The Rating Agencies Are Lost At Sea
Advisors Capital Management
By Charles Lieberman
June 25, 2012
Moody’s bank downgrade is such a breathtaking demonstration of
incompetence that it undermines the entire rating agency concept. If
the banks deserve downgrading now after domestic banks increased their
capital base dramatically over the past few years, declines in loan
defaults, and recovery in profits, one can only wonder why these very
same banks were not rated junk a few years ago before these improvements
occurred? If these banks were appropriately rated a few years ago, it
makes little sense to downgrade now. Either way, the timing of the
downgrades is so suspect that it suggests other considerations must be
behind the move.
Moody’s suggested that J.P. Morgan’s $2 billion trading loss
demonstrated the degree to which banks are black boxes, so somewhat more
risky than previously thought. This “explanation” was more
understandable in 2007, when sub-prime mortgages blew up and outsiders
did not appreciate the exposures on the bank balance sheets, but it
surely does not work in 2012. It makes even less sense in the aftermath
of 2007, since the rating agencies should have woken up and these firms
do have access to inside information. And if the banks really are
black boxes to the rating agencies, how can portfolio managers
reasonably rely on their ratings?
So, why did Moody’s downgrade the banks now? The only recent
developments that hint at the timing are J.P. Morgan’s $2 billion
trading loss and the ongoing efforts of regulators to define the rules
to implement Dodd-Frank. But J.P. Morgan’s loss, while large in
absolute terms, was small relative to the size of the firm and its
recurring profit stream. And the efforts of regulators to figure out
how to establish rules for banks should have nothing to do with bank
ratings. So, the timing of this action, as well as the typical two
notch rating reduction, is hard to understand. It is even more
disconcerting to think that changes in a bank’s rating might reflect
outside considerations.
What lessons can be drawn from the bank downgrades? While the rating of
one bank relative to another may provide some useful information on
their relative risk, it is hard to conclude that the level of the
ratings of each bank provides much insight. It is clear that credit
ratings are highly imperfect. Indeed, the market, as usual, is well
ahead of the rating agencies and bank stock prices rallied and CDS
prices fell after the downgrades, despite the increased margin
requirement to reflect the new ratings. The bottom line is that the
rating agencies themselves are simply overrated.
(c) Advisors Capital Management
