Shareholder activism may be negative for credit

Equity investors might find it a bit surprising that the rating agencies are not necessarily all that excited about the recent wave of stock investor activism. In fact some view such aggressive investor involvement as risk to corporate credit. Instituting strong corporate governance is certainly a positive, but equity investors will also continue to insist that companies do something with their cash (see discussion), including paying dividends or buying back shares. That ends up helping shareholders in the short run but increases net leverage - which is not ideal for credit investors. And certain structural, management, and board changes that result from shareholder activism will conflict with the needs of corporate debt holders.

Fitch: - The unprecedented level of shareholder activism seen across the energy space has increased the tail risk of future unexpected shareholder-friendly actions for credit in the space, according to Fitch Ratings.

Activist campaigns and/or proxy-related issues have flared up widely across the energy sector this year at several key names including Hess, Nabors, Transocean, Chesapeake, and Occidental Petroleum. The net result of these campaigns has been a wave of changes on the corporate governance, financial, and operational levels.

... Financial changes such as new shareholder-friendly distributions include new or expanded buyback programs and new or expanded dividend payouts while operational changes include accelerated restructuring plans and asset sales.

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From our sponsor:

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

The spike in ratings downgrades is driven by banks

Fitch has been on a downgrade "war path" recently. The latest downgrade vs upgrade statistics are showing a "mini spike" in the number of downgrades. It's not nearly as bad as the 2008/2009 cycle, but is clearly visible. This spike is coming entirely from rating actions in the developed markets.

Drilling down further reveals what is actually driving the downgrades. The chart below compares the rating actions for industrials versus financials. Clearly Fitch has been aggressive in downgrading banks.

Source: Fitch; click to enlarge

The equity market seems to agree with this assessment. Financials have underperformed considerably over the past year (covering the period of these downgrades).

Financials (white) vs. the SP500 (green) performance over the past year

The other rating agencies have also been active in downgrading financials - particularly last year. At this rate it is only a matter of time before many banking institutions will lose their investment grade standing. It will be interesting to see how the high yield and the crossover markets handle this inflow of new names.

SoberLook.com

Bank ratings migration is an attempt to fix old errors

Here is a recent chart from Fitch that shows ratings migrations for US banks between 2007 and 2011. The trend makes sense in terms of what has transpired during this period as the whole ratings distribution was shifted down.

Banks ratings migration (Fitch)

But take a second look at these results. Ratings are supposed to represent credit risk. Therefore this is telling us is that there is more risk in the US banking system now than there was in 2007. Really?

The chart below shows the core capital ratio for all FDIC insured institutions. It represents tier-1 capital as a percent of average total assets (with some adjustments per FDIC). This is telling us that bank capitalization in the US has improved significantly since 2007.

US bank capital ratio (FDIC, Bloomberg)

The weaker banks - 417 of them - have been closed since 2007.  So how is it that according to Fitch US banks are more risky now? Maybe it has to do with bank ratings being incorrect to begin with - possibly off by several notches. And maybe this "rating migration" is simply an attempt to correct that error.

SoberLook.com

Could the "wisdom of crowds" be wrong on France downgrade?

Intrade generally represents an efficient market with thousands of participants placing bets on various events - what is sometimes referred to as "wisdom of crowds". That is why it is quite surprising that Intrade has the probability of France being downgraded by June 30th, 2012 at only 67%. This probability should be in the 90s.

The rules are clear - it takes only one rating agency to pull the trigger before next summer and the contract settles at par.

Intrade.com:

• This market will settle at $10.00 if either Moodys, Standard and Poors or Fitch announce they have downgraded the long term credit rating of France below AAA.

• This market will settle at $0.00 if neither Moodys, Standard and Poors or Fitch announce they have downgraded the long term credit rating of France below AAA.

• This market will be settled using official statements from Moodys, Standard and Poors or Fitch regarding the downgrading of France's credit rating, as reported by three independent and reliable media sources. Please note that only one of the rating agencies needs to announce a downgrade for this market to be settled at $10.00.

But the rating agencies all but told us the downgrade is coming. Here are the two warnings.

Warning #1:

Standard and Poor's: 

France (Republic of) Sovereign Credit Rating AAA/Watch Neg

Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

Warning #2:

Fitch: Fitch has also revised France's Rating Outlook to Negative from Stable. While France's 'AAA' status is underpinned by its wealthy and diversified economy and financing flexibility, the Negative Outlook reflects heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone.

At 67% odds, it looks like easy money - there is very little doubt France is getting downgraded.  But back to the "wisdom of crowds" and the predictive markets. What this is telling us is there is (highly surprising) a significant portion of the market - a third to be precise - that is holding out hope that France will not get downgraded in spite of the rating agencies' open warnings. They will be thoroughly disappointed.


Note:  With regard to US citizens trading contracts on Intrade, the internet gambling prohibition makes it illegal to operate a gambling website in the U.S. but it has no restrictions/penalties on clients.

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Awaiting the S&P's decision on sovereign ratings

One major overhang on the markets continues to be the threat of sovereign downgrades in Europe by the S&P:

S&P Press Release, Dec. 5, 2011--Standard & Poor's Ratings Services today placed its long-term sovereign ratings on 15 members of the European Economic and Monetary Union (EMU or eurozone) on CreditWatch with negative implications.

The downgrade threat pertains to the usual suspects: Italy, Spain, Portugal, Ireland, and Belgium as well as to nations that were thought to be safe from downgrades: France, Germany, Netherlands, Finland and some others. The main concern is France because of their leadership position and a high likelihood of a downgrade. In fact S&P is threatening to downgrade them by two notches.

Here is S&P’s rationale for the downgrade watch:

(1) Tightening credit conditions across the eurozone;

(2) Markedly higher risk premiums on a growing number of eurozone sovereigns, including some that are currently rated 'AAA';

(3) Continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members;

(4) High levels of government and household indebtedness across a large area of the eurozone; and

(5) The rising risk of economic recession in the eurozone as a whole in 2012. Currently, we expect output to decline next year in countries such as Spain, Portugal and Greece, but we now assign a 40% probability of a fall in output for the eurozone as a whole.

Europe can in fact control 3 out of the 5 factors listed by the rating agency. The first two can be addressed with one action: providing support to the bond market. That will ease tightening of credit limits within banks and may create some demand for corporate debt, taking care of factor 1 (above). Supporting Spanish and Italian bonds will certainly lower the ”risk premiums”, eliminating item 2.  But significant support to the bond market will mean QE, and the ECB is currently not in the mood for that. Hopeful comments to that effect however continue to leak out of the eurozone:

Reuters: Comments from France's candidate for a seat on the European Central Bank's Executive Board, Benoit Coeure, who said the ECB may need to step up its bond-buying to help reduce borrowing costs for some states, were also euro-positive.

Item 3 is actually in reasonable shape as the eurozone's new treaty begins to crystallize. Factors 4 and 5 are long-term concerns and outside of the eurozone’s immediate control.

One may ask - who cares about S&P ratings? The issue goes back to European banks whose capital requirements are linked to the ratings of bonds they hold. And downgrades may increase the “risk weightings”, lowering capital ratios and potentially forcing banks to raise even more capital – beyond the already onerous requirements.

For now we wait as the S&P's decision looms, potentially coming at any time:

S&P: We expect to conclude our review of eurozone sovereign ratings as soon as possible following the EU summit .... Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

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Would you deposit your money at JPMorgan Chase or Credit Lyonnais?

The equity markets sold off after the close, with Morgan Stanley down 0.8% after hours and 3.5% correction intraday.  At least a portion of this move was driven by the S&P "refreshing" their rating methodology for financial institutions:

Reuters: Standard and Poor's reduced its credit ratings on several big banks in the United States and Europe on Tuesday as the result of an overhaul of its ratings criteria. 

A few surprising results:  Most US  and UK institutions got their ratings reduced by one notch, while ratings for firms like Deutsche Bank, Societe Generale, Credit Agricole, BNP Paribas, and Credit Lyonnais were left unchanged.  What changes in the methodology would explain this?

There are two factors impacting these new ratings in addition to the traditional "bank-specific factors" (see chart below):

1. Macro:  the rating agency is focused on how strong the banking business is in that country. Is the economy reasonably strong, how creditworthy is the sovereign where the bank operates, how good is the regulatory framework, how strong is the private sector, etc.

2. External support: how much is the government of that nation willing to do what the Fed and the US Treasury did with the banking system in the US in 08/09? 

So according to the S&P, because France and Germany are rated higher than the US based on the combination of the above criteria, there is a downward adjustment to the US firms.   The US sovereign rating is lower, the economy is slow, the regulatory framework is getting worse, and the government is no longer willing to support the financial system in a crisis (in a way that say Germany, France, or for that matter Japan or China are willing to do).  

This all makes sense, but should Credit Agricole, Credit Lyonnais, and Deutsche Bank really be A+, while JPMorgan Chase be A?  With the eurozone crisis raging,  here is a simple question - would you deposit your money at JPMorgan or Credit Agricole?


Source: Standard & Poor's

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Learn Enterprise Risk Management from S&P

PRMIA, an organization for "risk management professionals" (whatever that means these days) generates some revenue by organizing courses. Among others they offer a course on Enterprise Risk Management (ERM). This type of course is meant to address risk management policies and practices across an organization (supposedly combining market, credit, and operational risks). James Lam (James Lam & Associates), who calls himself "the first ever chief risk officer”, is teaching the next ERM course for them. But there is more to this course:

PRMIA: Joining James Lam in discussing best practices in designing and implementing an ERM program will be Laurence Hazell, a director at Standard and Poor's in New York. Mr. Hazell, recognized in 2008 by Directorship Magazine as one of the 100 most influential people in Corporate Governance, will speak on Standard and Poor's ERM criteria and how they evaluate a company's ERM program as part of their rating process.

Wait, S&P will actually teach Enterprise Risk Management?

PRMIA: WHAT YOU WILL LEARN
 Establishing a strong business case for ERM, and overcoming organizational barriers
 Developing an practical ERM framework and implementation plan
 Demonstrating tangible benefits from ERM adoption
 Implementing and integrating ERM into strategic and business decisions
 Establishing effective risk management policies and explicit risk tolerance levels
 Developing effective dashboard reporting for senior management and the board
 Creating an effective feedback loop for ERM performance

They have a great deal to contribute. After all S&P has been good at overcoming "organizational barriers" - when need be.


source: CNBC


Yet at other times organizational barriers persisted at S&P, as one could get a different rating depending on which group one approaches or how one describes the product being rated. And of course you too can learn how to deploy ERM to manage conflicts within your firm the way S&P did. You get both Mr. Lam and Mr. Hazell for a whole day (maybe) for only $1,200 per participant.



hat tip Ed

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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

Insurance firms try to break free from rating agencies

The rating agencies are not just under fire from regulators and lawsuits, but also threatened by new competitors from outside the traditional ratings roles.

WSJ: Under the proposal being considered, the NAIC [National Association of Insurance Commissioners] would arrange the contract and work with the analytical firm. Any firm large enough to handle the job could seek it, with insurers paying fees to the NAIC to cover the cost. The proposal, expected to pass, comes from trade group American Council of Life Insurers.

But the alternatives are not without controversy, and it's unclear whether these other firms come with their own string of conflicts. One of the firms considered for the job for example is BlackRock, which is raising eyebrows across the blogosphere:

Reuters: It’s amazing how well the company has positioned itself to clean up the mess left behind by the financial crisis. It already has chummy ties with the government, including the Federal Reserve which tapped it to manage and eventually liquidate toxic assets the central bank took on from AIG. It’s also the risk and analytics manager in chief for the Fed’s MBS purchasing program.

NAIC of course is considering other firms:

WSJ: In addition to BlackRock, the insurance regulators also recently have talked to Pimco Advisory, part of Newport Beach, Calif., bond-powerhouse Pacific Investment Management Co., a unit of Allianz SE; Promontory Financial Group, a Washington, D.C., firm founded and headed by Eugene Ludwig, a former U.S. comptroller of the currency; and Andrew Davidson & Co., a 17-year-old New York firm that also has a specialty in evaluating complex structured securities, according to the regulators.

Pimco is plugged into various government programs to such an extent that they were advised to keep away from PPIP (as they promptly did) to avoid any perception of conflicts. Allianz is itself an insurance firm, making it unclear how effective they would be advising their competitors on potential investments. Promontory Financial Group may have political ties given their founder. Andrew Davidson & Co is a financial analytics firm that in fact developed the models many firms used to value RMBS and CDO products before the crisis. It's not clear how this expertise would qualify them to evaluate credit worthiness of securities purchased by insurance firms going forward.

These are just some of the challenges faced by the investment community as they try to shift away from reliance on the rating agencies. But the shift is definitely under way.

hat tip Ed.

Rating agencies under fire

The rating agencies are now taking hits from every direction. The Big Three are becoming increasingly focused on trying to defend themselves against law suits, investigations, and pending regulation. The most critical blow recently came from the highly publicized case involving Cheyne Finance. This was an SIV that issued medium term notes which were rated "investment grade" by the agencies. The notes defaulted recently and the holders took the agencies (as well as Morgan Stanley) to court.

Dow Jones: Two credit-rating agencies must defend a lawsuit over the collapse of a $5.86 billion structured investment vehicle in 2007, a federal judge has ruled, rejecting an argument that their ratings are protected free speech.

In an order Wednesday, U.S. District Judge Shira Scheindlin in Manhattan rejected an argument by rating firms Moody's Investors Service and Standard & Poor's that their ratings of SIV Portfolio PLC were protected by the First Amendment.

The rating agencies' traditional defense had always been the "freedom of speech" concept. The argument is that the ratings they issue are simply their opinion and therefore should be protected under the US constitution. This case however shook things up because the judge ruled otherwise (at least in a couple of specific instances). With evidence like this IM exchange between two S&P employees, it's a bit difficult to argue freedom of speech.

source: CNBC

The agencies are confident they will be able to overturn this ruling, but nevertheless this may set a precedent and open a floodgate of litigation.

But the Big Three's problems are not limited to investor lawsuits. As people begin to fully appreciate their role in the financial crisis, more players are coming out of the woodwork to start investigations, file complaints, or propose regulation. Now the California Attorney General is jumping on the bandwagon.

Reuters: California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's, Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.
…
The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition.

The insurance industry is also getting ready to pound on the rating agencies.

NAIC: The National Association of Insurance Commissioners (NAIC) will hold a public hearing on September 24 to discuss the past and future roles of Nationally Recognized Statistical Ratings Organizations (NRSRO). The hearing will examine the role of these credit rating agencies in the insurance regulatory system and what changes may be needed in light of the financial crisis.

Insurance companies hold nearly $3 trillion in rated bonds and the insurance industry constitutes the largest sector of the financial services industry to rely on credit ratings to supervise capital asset adequacy. Insurance regulators currently mandate the use of credit ratings to determine capital reserves and other regulatory requirements for insurance companies.

And here comes the SEC with what seems to be a fairly constructive disclosure rule that may cause the agencies and banks some pain:

Reuters: The SEC may require banks and other issuers to disclose preliminary ratings, to prevent them from shopping around for the better ratings, the people familiar said. They requested anonymity because the discussions are private.

The SEC may also require all credit agencies to reveal more information about past ratings so investors could compare their relative performance, with perhaps a one- or two-year time lag, the people said.

The structural problem with the rating agencies and their role in the crisis is finally getting the much needed attention. Here is a simple fact: if the rating agencies' subordination requirement for AAA subprime paper was higher when the deals were rated, the subprime market would never have grown the way it did. A typical subprime deal had 21% of collateral below AAA, while Alt-A subordination was about 7%. If the rating agencies were just a bit more conservative, requiring a higher cushion, the mortgage rates for these loans would have been much higher to make the securitization work. And that simply means most such mortgages would not have been possible.

The question is where do we go from here. Securities ratings process is so entrenched in the financial services industry, it's hard to imagine the system functioning without some form of ratings. It's part of the lexicon: when we discuss "investment grade" market or the "high yield" market, there is an implied rating assumption - whether people use it or not. The lesson of 2008 was of course to rely less on the agencies, but the system depends on them being there. And the government is doing a great deal to increase (rather than reduce) reliance on the ratings process: from new money market regulation to TALF - all depend on some form of agency ratings.

That means that the rating agencies are here to stay, and when the dust settles, the surviving agencies (and it's not clear if all of the Big Three will survive) will have a great deal of work to do. It's critical that we fix the ratings system: from agencies' internal structure to the ratings process to models and transparency to fees/conflicts - all must be revamped in order for the system to function properly. Because not getting this right will set us up for another fiasco down the road.

David Kotz's tree in the forest

Here is another example of a clueless government bureaucracy missing the point when it comes to what was at the heart of the financial crisis.

David Kotz, the SEC's inspector general, has decided that the real problem with the SEC's supervision of the rating agencies (Nationally Recognized Statistical Rating Organizations - "NRSROs") is in the application process. In order for a start-up to become an NRSRO, the firm has to go through an approval process with the SEC, and the key issue according to the inspector general is the flaw in the process. Moody's, S&P, and Fitch (the Big Three) must be ecstatic. The SEC will be making it that much harder for any new competition.

The key issue Mr. Kotz identified in the SEC's supervision of NRSROs has been one "improperly approved" small rating agency because of the possible inaccuracy of the firm's financial statements and questions about the firm charging "reasonable" fees (the report blanks out the name of the NRSRO in question). Talk about focusing on a tree without seeing the forest.

So that's what went wrong with the massive ratings fiasco of structured credit paper - a start-up was improperly approved. Incredibly, the new rules Mr. Kotz is proposing will make it that much more difficult, tedious, and expensive for new rating agencies to enter the market, virtually assuring the Big Three's oligopoly.

The gap in the US banking system

We recently received a comment related to bank failures from someone pointing out that in Germany, with a population of some 82 million, there are only about 5 banks (there are actually more - but let's stay with this line of thinking). The question was why does the US need that many banks?

For one thing, banks in the US used to be quite profitable in the real estate boom days. They were also relatively easy to set up (particularly relative to Europe). The 2008 crisis however may have taken care of that, pushing the US closer to the German banking system, dominated by large national banks. The chart below shows the 2001 US banks sorted by total assets. It's a fairly continuous chart that may resemble other sectors with a relatively open competition.



But the crisis changed all that. The 2009 picture looks quite different, showing a large gap between the fourth (Wells) and the fifth (PNC) largest bank (when comparing total assets). The ratio of assets between these two is over 4.5, showing that the top four banks are massively ahead of the rest of the industry.



Large banks have tremendous advantages - from regulatory support to cheaper cost of funds and less reliance on deposits (ability to borrow interbank or in the capital markets). That advantage will continue propelling the larger banks ahead of the rest.

The gap some may argue is filled by institutions that have just become bank holding companies, such as Goldman and Morgan Stanley or non-banking firms such as MetLife and Amex (both of which have a bank holding status). But these firms don't significantly impact the consumer landscape, where the big three banks are beginning to completely dominate (it's unclear if the investment banks have any plans to get into retail banking). The chart below from the Washington Post illustrates the deposit growth at large banks (mostly driven by government arranged acquisitions, but also attracting nervous depositors leaving smaller banks.)



And here is a comparison to the deposits various institutions controlled in 2007 (from the Washington Post):



Unlike Germany, where regulators are quite happy with the large few (Landesbanks, Commerzbank, Deutsche Bank, DZ Bank, etc.) dominate the landscape, the US regulators are quite nervous. From the Washington Post:

Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess.

One solution the regulators are proposing is to increase capital requirement on the larger banks.

That [Obama administration's proposed] plan would impose higher capital standards on large institutions and empower the government to take over a wide range of troubled financial firms to wind down their businesses in an orderly way.

But capital increases will negatively impact lending, as banks would rather focus on fee businesses that require little balance sheet usage. Reduced lending is the last thing this economy needs. But that seems to be the direction large banks are taking as they continue to probe for weaknesses in the wall of regulatory rules to come up with solutions that require less capital (whether it's rating agency shopping or TRS).

On the retail side however, foreign institutions are starting to make inroads, trying to fill the gap. From HSBC to ING, foreign banks are trying to grab share of US deposits. Some are trying to get in by acquiring failed US banks. From the WSJ:

The sale of the operations of failed Guaranty Bank in Texas on Friday to the U.S. division of a Spanish bank signals that foreign banks can succeed in the auctions for collapsed U.S. lenders.

Banco Bilbao Vizcaya Argentaria SA on Friday became the first foreign company to buy a failed U.S. bank in this crisis; on Friday, federal regulators shut down Guaranty.

Other foreign banks with a U.S. presence interested in gobbling up failing U.S. banks include French bank BNP Paribas SA through its San Francisco subsidiary, Bank of the West; Toronto-Dominion Bank, through its Portland, Maine, subsidiary, TD Bank; and Rabobank, the El Centro, Calif., subsidiary of Rabobank Group of Utrecht, Netherlands.

With competition still in place in the US (for now), it's unlikely the US banking system will converge to look exactly like the one in Germany going forward (it's much harder for a new bank to make inroads in Germany). However the landscape, shocked by the financial crisis, will be changing rapidly, becoming almost unrecognizable in years to come.

Rating agency shopping from the inside

Here is a great BNN interview with Ed Grebeck discussing bank capitalization and the rating agencies. Of particular interest is the discussion on rating agencies' methodologies and the resulting ratings that vary across the various departments within a single agency. Here are some highlights:

1. Basle-II convention treats a company (such as GE) debt "AAA" and a structured credit "AAA" (such as a CDO) in the same manner, allowing banks to hold minimal capital against both. Thus by pooling risky assets and selling the junior tranches of these pools, banks retained (and still sometimes do) the senior most tranches (which have much higher notionals than the junior tranches) with minimal capital requirements. That allowed banks to run excessive leverage, getting to 30:1.

2. "AAA" tranches used to trade with such tight spreads that the yields and the implied levels of risk were approaching treasuries. And a number of institutions were buying paper based entirely on agency rating. Many have learned their lessons.

3. Mr. Grebeck discusses the issue of rating agency "shopping". In addition to banks' ability to "shop" the various agencies for the best rating, an even bigger ratings arbitrage exists among the various departments within a single agency. Rating agencies' internal departments covering various products or in different geographic locations operate in silos from one another.

A bank familiar with the agencies' internal workings can pick them off to obtain a reduced capital charge - depending on how they structure a security and which department/location does the rating. In effect to get a desired rating a bank can find a department within an agency that would require the least amount of subordination, thus increasing permitted leverage.

Hat tip Ed!