by Charles Lieberman, Advisors Capital Management
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.
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