Saturday 5 June 2010

AAA, the most endangered rating, regulating the rating agencies and Basel III

This title sounds like a warning issued from the WWF, relating to endangered species. Truth is the coveted AAA rating ranks have been seriously depleted by the past and current credit crisis we have been through. We will look at what happened in the corporate sector and as well in the sovereign space as well as the role of the rating agencies given the recent turmoils and scandals, regulations and Basel III implications.

Given the latest downgrade of Spain from AAA to AA+ is the latest in an increasing list given the current deflationary environment and credit situation in Europe, we can expect many more downgrades to come.

First we will look at the decline of AAA ratings in the corporate world:

The link below refers to an article which was published in 2002.

1969: 61 American Companies were AAA
1982: 21 American Companies were AAA
2002: 9 American Companies were AAA
2009: 4 American Companies were AAA

As of October 2009 only 4 remains rated AAA by S&P:

Automatic Data Processing (NYSE:ADP)
Johnson & Johnson (NYSE:JNJ)
Microsoft (NASDAQ:MSFT)
ExxonMobil (NYSE:XOM)

In 1979, there were 61 American companies that earned a top-level Aaa credit rating from Moody's. Ten years ago, there were 21. Today, there are only nine.

The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality.

"Corporate America has become more risky," says James Van Horne, a finance professor at Stanford's Graduate School of Business. "The triple-A decline is a manifestation of the decay of credit ratings in general."

In the same article, Kathleen Pender also review the list of AAA corporate entities in 2002:

The bankruptcies of Enron, Kmart and Global Crossing are refocusing attention on credit ratings and balance sheets.

"We've always focused on the balance sheet. In this environment, we've been even more focused," says Scott Glasser, co-manager of the Smith Barney Appreciation fund.

Glasser's top 10 holdings include five Aaa-rated companies: Berkshire Hathaway, ExxonMobil, General Electric, Pfizer and American International Group.

The other four Aaa-rated companies (excluding government-backed companies such as Fannie Mae) are Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Service.

In 1979, Moody's list of Aaa companies included 12 banks and insurance companies, such as Bank of America, Chase Manhattan, Chemical Bank and Citicorp.

It also included 25 industrial and consumer-oriented companies, such as Minnesota Mining & Manufacturing, General Motors, Ford, IBM, DuPont, Kellogg, Procter & Gamble, Sears Roebuck, Federated Department Stores and the major oil companies.

The remaining 24 companies were telephone and electric and gas utilities.

"The '80s really gutted the list," says Moody's economist Kamalesh Rao.

We all know what happened to the AAA for banks as well as for GM, Ford and we all know the dire situation of Fannie Mae, Freddie Mac and SLM.

From the same article:

"The major reasons cited for the decline in triple-A companies are deregulation, global competition, debt-financed mergers, bad management decisions and a growing tolerance for risk among investors.

Many banks also got hurt by the collapse of real estate in the early 1990s."

You would think the banks would have learnt from the real estate collapse in the early 1990s following the Savings and Loans debacle.

Does that sound familiar? We are talking about the economic environment of 2002...

The article goes on:

"Money managers are not too worried about the long-term decline in Aaa companies, mainly because the difference between a triple-A and a double-A company is slight.

They're far more concerned about a recent, widespread decline in ratings across the credit spectrum.

"You could do a story on the demise of double-A and single-A companies as well," says Putterman."

It is true the reputation of the ratings agencies have been seriously tarnished in the last two years given the evident conflict of interest which came with the business of providing AAA rating to dubious structured credit products.

This is what Bill Gross from PIMCO had to say about the rating agencies and discussion around reforms of their model:

"Credit rating agencies have fallen out of favour with top investors. Bill Gross, founder of Pimco, the world's biggest bond investor, recently said: "Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply it."

He added: "I come not to bury the rating services, but to dismiss them. To tell the truth, they can't really die – they serve a necessary and even productive purpose when properly managed and more tightly regulated.""

Truth is all the concerns regarding regulating the ratings agencies were previously discussed and not applied by many authors and Scholars. Below is an example of previous discussions surrounding regulation of rating agencies.

Claire Hill in a paper published in 2004 called Regulating the Rating Agencies

"Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable."

The only way to restore trust in ratings, is to remove conflicts of interest which means not an annual certification as suggested above but a review in the way rating agencies operate.
There was a similar issue with Equity Research Analysts during the run up to the Technology bust in 2000. Henry Blodget was barred from the securities industry because of fraudulent activity.

The only way to regulate is to impose accountability to the Rating Agencies, ensuring the risks twart the rewards. If ratings agencies face losing the license of conducting business due to high conflict of interests similar to what we have seen during the build up to the credit crisis, they might do a better job and serve their necessary purpose of independent assessment of credit risk.

Although credit ratings can be a good indicator in measuring the risk of a corporate or country, they always lag the market. Credit spreads and Credit Default Swap (CDS)spreads are better at indicating increased perceived credit risk in issuers.

The implication of ratings downgrade are very important in relation to assessing the risk for financial institutions, when taking into account Basel II regulation. This was particularly the case for structured credit positions in Banks.

"Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation."

Because of the need for independent assessment of credit risk, Rating Agencies must be regulated in a way that the ratings which are issued enable investors to trust these ratings and use them as a guidance in their investment.

As well as reviewing the role played by the rating agencies in the financial crisis, it is essential that bank regulation takes place.

Basel III proposed reforms are going in the right direction:

The introduction of a leverage ratio is essential to avoid the same mistakes which were done. The Canadian banking system had the leverage capped to around 20 times which meant that the Canadian Banks were in a much better situation than their American neighbours when the financial crisis occurred.

The idea of also promoting the build up of capital buffers in good times, is also a very good one.

There is great resistance from the bank to fully implement Basel III as indicated in this article from The Economist:

If the same idea of capital buffer could be implemented for goverments in relation to public finances, it would be great but given the propensity of our politicians to overspend in good times as well as in bad times, there is a very low probability of seeing it happen effectively.

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