Repositioning Ratings Agencies

Late Thursday, credit ratings agency Moody’s completed a review of bank credit ratings four months in the making and—in their words—“repositioned” their assessments. To use a less politically correct word, Moody’s downgraded more than a dozen large banks globally, in some cases by more than one notch.

As is often the case, coverage of these blanket downgrades has been, well, hyperbolic. Consider the following statements:

“...Fifteen major banks were hit with credit downgrades on Thursday that could do more damage to their bottom lines and further unsettle equity markets.”

“The health of 15 of the world's largest financial institutions has been called into serious question after Moody's downgraded their credit ratings, citing risk exposure and the eurozone crisis.”

Still others suggested the downgrades are “another weight” on the US economy “because the cost of doing business for these (banks) ... will go up as result of having their rating lowered.”

Suffice it to say, we’ll take these alleged implications with a healthy dose of skepticism—in our view, this move is likely to prove mostly ineffectual.

Moody’s moves aren’t based on any really new information. The actions are predicated on four major factors. First, there’s the fact some major banks have earnings and revenue streams partly tied to capital markets that (for good or ill) gyrate—which has been widely known as long as there have been capital markets. The second criteria are capitalization and liquidity, which are fine—but confusing timing, considering banks have more capital and are more liquid today than in recent years. Third and fourth are European and US real estate market exposure—seemingly, two more very widely known factors. So it truly doesn’t seem these forces are sneaking up on anyone, similar to the downgrade Moody’s has telegraphed since putting them on watch in February.

But at a broader level, raters’ importance is often vastly overstated—like in our selection of quotes above. Last December, for example, Standard and Poor’s downgraded over 30 global banks on similarly backward-looking information. No dire consequences ensued. In many cases, recent sovereign actions—like S&P’s 2011 US downgrade—were followed by lower interest rates (funding costs) on debt issued. Last week, Moody’s downgraded Spain’s rating from A3 to Baa3—and rates ticked up for a couple days thereafter. Yet as of Friday—nine days later—rates are below prevailing rates the day before the downgrade. Maybe Spain’s rates tick up from here, but if so, we’d suggest it’s highly unlikely Moody’s action is the culprit.

Now, there have been areas historically where ratings have mattered. Some institutions have been required by law to invest only in bonds above a certain grade. And bank regulation in both the US and EU has hinged on raters’ opinions (for reasons that utterly escape us). But the kicker is, these rules exist solely at the whim of the rule maker—and those whims can and do change.

Just ask ECB head Mario Draghi, who announced Friday it would ease collateral rules for eurozone banks, permitting them to borrow against lower-rated debt. In fact, the rules have even changed what kind of assets banks can borrow against—for example, securitized car loans are fair game now. Or ask EU officials, who just last week finished a slight rewrite of rules regarding ratings agency reliance on bank regulation.

There are a host of reasons to discount ratings agencies’ opinions—conflicts of interest, less-than-stellar track records and more. But another reason is this: There’s scant evidence the raters’ opinions are meaningfully predictive.