Europe’s Ratings Revenge Founders on Market Reality: Euro Credit
The European Union is retreating from a vow to defang credit-rating companies as reforms prompted by the 2008 crisis collide with the needs of bond investors.
“More than taking a sledgehammer to crack a nut, Europe is using TNT,” said Jonathan Pitkanen, who helps oversee about $43 billion of fixed-income as head of credit research at Threadneedle Asset Management Ltd. in London. “Then the law of unintended consequences kicks in and they have to back off.”
Finance ministers agreed last week to revisit plans to oblige borrowers to rotate credit assessors every three years, or six if a business hires more than one firm. The backtrack comes as investors describe the changes as unworkable, citing the risk of relying on grades from firms with insufficient expertise or forgoing formal assessments.
The European Union has been seeking to rein in the raters for almost four years, blaming Standard & Poor’s, Moody’s Investors Service (MCO), Fitch Ratings and smaller peers for ignoring conflicts of interest that helped fuel the 2008 financial crisis. While the authorities have set up a regulatory agency, outlawed some abuses, forced companies to register and to reassign analysts regularly, attempts to crack down further are foundering on concern the industry may be rendered unviable.
Yields on French 10-year bonds rose 11 basis points to 3.24 percent on Dec. 6, the day after S&P said it might downgrade the nation. They dropped four basis points to 3.03 percent on Jan. 16, the first business day after S&P stripped the nation of its AAA grade.
Valuing the Valuers
Stock prices suggest investors are relaxed about increased regulation crimping profits. Shares of New York-based Moody’s have gained more than 23 percent since Nov. 15, when the European Commission’s Financial Services Commissioner Michel Barnier proposed a suite of rules. Those of McGraw-Hill Inc. (MHP), S&P’s parent, are up 11.5 percent in that period. Fitch is a unit of Fimalac (FIM) SA in Paris, whose shares have lost 2 percent.
Investors demand a yield premium of 246 basis points more than benchmark Treasuries to hold Moody’s $500 million of BBB+ rated 5.5 percent bonds due 2020. That compares with an average spread of 243 basis points shown by Bank of America Merrill Lynch’s index of similarly rated bonds. The spread on McGraw- Hill’s $400 million of 5.9 percent notes maturing in 2017 is 156 basis points, in line with the 168 basis-point average on Merrill’s U.S. Corporates, A Rated Index.
Moody’s “remains hopeful” that a revised regulatory framework “will not include features that would undermine the functioning of European credit markets and access to credit,” said Daniel Piels, a spokesman for Moody’s in London.
Regulatory efforts since the financial crisis have come in three waves, starting in November 2008. The first set out rules of conduct and governance to create a formal framework for raters’ activities.
The second set of proposals came from the EC in June 2010 as Greece suffered a series of downgrades. It dumped self- regulation and placed the European Securities and Markets Authority in charge of supervising the industry across the 27- nation region. The third stage was presented in November.
The aim of the changes is to reduce “over-reliance,” boost competition and bolster the independence of ratings firms from the companies they assess, according to Barnier.
His focus on rotation may make life harder for bondholders. A seven-year bond, for example, would start out rated by two firms, one of which would have to drop out after three years. For an issuer with grades split between A- and BBB+, say, the firm that gets its mandate renewed after the first three years may not be the one that assigns the BBB+ grade, said Pitkanen at Threadneedle.
“This would be vindictive, aimed at undermining the agencies’ business model,” said Roger Doig, an analyst at Schroders Plc in London, which manages about $58 billion in fixed-income assets. “It would raise questions about their ability to staff themselves, about their ability to cover issuers and about maintaining coverage.”
The proposals are “impractical and remove the continuity of experience,” the European Association of Corporate Treasurers said in a statement. Chantal Hughes, a spokeswoman for Barnier, declined to comment.
Ratings are “deeply embedded” in financial markets and in the regulations that govern those markets, said Doig. Definitions of creditworthiness help define what money managers can and can’t do with their clients’ funds, delineate the boundary between investment-grade and high-yield debt, and guide the cost of repurchase agreements banks use to borrow from central banks, he said.
Barnier was defeated on his proposal that ESMA, which has regulated the industry since July, should have the power to temporarily ban sovereign grades for countries negotiating international bailouts. He also failed win backing from his EC colleagues for a temporary ban on mergers and acquisitions by the largest ratings firms.
Ideas that did make it into the draft law include giving investors the right to sue if they lose money because of gross negligence or misconduct, putting the burden of proof on the assessor.
Raters would become more conservative, less willing to assay smaller companies, and quicker to react when an issuer’s circumstances change, according to a February discussion paper from BlackRock Inc., the world’s largest money manager. It would also cause “irreparable harm to the European securitization markets,” hurting European banks and constricting the flow of credit, according to the paper.
There would be restrictions on the time of day assessments of government creditworthiness could be published, and more details would have to be provided on the rationale behind a sovereign downgrade. Supplying full details of methodologies would allow copying by imitators.
One aspect of Barnier’s proposals that does have support from the industry is his plan to remove references to credit grades from banking and market regulations.
S&P said in January that it backed an end to “mechanistic reliance on ratings” and supported “requiring investors to conduct their own analysis of credit risk rather than relying solely on ratings.” Mark Tierney, a spokesman for S&P in London, declined to comment.
Fitch “is fully committed to compliance” and understands “the need for continuous improvement,” Mark Morley, a spokesman in London, said in an e-mail.
“It’s a costly venture to set up a rating agency in any case,” said Gary Jenkins, director of Swordfish Research Ltd. “They’re trying to encourage new entrants at the same time they’re increasing costs with regulation, opening the business to potentially crippling litigation and maybe having their models stolen. The lesson coming out of Brussels is that they want to punish someone.”
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