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When Moody’s Investors Service greeted the start of summer by lowering the credit ratings on 15 of the world’s largest banks, citing the increased chance of “outsized losses,” major newspapers dutifully reported the event with headlines such as “Move Adds Pressure to Borrowing Costs,” “Downgrades Add to Market Jitters” and “Mark of Greater Risk.”
None of these declarations of calamity is proving to be true four days later. Every measure of risk in the credit markets shows the banks enjoy greater confidence among investors now than before Moody’s said the downgrades reflected a deteriorating outlook. An investor who bought $1 million of Citigroup (C) Inc.’s 4.5 percent benchmark bonds due January 2022 on June 21 has a profit of $21,400. The bank’s shares are up about 10 percent since June 1.
Moody’s downgrades are “the most obscene act I’ve ever seen by a major institution,” Richard Bove, an analyst at Rochdale Securities, said in an interview with Tom Keene and Ken Prewitt on Bloomberg Television’s “Surveillance” on June 22. “What we’ve seen is a consistent increase in the prices of bank debt and a consistent decrease in the yield. And now we’ve got Moody’s coming along, downgrading the debt of companies where the investors are finding a real desire to purchase.”
The conflict between investors, who own $2.2 trillion of debt sold by the 15 banks, and Moody’s shows that money managers have limited confidence in the ability of rating firms to determine whether companies or governments are creditworthy. For the third time in less than a year, the conclusions of credit- rating companies are being rejected by the people with the most at stake: investors in the $43 trillion global fixed-income market.
Moody’s, which helped start the business of ranking companies by their ability to repay debt in 1909, at this point has little credibility after lowering ratings on the 15 banks from Goldman Sachs Group Inc. (GS) to UBS AG (UBSN), the market measures show. After New York-based Moody’s said the banks had become riskier borrowers, their bonds rallied and the cost to insure their debt against non-payment diminished.
While the banks subjected to Moody’s examination have boosted their capital by $591 billion since the global financial crisis ignited by the failure of Lehman Brothers Holdings Inc., Moody’s has lowered their credit grades an average four levels. To investors, they have become more creditworthy, as yields on their bonds fell to an average 4.09 percent from 8.46 percent in October 2008 and prices of credit-default swaps dropped 5 percent, according to data compiled by Bloomberg.
In August, when Standard & Poor’s cut the credit grade of the U.S. government from AAA for the first time, Treasuries staged the biggest rally since December 2008, returning 2.8 percent that month as investors repudiated the decision, Bank of America Merrill Lynch index data show.
S&P’s decision was flawed by a $2 trillion error, according to the Treasury Department. The ratings company has said there was no mistake. Treasuries are beating all other U.S. fixed- income securities this quarter, gaining 2.89 percent since the end of March compared with 2.1 percent for investment-grade corporates, Bank of America Merrill Lynch index data show.
After S&P reduced France’s grade to AA+ on Jan. 13, its bonds returned 0.46 percent through the end of the month versus 0.35 percent for AAA rated corporate debt denominated in euros. France’s newly elected President Francois Hollande, who has advocated a government-funded agency as an alternative to S&P and Moody’s, is seeking to revive the nation’s economy through spending and growth rather than austerity measures.
Predicting the consequences of a sovereign rating change by Moody’s or S&P may be little different from a coin flip. Almost half the time, government bond yields fall when a rating action suggests they should climb, or they increase when a change signals a decline, according to Bloomberg data on 314 upgrades, downgrades and outlook changes going back as far as 38 years.
The rates moved in the opposite direction 47 percent of the time for Moody’s and for S&P. The data measured yields after a month relative to Treasury debt, the global benchmark.
On June 22, the day after Moody’s cut the banks’ ratings, the extra yield investors demand to hold bonds of financial companies rather than government debentures narrowed 2 basis points to 284 basis points, or 2.84 percentage points, the lowest in more than five weeks, Bank of America Merrill Lynch index data show. Spreads are down from this year’s high of 361 on Jan. 3.
Credit-default swaps, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, declined an average 3 percent, Bloomberg prices show. Morgan Stanley (MS) swaps decreased 7 percent.
“We view the Moody’s downgrade as another overhyped story of 2012,” David Trone, an analyst at JMP Securities LLC, wrote to his clients. “The corporate market thinks for itself and credit rating agencies are often lagging indicators.”
When Moody’s announced its review in February, it listed “higher credit spreads” and “more fragile funding conditions” as key challenges for global banks.
Among the reasons that Moody’s cited for its moves last week were regulations poised to limit profits and trading risks.
“All of the banks affected by today’s actions have significant exposure to the volatility and risk of outsized losses inherent to capital-markets activities,” Greg Bauer, Moody’s global banking managing director, said in a June 21 statement.
JPMorgan Chase & Co. announced a trading loss of more than $2 billion on May 10 stemming from credit derivatives bets made in its London chief investment office.
“That exemplified some of the issues, and exact issues, that we had highlighted back in February when we began the review around opacity of risk and the potential for tail risk and the difficulty in risk managing some of these firms,” Bob Young, managing director of North American banking at Moody’s, said in a telephone interview on June 21.
Absent the potential for government support, the average rating for global investment banks is Baa2, which means Moody’s expects about one in 25 of the firms to fail over a 10-year period, the ratings company said in a report. The analysis cited examples from Drexel Burnham Lambert Inc.’s 1990 collapse to the run on MF Global Holdings Ltd. last year.
Moody’s took improved access to cash and stronger capital positions into account for some of the banks it downgraded, saying in its report that the cuts would otherwise have been greater.
The banks said Moody’s isn’t giving them enough credit for the steps they’ve taken to build capital cushions and improve oversight of risky trading.
Citigroup, the third-largest U.S. bank by assets, said in a statement that the downgrade was “arbitrary and completely unwarranted.” Morgan Stanley, owner of the world’s largest brokerage, said its ratings don’t reflect the actions taken to cut risk. Both are based in New York. Bank of America Corp. (BAC), the second-biggest U.S. lender, said it has strengthened capital and risk management.
“It’s all rearview mirror stuff,” Paul Miller, an analyst at FBR Capital Markets, said of the bank downgrades in a Bloomberg Television interview on June 22.
Banks have heeded calls to add to safety margins in the aftermath of the credit crisis by selling businesses and raising capital. In 2010, the 27-country Basel Committee on Banking Supervision more than doubled its minimum capital requirement for the largest firms to almost 9 percent of risk-weighted assets from 4 percent.
The Federal Reserve’s stress tests in March showed that 15 of the 19 largest U.S. banks could maintain adequate capital levels even in a recession scenario in which they continue to pay dividends and buy back stock.
Moody’s, along with S&P and Fitch Ratings, helped fuel the global housing bubble by awarding AAA ratings to bonds tied to subprime mortgages to homebuyers with poor credit, augmenting demand for securities, which resulted in more housing loans to riskier borrowers and the creation of more bonds backed by the debt. The rating companies engaged in a “race to the bottom,” inflating credit grades to win business from Wall Street banks, a Senate panel reported last year.
When the homeowners couldn’t keep up with their payments, real-estate prices tumbled, defaults soared, thousands of the bonds plunged in value and investors, no longer able to accurately value their securities, froze. The credit crisis that followed resulted in $1.5 trillion in bank writedowns and losses that forced governments to bail out banking systems.
Those soured securities were part of the reason the U.S. set up a $700 billion program in 2008 to bolster the financial industry. The crisis also spurred $787 billion of tax cuts and spending to help the U.S. economy.
The banks never deserved the ratings they had before the 2008 credit crisis, James Camp, managing director of fixed income in St. Petersburg, Florida, at Eagle Asset Management Inc., said June 22 in a Bloomberg Television interview. Lehman was rated (LEH) A2 by Moody’s in September 2008 before it collapsed.
“Rating agencies are fighting the last war,” David Hendler, an analyst at CreditSights Inc. in New York, wrote in a report dated June 22. “Moody’s did not seem to acknowledge and factor in real balance sheet improvement.”
The downgrades brought Moody’s average rating for the 15 banks to A3, four levels above junk, from Aa2 in October 2008, Bloomberg data show. High-risk, high-yield bonds are rated below Baa3 by Moody’s and BBB- by S&P.
Investors reacted with relief last week after Morgan Stanley, which faced a potential three-step cut, was downgraded two levels to Baa1. Its average bond yields fell to 5.18 percent, compared with 16.3 percent in October 2008, Bank of America Merrill Lynch index data show.
Credit-default swaps on debt of Morgan Stanley declined 27.4 basis points on June 22 to a mid-price of 353.9 basis points, Bloomberg data show.
Swaps on the 15 banks cut by Moody’s fell to an average of 239.9 basis points on June 22 from 246.7 a day earlier, Bloomberg data show.
The contracts typically fall as investor confidence improves and rise as it deteriorates. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
Morgan Stanley’s $2.45 billion of 5.5 percent notes due July 2021 rose 2.1 cents on June 22 to 99.9 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Charlotte, North Carolina-based Bank of America was lowered one step to Baa2 from Baa1. Its bonds yield 4.37 percent, down from 6.41 percent in June 2008, when it was rated Aa2, the lender’s index data show.
Default swaps on New York-based Goldman Sachs fell 14.7 basis points to 279.5 basis points, even though its rating was lowered to A3 from A1. The swaps traded as high as 502.5 in October 2008.
“The overall credit quality of U.S. banks is improving,” Krishna Memani, director of fixed income at OppenheimerFunds Inc., said in an interview Betty Liu on Bloomberg Television’s “In the Loop” on June 22. “Spreads are tightening as we had expected that they would.”
Average spreads on Zurich-based UBS, Switzerland’s largest bank, narrowed 3 basis points to 310 basis points, Bank of America Merrill Lynch index data show. That compares with 469 on Oct. 1, 2008.
“This time the market got it right,” Marilyn Cohen, president of Envision Capital Management Inc. in Los Angeles, said in an e-mail. “Poor Moody’s. Their big splash turned out to be a belly flop.”
The average spread of 284 basis points on global financial debt is down from a high of 683 in March 2009. Fed Chairman Ben S. Bernanke has held the benchmark lending rate in the U.S. near zero percent since late 2008 and the European Central Bank began offering unlimited loans to the region’s lenders in December.
“All the liquidity in the world is being made available by Mr. Bernanke and friends,” Eagle’s Camp said.
Moody’s left all the U.S. banks that it downgraded on negative outlook, meaning their grades may be cut again because of uncertainty over government support. Moody’s said in the statement that bondholders bailouts are becoming “less predictable” because of the “evolving attitude” of policymakers.
“They’re really shifting their whole approach to rating these companies,” Gerard Cassidy, a bank equity analyst with RBC Capital Markets, said in a telephone interview. “What Moody’s is saying and trying to address is that ‘our ratings were wrong three years ago.’”
While U.S. banks’ credit has improved since 2008, that’s not the case for many European lenders caught up in the continent’s sovereign debt crisis. The region’s regulators have also made changes designed to impose losses on bondholders when banks collapse and have to be rescued. Bank spreads in Europe have climbed to 292 basis points as of June 22 from this year’s low of 253 on March 20.
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 4.5 basis points to a mid-price of 119.8 basis points as of 11:39 a.m. in New York, Bloomberg prices show.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, dropped 0.94 basis point to 22.28 basis points as of 11:39 a.m. in New York. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of General Electric Co. (GE) are the most actively traded dollar-denominated corporate securities by dealers today, with 38 trades of $1 million or more as of 11:39 a.m. in New York, Trace data show.
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