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.

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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.

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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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