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from Breakingviews:

Moody’s shows UK needs more austerity, not less

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How cruel. Moody’s is threatening to dump the UK’s triple-A rating. Its justification – “materially weaker growth prospects” – has been seized by the government’s opponents to attack spending cuts. But Moody’s warning is in reality a Valentine to austerity. George Osborne, the UK Chancellor, really does need to continue his policy of tough love.

The UK’s big problem, half forgotten amid the euro crisis, is that its fiscal deficit, at over 8 percent of GDP, is double the average for the euro area, where only Greece and Ireland have a bigger gap. That government cuts have wounded growth in the short term is true. But how much deficit-spending do the critics want? This year, if the cuts go according to plan, the government will still spend 120 billion pounds more than it takes in taxes. That would normally be considered pump-priming on a heroic scale.

The risk for the UK is that if the huge deficit is not brought down fast, government debt will become problematic. At present it amounts to 64 percent of GDP which, at half Italy’s level, looks rather good. But the Office for Budget Responsibility, the government’s fiscal watchdog, forecasts a rise in the debt to GDP ratio to 78 percent in 2014-15, even if the government sticks to its policies.

The real policy dilemma would come if cuts were to send the UK into deep recession – as has happened in the euro zone periphery. But fortunately that doesn’t seem likely. Current data point to stabilisation. The prospect is for a pickup in growth later this year. An easing of inflation, down to 3.6 percent in January from 4.2 percent in December, will help. Britons’ earnings are not set to be eroded as swiftly as before.

Moody’s growth warning may be overdone. And provided the government sticks to the task of aggressively reducing its deficit – so-called “Plan A” – the country will remain highly creditworthy. That is how the markets, buying UK 10-year bonds for a yield of just 2.2 percent, see it for now. Of course, the Bank of England’s abundant money printing and debt purchases are a factor in those low yields. But they wouldn’t stay low if markets saw the government unveiling a cuddlier side.

from Breakingviews:

S&P warning won’t change euro zone equation

By Pierre Briancon The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Standard & Poor’s mass warning was spectacular, but its impact will be limited. The rating agency is threatening to downgrade all the euro zone’s members – with the exception of Greece and Cyprus, which could hardly be punished further – if leaders don’t come up with a credible plan at their summit this week. S&P’s statement may add a little pressure, but it doesn’t change the terms of the euro zone equation. Governments must show that they are serious about fiscal reform in order to clear the way for the European Central Bank to put out the most urgent fires.

When it comes to sovereign debt, ratings agencies aren’t telling investors anything they don’t know: all data is public and out in the open, and the political background is there for anyone to interpret. That’s why euro zone government bond yields barely moved on the news – Italian and Spanish yields actually declined. Even France, which was singled out by S&P as the only euro zone member that might suffer a two-notch downgrade, saw its 10-year government bond yields rise only slightly.

The collective nature of S&P’s warning also dampens its impact. Sovereign ratings are relative. If all countries were downgraded at the same time, AA would simply become the new AAA. Still, borrowing costs across the euro zone will probably rise somewhat if S&P follows up on its threat. The euro zone’s bailout fund, the European Financial Stability Facility, would also lose its top rating. Then again, its funding costs have already risen as investors priced in the possibility of a downgrade.

The more pressing problem for euro zone leaders is to convince the ECB of their commitment to reform. Mario Draghi, the central bank’s president, has hinted that he needs that signal before unleashing the ECB’s full crisis-fighting powers by lowering interest rates, opening a longer-term liquidity facility for banks, and buying sovereign bonds more resolutely. In spite of this week’s French-German compromise on European treaty changes, it is still too early to say that the stars are beginning to align in that direction.

from The Great Debate UK:

Rating agencies as powerful as ever

By Kathleen Brooks. The opinions expressed are her own.

Some people assumed that after the debacle over the 2008 mortgage-backed security crisis in the U.S., the credit rating agencies would be discredited. However, here we are three years later and the focus is still on the same rating agencies, waiting with bated breath to see whether they move the ratings of some of the world’s most important economies.

Within the last six months rating agencies have played a big part in shaping the direction of financial markets. First, there was Standard & Poor’s downgrading of the U.S. at the start of August, which caused a wave of risk aversion and turmoil on financial markets. Europe has also been the focus of concern.

Italy has seen its credit rating slashed to the lowest A rating you can have, while new kid on the block rating agency Egan Jones has gone one step further and on Monday cut Italy’s rating to BB from BB+. Belgium has also been cut and rumours are spreading that France isn’t going to keep its coveted triple A status for much longer.

Far from drift into the background, the focus has been on the diminishing number of countries rated triple A in the western world and what this means for borrowing costs. France has also been under the rating agencies’ microscope. It is at risk of losing its triple A credit rating due to its high public sector debt level combined with a sizeable deficit, also Paris has been slow to take steps to try and bring public sector finances under control. A false statement that France had been downgraded by Standard & Poor’s in October caused French bond yields to surge and it also enraged the French government who threatened to take steps to ban the rating agencies from commenting on France again.

But in recent months there has been no smoke without fire and newspaper reports this week suggest that S&P is days away from stripping France of its top rating due to the slowdown in global growth and the impact this will have on French tax receipts. This couldn’t come at a worse time for Europe as France is integral to the European Financial Stability Facility (EFSF) – Europe’s rescue fund, which relies on France and Germany’s triple A status to keep its own top rating. Thus if France is stripped of its triple A this will have ripple effects on the EFSF fund and could make bailing out Europe’s troubled members more expensive, thus aggravating the debt crisis even more.

There were rumours that France was meant to be downgraded last week along with Belgium; however this was scrapped at the last minute. This has set the market rumour mill into over-drive with speculation building that the EU high command could have had something to do with the delay.

from Breakingviews:

Timing of S&P U.S. downgrade couldn’t be better

By Agnes T. Crane The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

The Standard & Poor's downgrade of the United States couldn't have come at a much better time. Markets may be wobbly, but interest rates are at historic lows and buyers of U.S. debt are plentiful as the world braces for another economic slowdown. There may be some initial turbulence when investors return on Monday, but if the rating agency waited until markets acted first the consequences would be far more severe.

After all, the rating agency's decision shouldn't have come as a shock. S&P made no secret of what it expected from the debt ceiling brawl that put the full faith and credit of the largest debtor nation in the world on the line. It wanted roughly $4 trillion in deficit reduction and a credible plan to fix longer-term deficit problems. It got neither.

Yet despite expectations of a downgrade, during last week's financial market rout investors plowed into U.S. Treasuries. Ten-year yields fell as low as 2.34 percent. With few alternatives at their disposal, it will take more than the downgrade by one closely-watched rating firm to change America's go-to status for investors in times of trouble.

Anyway, the fact that Fitch Ratings and Moody's Investors Service affirmed their AAA ratings also should keep a lid on any forced selling in credit markets as investors with mandates to hold only top-rated debt can lean on the opinions of the other two raters.

Moreover, it's hard to see an alternative to S&P's verdict having much of a salutary effect on markets. For starters, affirming its AAA rating, after it had aggressively drawn its line in the sand, would have destroyed S&P credibility with investors -- far more than the $2 trillion error it initially made in its assumptions.

Even worse, it would have sent a signal to Washington that its political shenanigans come without consequences. It's better for S&P to call out the failings of America's leaders before global investors do. The euro zone's woes serve as a cautionary tale of how swiftly investors lose confidence -- and how difficult it is to regain.

from Global News Journal:

Rating agencies warned to watch their step

Credit rating agencies cannot win.

They were blamed for carelessness before the crisis, handing out over-generous ratings on the packets of mortgage-backed securities that subsequently unravelled, sending the global economy into a spin and leading to Lehman Brothers collapse. Now they are being criticised again, this time for being too cautious, by dishing out rating downgrades to countries in Europe being sucked into Greece's debt crisis.

Standard & Poor's recently downgraded Spain's rating one notch to AA, warning that the outlook was bleak for the euro zone's fourth biggest economy. Struggling Greece has also been marked down -- to junk status -- and now hovers close to Pakistan and Venezuela in the credit stakes. Portugal is another country to be singled out for downgrades from the leading ratings companies.

It's all little too much for the European Union, which worries about the downgrades creating a vicious spiral that exacerbates the crisis rather than helping to stall it.

Yesterday, the European Commission warned the rating agencies to watch their step.

"We of course expect that credit rating agencies ... in particular during this difficult and sensitive period, act in a responsible and rigorous way," a spokeswoman said. The Commission, which makes the laws governing rating agencies in Europe, added somewhat ominously: "We will continue to observe very closely what's going on."

Tempers in the Commission are rising, with officials angry with what they see as hasty decisions.

from Breakingviews:

Why do markets pay attention to rating agencies?

Why do markets still pay attention to what rating agencies have to say? Following their appalling record predicting the subprime mortgage crisis, it is astonishing and sad that investors still seem to quake when Standard & Poor's junks Greece and downgrades Spain.

An arriving Martian would find it hard to understand why anybody gives any credence at all to S&P and its rivals Moody's or Fitch. It's not just that they were pumping up the U.S. subprime market -- for example giving a triple-A rating to Abacus, Goldman Sachs' now-notorious synthetic collateralised debt obligation -- after smart investors saw trouble in the market.

They were late in spotting the wave of corporate debt defaults, including Enron's, in the early part of the century. And they have been dilatory in calling attention to the current euro zone sovereign debt crisis. Even after S&P's downgrade of Spain, Moody's and Fitch, the other big agency, are still rating the country's debt at triple-A. Ratings agencies are consistently behind the curve.

So why do they still wield influence? There are at least two reasons. One is because they are embedded in the way markets operate. Some investors, for example, are only allowed to buy investment-grade securities. That means they have to sell securities when they are junked. Similarly, ratings are used in determining the riskiness of a bank's balance sheet and how much capital it needs to set aside.

Ratings are also common in deciding how big a haircut is required when banks and investors pledge collateral. One saving grace in the euro zone crisis is that the European Central Bank has stopped saying that only the highest rated sovereign debt can be pledged as collateral. But ratings are still far too entrenched.

The other reason why markets pay attention when the agencies bark is what could be called the "megaphone" effect. S&P and Moody's may not be the smartest observers in the market; but they do make a big noise. It's a bit like shouting fire in a crowded cinema. The agencies aren't the first to spot the problem; but they sure help create a panic.

It is high time regulators and investors dethroned them from their privileged status.

from Commentaries:

German covered bonds under scrutiny

Fitch Ratings seems to be getting nervous about the amount of commercial real estate loans included in German banks’ covered bond pools.

The agency today affirmed 17 covered bond programs as part of a review, but kept nine German banks programs `under analysis.’ The rating firm now wants more information from the banks on the kind of real estate debt they use as collateral for their covered bonds.

Covered bonds are a kind of secured debt issued by banks in which bondholders have recourse against both the issuer and a segregated pool of assets, such as mortgage or public sector loans.  German banks include large amounts of commercial real estate debt in the covered bond pools, alongside more granular and lower risk residential and public sector loans. Investors were happy to keep funding the banks and rating agencies gave the debt AAA ratings because the loans included in cover pools were required by law to be backed by a minimum amount of collateral, giving the loan a cushion in case the borrower defaulted.

The rules state that loans can only be included in covered bond pools if the principal is no more than 60 percent of the value of the property. However, given the sharp fall in commercial property values in recent years, Fitch is no longer comfortable relying on just this rule.

Fitch said today in a report:

``Whereas so far, Fitch considered that the mortgage lending value threshold set at 60% by the German Pfandbrief Act provided adequate protection against expected losses evening higher stress scenarios, the agency recognises commercial real estate risks in German cover pools need to be assessed more precisely’’

The rating firm has given banks three months to gather all the necessary data it needs to analyse the loans. There’s no mention of downgrades in Fitch’s report., though if the firm does decide the bonds aren’t adequately covered by the current cover pool, it could mean banks will have to stump up more collateral to support the deals’ ratings.

from Commentaries:

Is the Fed having trust issues with rating agencies?

The Fed published changes to its TALF facility that provides financing to investors buying eligible asset-backed securities. One, the Fed is looking to expand the number of rating agencies issuers could use to evaluate the AAA-worthiness of their debt offerings.

The second one looks more interesting though.

Starting with the November subscription, in addition to continuing to require that collateral for TALF loans receive two triple-A ratings from TALF-eligible NRSROs, the Federal Reserve Bank of New York will conduct a formal risk assessment of all proposed collateral--ABS in addition to CMBS, which are already subject to a formal risk assessment. The change to the collateral review process will enhance the Federal Reserve's ability to ensure that TALF collateral complies with its existing high standards for credit quality, transparency, and simplicity of structure.

To facilitate the risk assessment, each issuer wishing to bring a TALF-eligible ABS transaction to market will be required to provide, at least three weeks prior to the subscription date, information including, but not limited to, all data on the transaction the issuer has provided to any NRSRO.

This additional red tap is likely to be off putting to some investors, but it's not like the program has been going gangbusters either. Investors only applied for $2.5 billion in loans in the latest round of TALF financing.

from Commentaries:

What did rating agencies know about AIG?

It's time to start asking the big credit rating agencies just when they realized that American International Group might pose a systemic risk to the global financial system.

And what, if anything, did the rating agencies do to warn financial regulators of the global crisis that might ensue, if AIG's debt ratings were suddenly slashed.

There's been a lot of attention paid to the role the credit agencies played in the build-up to the financial crisis by slapping triple A ratings on complex securities built from mortgages to subprime borrowers.

But there's not been enough scrutiny into the behind-the-scenes work the credit rating agencies did last summer as Lehman Brothers lurched toward bankruptcy and AIG's cash crunch grew increasingly grave.

By virtue of their status as Nationally Recognized Statistical Rating Organizations, the major credit agencies are charged with making sure companies that sell bonds are able to make good on their obligations. Some 30 years ago, securities regulators effectively deputized Moody's Investors Service, Standard & Poor's and Fitch Ratings as gatekeepers for the financial system.

And with that lofty and privileged status, there should come a responsibility to help regulators keep an eye out for systemic financial risk.

"We rely on our gatekeepers to help insure that financial markets are safe and information is accurate," says law professor Frank Partnoy.

from Commentaries:

Forecasting takedown

It's a wonder that anyone has any faith in forecasting anymore. The failure of ratings agencies to see the storm brewing in subprime and economists to fully grasp the vulnerability of the financial system should be making cynics out of all of us. Paul Krugman devoted 8 page screens over at the New York Times explaining what went wrong with economists. I must admit, I stopped reading after this line:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.

Bank of America Merrill Lynch analysts devoted a portion of their research to a glitch they see in forecasting corporate default rates. For high-yield bond and loan investors, default rates are a key component in trying to figure out whether it's time to snap up that incredibly risky CCC debt or exit quickly. If they're looking at S&P and Moody's forecasts it could be both.

Moody’s forecasts defaults to peak at 12.6% in November 2009, and then improve rapidly over the next 9 months, reaching 4.3% by next year, a level which is below historical average of 4.8%. This puts the two major rating agencies on the opposite ends of default forecasting spectrum. S&P is forecasting a 13.9% default rate in a year from now.

That differential highlights the critical role of liquidity - the ability to refinance maturing debt - in forecasting defaults. In our assessment, Moody's historically had ignored such a variable and as a result during the credit bubble years consistently overstated default forecasts. Partially as a result of such errors, in August 2007 they switched their modeling methodology to incorporate implicitly a liquidity factor. Incorporating liquidity factors into default models is very difficult as no precise measure of liquidity exists. Unfortunately from a modeling perspective, Moody's chose to use credit spreads.

While the inclusion of spreads lends to better explanation of defaults in sample, such an inclusion raises logical flaws when the output of the default forecast is to be used to forecast spreads. That is because a forecast of spreads is required to forecast the Moody's default rate. In the above forecast of 4.3%, Moody's forecasts spreads at 578 (vs. roughly 900 currently).

Circular thinking at its best.