By Lance Pan, Capital Advisors
Recent bank ratings changes are more than indicative of the current difficult economic and market conditions and may not return to their former glory any time soon.
It’s happened so often we’ve become inured to it: banks getting beaten up by credit rating agencies time and again since the financial crisis began in 2008. While banks always rode their ratings through the ups and downs of market cycles, this time is different. What’s happening is a mega-trend in the making; bank ratings are drifting into the BBBs.
The question is, if bank ratings are headed for triple-B territory, and there are indications of that happening, how might that trend impact corporate treasury professionals? How do we rethink our corporate cash investment strategies? What about uninsured bank deposits or counterparty risk management?
The corporate treasury community will feel the impact of the bank ratings megatrend sooner or later. As such, cash investors should be aware of the potential supply shortages in the debt markets and the need for robust credit and counter- party research capabilities. Investors also should explore eligible investments in non-financial credits and consider direct investments through separately man- aged account solutions.
A BBB’S DRIFT
On February 15, 2012, Moody’s Investors Service took two separate actions plac- ing 120 financial institutions and firms worldwide on review for downgrade. In its first action, Moody’s placed the ratings of 114 banks in 16 European countries on review for downgrade. In its second action, Moody’s announced a negative review of 17 banks and securities firms that are global capital markets intermedi- aries (GCMIs), with several of those Euro- pean banks named in the first action also appearing on the second action list.
The Moody’s action on the 17 GCMIs represents a fundamental shift in the agency’s view of banks with capital market operations. In a related credit commentary, Moody’s said it now views the average standalone credit ratings of GCMIs, currently at A2, as moving to “the Baa range.” Note that Baa (Moody’s nomenclature for BBB) is the lowest in- vestment-grade credit category. Securi- ties with this rating often are considered ineligible for corporate cash portfolios.
Moody’s is not alone in its change of thinking. In some sense, Moody’s simply is playing a catch-up game with Standard & Poor’s. The two firms have crisscrossed each other in downgrading bank ratings over the last few years. As of February 15, 2012, the S&P ratings of 43 of 56 US banks are between A- and BBB-.
The revised views on banks and finan- cial firms at Moody’s and S&P should not be taken lightly. Many of the banks affect- ed by recent ratings actions are the larg- est and most active issuers of short-term debt or are counterparties to repurchase agreements (repos). If Moody’s follows through on its reviews, some banks may lose up to three ratings notches, including some banks that may lose their top tier (P-1) short-term ratings. Those banks may face considerable funding challenges as they rely on short-term debt markets to finance their balance sheets.
MARKET OPINION VALIDATION
In a way, global capital markets banks’ road to BBB-land should not be a surprise to market observers. The financial crisis, regulations and resolutions have reduced government support assumptions built into many of the bank ratings. Burgeoning government fiscal deficits lowered sover- eign ratings ceilings, further depressing bank ratings. Economic sluggishness, as well as challenges in the employment, housing and consumer credit sectors, further impacted bank profitability, loan quality, capital positions and so on. Liquidity and capital constraints from the Eurozone debt crisis made banks more vulnerable. Interestingly, markets already seem to be treating bank debt as though it is rated BBB or worse.
Figure 1 on the next page represents the year-end average credit ratings of two sub-indices in the Merrill Lynch 1- to 3-Year Corporate Index—financial and non-financial—since the indices’ incep- tion in 1997. “Financial Premium” refers to the average effective yield of the financial sub-index over the non-financial sub- index expressed in percentage terms. So, bonds with lower ratings are expected to pay a higher yield, expressed as positive percentages in the graph.
The chart on the next page also shows that the average credit rating of financial debt at one time was three ratings notch- es higher than non-financial debt. What is striking is that since 2007, yield premium on financials turned positive despite the debt’s higher credit ratings. The premium went up to 86 percent at the end of 2011 despite financial debt’s credit rating be- ing at A1 vs. a lower A3 for non-financial.
The anomaly of higher ratings and higher yield premium since 2008 can only mean one thing: credit ratings overstated the creditworthiness of financial issuers relative to their non-financial counter- parts. The implication is that the average credit rating for financial debt may be low- er than A3, which implies BBB or worse.
In short, the ratings agencies’ recent moves simply may have confirmed what investors believed for years—bank ratings were systematically overstated. Investors validated the long-held market convention that at the same ratings level one should demand higher yield from a financial cred- it than from a non-financial credit.
VARYING CORPORATE CASH EFFECT
While the long-term effects of this ratings mega-trend on corporate treasuries are difficult to discern, we think the immedi- ate impact may be quite benign. Here are some suggestions on what to expect and what treasurers can do.
Short-term Impact Manageable: For starters, many of the weaker bank credits in Moody’s crosshairs already are out of cash investors’ portfolios. These include several major US banks and brokerage firms and banks from peripheral Europe and France. For those that remain on investors’ shopping lists, money market funds and separate account managers have switched to collateralized lending such as repos or asset-backed commer- cial paper. Even if some names were to suffer multi-notch downgrades to BBB levels, they may continue to have depos- its and central banks to help them fund operations.
Expect Supply Shortage: With succes- sive ratings downgrades and higher costs of funding, some banks may exit certain national markets. Others may abandon capital markets activities altogether. Still others may merge. The net result may be a reduced universe of investable issuers, thus worsening the short-term debt mar- kets’ supply shortage.
Uninsured Deposits Riskier: Adding to the supply challenge is the planned expiration of FDIC unlimited insurance on transactional accounts, set to expire at the end of 2012. Lower credit ratings mean higher credit risk in uninsured de- posits for corporate depositors. As the list of creditworthy banks dwindles, treasury professionals need to find other channels to substitute uninsured deposits at lower- rated banks.
Lower Yield Potential: As more bank ratings erode, money market funds and other managers may pare back their credit investments and focus on a few highly rated bank names. The process of weeding out lower-rated, higher-yielding banks may result in lower yield potential in investment portfolios.
Strict diversification rules in pooled liquidity vehicles, such as money market funds, may force managers to turn to still lower-yielding US government securities to stay invested. An alternative may be to seek out less liquid investments with un- known risk characteristics.
CALL FOR ACTION
We think the first thing investors should note is that recent bank ratings changes are more than just indicative of the cur- rent difficult economic and market conditions. In our opinion, bank ratings may not return to their former glory any time soon. The risk profiles of many global cap- ital markets banks may mean that they no longer are creditworthy debt issuers or counterparties for the corporate cash investor. Waiting for the storm to pass may not be the best course of action.
Recognizing this secular trend, one of the first orders of business for treasury or- ganizations is to build stronger research capabilities for credit analysis and coun- terparty assessment of banks. Some corporations may develop in-house research capabilities; for others, outside expertise may be sought through separate account management, portfolio credit reviews or outsourced credit research services.
While the supply shortages are clearly present in the short-term debt market, non-financial corporate issuers recently have increased their issuances. Rather than accessing the debt markets through banks suffering from ratings pressure, coRporations with healthy profit margins and strong balance sheets have taken advantage of their own high credit ratings and the market’s demand for non-financial paper by tapping the CP market directly.
The ratings challenges and their impli- cations again point to the inadequacies of simply relying on deposit products or pooled vehicles for corporate cash management. Building self-sufficient cash investment capabilities should help maintain better credit and counterparty risk control and mitigate liquidity uncertainties in pooled investments. Such capabilities may come from in-house investment ex- pertise or through customized separately managed accounts.
Lance Pan is Director of Investment Research & Strategy at Capital Advisors. He can be reached at +1-617-630-8100 or [email protected].