), Catalunya (to Ba3 from Ba1) and Murcia (to Ba3 from Ba1) was driven by the deterioration in their liquidity positions, as evidenced by their very limited cash reserves as of September 2012 and their significant reliance on short-term credit lines to fund operating needs.

In addition, Catalunya, Andalucia and Murcia face large debt redemptions in Q4 2012 when retail bonds issued in 2011 are due to mature. In this context, five regions -- namely, Catalunya, Andalucia, Murcia, Valencia and Castilla La Mancha -- have already requested liquidity support from the Fondo de Liquidez Autonomico (FLA) to cover their financing needs in the second half of 2012.

While the FLA greatly reduces the risk of a region's liquidity driven default in the short term, it does not address their fundamental economic and financial weaknesses, namely: (1) the significant uncertainty regarding viable long-term funding alternatives, and the resulting considerable reliance on government funding; and (2) the regions' significant difficulties in controlling their deficit and debt trajectories in an economic environment in which the implementation of cost-cutting measures to redress the regions' structural deficits will likely take longer than expected.

As discussed before (see this post), Spain's government is waiting for the market to force its hand before the officials finally request a bailout package from the ECB/EC. But Spain should use this downgrade as an opportunity to ask for help, since it may give politicians some cover. If Mariano Rajoy waits much longer, he may end up asking for aid under duress.

SoberLook.com

Rating agencies will become less relevant for bank risk

The bank downgrades last night were met with enthusiasm by the markets. Morgan Stanley stock jumped after hours when the downgrade was less severe than expected.

SFGate/Bloomberg: - "If anything, the market is reacting with relief," said Strickland, who helps oversee $14 billion of fixed-income assets as a managing director at Santa Fe, New Mexico-based Thornburg. Morgan Stanley bonds likely will rally, said Strickland, whose firm owns the bank's debt. "The market is shrugging it off."

None of the financial firms was cut more than Moody's had forecast. Morgan Stanley's long-term senior unsecured debt rating was reduced two grades to Baa1, and nine other firms received two-level cuts, Moody's said yesterday in a statement. Credit Suisse's rating was cut three levels to A2 and Zurich- based UBS AG, the other firm singled out for a potential three- level cut, was lowered two instead.

Now that the well telegraphed downgrades are over, bank CDS are tightening this morning (MS and JPM CDS shown below).

MS and JPM CDS

At this point Moody's might as well downgrade major banks to below investment grade level and be done with it. Over time rating agencies will become less relevant for large bank credits as all major banks involved in capital markets will converge to roughly the same rating.

SFGate/Bloomberg: - "To downgrade a BofA or Citigroup or companies that are sitting on hundreds of billions of dollars of cash in government-backed securities makes no sense," Richard Bove, an analyst at Rochdale Securities LLC, said in an interview on Bloomberg Radio and Television's "Bloomberg Surveillance."

"You can forget Moody's," Bove said. "You should have forgotten them a long time ago."

Credit ratings may not even matter when government policy will dictate the outcomes. Bail-in provisions may drive the payout on unsecured bank bonds, particularly in Europe. Spain just announced that it plans to haircut some unsecured bank bonds (discussed here), setting precedent for this approach going forward.

Bloomberg (June 22): - Spanish policy makers are considering forcing investors who hold equity and junior debt in banks to absorb losses in a restructuring, according to a person with knowledge of the plan.

Such burden sharing is among conditions being negotiated with the European Union in a 100 billion-euro ($126 billion) rescue for Spain’s financial industry, said the person, who asked not to be named as the conversations are private. Depositors who bought subordinated instruments such as preferred stock may be partially shielded from losses through a compensation plan being considered, the person said.

There is very little that a rating agency can do to assess the risks of such policy decisions and whether or not a bank bondholder will receive par.

SoberLook.com

Moody's lashes out against Sober Look

Attorneys for the rating agency Moody's apparently became quite unhappy when they saw a post from two years ago entitled "Learn structured finance from the best in the business".

Needless to say the post wasn't flattering to the firm because it pointed out the irony that Moody's was teaching structured credit after what they had "accomplished" with the sub-prime CDO ratings, ABCP, etc.  And charging over $4,000 for it in 2009.

The post contained a copy of Moody's old structured credit course brochure (available to the public on their website at the time). So they forced Sober Look (via Scribd) to remove the catalog for what they call a "copyright infringement".

A two year old publicly available course brochure?  Really? Congratulations Moody's.  You get the Sober Look Hype Award.

SoberLook.com

Learn structured finance from the best in the business

For a mere $4,095, you too can learn from the best in the business of rating structured finance securities - Moody's. Learn things like Moody's rating methodology for securitization, Moody's approach to rating RMBS, CDOs, and of course ABCP. Each session is followed by group exercises...

And people thought there is no more money to be made in structured finance. Entrepreneurship at it's best. It's impressive that Moody's has put this out there. It's probably a great course, but it is equivalent to having Enron sponsoring courses on how to set up off-balance-sheet SPVs and taking future revenues into income.

Enjoy!
Moody's Course

Moody's luck of the Irish

Moody's is playing catchup with European bank downgrades, particularly with regard to the Irish banking institution. The chart below shows the number of notches they have downgraded banks in various European nations.





LTDR means long-term debt rating and BFSR (overview link at the end) stands for bank financial strength ratings. As with other types of ratings the agency has been behind the curve on European banks. Moody's fully bought the propaganda coming out of European governments and banks that they had little US sub-prime exposure and therefore were in great shape. If the real estate exposure is not sub-prime, it's got to be fine.

Here is a Reuters story from April 2008:

Irish banks have only limited exposure to subprime and the other related risky assets that have sparked huge writedowns at major international finance houses, Ireland's central bank said on Friday.

In its latest quarterly report, the central bank said that stress-testing showed Irish banks, which have a weighting of over 40 percent of Ireland's stock market, were well-capitalised and profitable.

Of course what Moody's didn't see (because by then they were totally fixated on their little US sub-prime problem) was how leveraged Irish banks were in their exposure to Irish real estate, including development and property loans. A few months after the Reuters story above, the Irish government was cooking up a bailout. They created a "bad bank" fund (sounds familiar ?) called National Asset Management Agency or NAMA (TARP, Irish style) to purchase massive amounts of bad loans from Irish banks using government funds.

Irish Sunday Business Post: The night of September 29, 2008, saw the state decide to guarantee the loans and deposits of the Irish banks, amid fears that the entire sector was about to collapse.

The state’s involvement in the Irish banking system - massive transfers of capital, nationalisation and now the National Asset Management Agency (Nama) scheme to rescue the sector from the consequences of its own disastrous lending policies - all stem from the fateful decisions made that night.

Anglo Irish Bank got hit particularly hard.

Finfacts: Anglo, along with other major lenders, has already taken some provisions to cover the cost of its deteriorating loan book -- the interim figures published on May 29 last showed loan "impairment" charge of €4.1bn.

However, the losses in the next report look set to be substantially greater. Apart from being NAMA's biggest single client, Anglo is also the bank with the most exposure to the troubled commercial and development property sector.

The fact that Irish banks came close to the brink and were saved by the government because of the types of exposures they had was slow to show up on Moody's radar screens. Until it happened. Of course the downgrades followed rapidly. A similar story took place in Spain and some other countries.

Moody's continues to get paid for financial strength ratings of banks.

Moody's pounding CLOs with downgrades

Moody's has become a downgrading machine. Just in the second quarter of 2009 alone, Moody's downgraded 510 CLO tranches from 93 transactions ($33 billion of paper). These are structured deals with mostly corporate loan collateral. 74% of the Aaa-rated (AAA) tranches that were on review got downgraded.

From Moody's (click to enlarge):


Moody's is trying to compensate for it's destructive mistakes with AAA RMBS of years past. They are expecting to downgrade "a majority" of the CLO senior tranches by year-end.

Looking at the vintage of the deals, as expected, the 06-07 deals are the most vulnerable.

Tranches on review for downgrade by year of origination:

Here is what the ratings transition matrix looks like over Q2-2009:

And here is the matrix showing credit migration life-to-date. Subordinated tranches have been hit the hardest, but the senior downgrades are coming in quickly.

So what's been driving these downgrades? Here are some of the trends from Moody's. The chart below shows the weighted average rating factor (WARF) for CLOs with rapid escalation earlier in the year. Higher number means lower average rating, and at 2900 the CLO average rating is worse than B2. The collateral was rapidly getting downgraded earlier in the year, but in Q2 the managers started rotating into better credits, trying to improve their WARF.

CLOs also have a limitation on their Caa (CCC) or below basket. Most are at 7-10%, and as the graph shows, most are violating their limit. This doesn't cause a default of the deal, but creates other nasty issues. The overage of the CCC basket is carried at market value rather than par (the bulk of the collateral in CLOs is carried at par), which creates problems when the market for loans tanks.

The next graph shows the pace of defaults, which continues on it's upward march. This is what made Moody's really nervous, forcing them to quickly downgrade the subordinated tranches.

As defaults and the CCC basket overages increased, the overcollateralization (OC - the amount of eligible collateral over the liabilities) had been dropping rapidly. As the OC hit certain triggers on it's way down, the deals were forced to trap net interest income cash, usually distributed to equity (and fees distributed to the manager - see CLO managers forced into bad behavior), and use that cash to pay down the senior liabilities. That cash along with the recent rally in bank debt helped reduce some of that OC pressure, as the average OC has begun to stabilize.



Even with high default rates on the collateral, it's highly unlikely many CLOs will experience an "event of default" and be forced to liquidate collateral. These transactions are much more stable than the CDOs with RMBS collateral. Of course to Moody's that's all not very relevant. They are on a war path to repair their tarnished image, and the motto these days is - downgrade first, ask questions later.