Rating Agencies Regain Their Relevance

Jun.27.12 | About: Moody's Corporation (MCO)

When Moody's (NYSE: MCO) downgraded 15 banks the market laughed it off initially, and those banks even rallied on the same day last week. Market pundits were openly questioning whether Moody's, Fitch and S&P were even relevant anymore. However, just one day later on this past Monday, those same stocks suffered serious losses. The media attributed the action to the latest scare out of Europe, with Spain and Cyprus requesting rescue funds from the EU. The media was right, and so was Moody's. The shares of Bank of America (NYSE: BAC), Citigroup (NYSE: C), Morgan Stanley (NYSE: MS) and The Royal Bank of Scotland (NYSE: RBS) exaggerated the decline of the broader market and exceeded most other banks on the downslide, save those based and focused in Europe. Those same banks just happened to be the ones Moody's highlighted as the riskiest, with noteworthy entanglements to the euro region.

Moody's cut the debt ratings of 15 banks and securities firms late last week, including U.S. based, J.P. Morgan Chase (NYSE: JPM), Goldman Sachs (NYSE: GS), Morgan Stanley, BofA and Citi.

Moody's Reasoning:

"All of the banks affected by today's actions have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities", says Moody's Global Banking Managing Director Greg Bauer. "However, they also engage in other, often market leading business activities that are central to Moody's assessment of their credit profiles. These activities can provide important 'shock absorbers' that mitigate the potential volatility of capital markets operations, but they also present unique risks and challenges."

Moody's broke the banks up into three groups based on degree of risk, with the highest risk found in the "Third Group," containing the four institutions atop this report. With regard to that "Third Group" specifically, Moody's said:

"The third group of firms includes Bank of America , Citigroup , Morgan Stanley , and Royal Bank of Scotland . The capital markets franchises of many of these firms have been affected by problems in risk management or have a history of high volatility, while their shock absorbers are in some cases thinner or less reliable than those of higher-rated peers. Most of the firms in this group have undertaken considerable changes to their risk management or business models, as required to limit the risks from their capital markets activities. Some are implementing business strategy changes intended to increase earnings from more stable activities. These transformations are ongoing and their success has yet to be tested. In addition, these firms may face remaining risks from run-off legacy or acquired portfolios, or from noteworthy exposure to the euro area debt crisis."

The "Second Group" included risky banks but less risky than the first four. Regarding the banks in the "Second Group" Moody's said:

"The second group of firms includes Barclays (NYSE: BCS), BNP Paribas (OTC: BNPQY), Credit Agricole SA (OTCPK:CASA) (OTC: CRARY), Credit Suisse , Deutsche Bank (NYSE: DB), Goldman Sachs , Societe Generale (NYSE: SCGLY) and UBS (NYSE: UBS). Many of these firms rely on capital markets revenues to meet shareholder expectations. Their relative position reflects a combination of differentiating and sometimes adverse factors. Capital markets operations constitute a large part of the overall franchises for Credit Suisse, Goldman Sachs, Barclays, and Deutsche Bank, but less so for UBS, Societe Generale, BNP Paribas and CASA's cooperative group, Groupe Credit Agricole.

Other factors contribute to the relative positioning. For example, Barclays, BNP Paribas and Groupe Credit Agricole have, to varying degrees, relatively robust shock absorbers. Exposure to capital markets businesses is very high for Goldman Sachs, but this is balanced by a record of effective risk management. Barclays, BNP Paribas, Groupe Credit Agricole, and Deutsche Bank also have sizeable but varying degrees of exposure to weaker European economies. Some firms are relatively weak with regard to structural liquidity or reliance on wholesale funding."

Moody's saw lighter risk for the "First Group" of downgraded banks and stated:

"The first group of firms includes HSBC (NYSE: HBC), Royal Bank of Canada (NYSE: RY) and JPMorgan . Capital markets operations (and the associated risks) are significant for these firms. However, these institutions have stronger buffers, or 'shock absorbers,' than many of their peers in the form of earnings from other, generally more stable businesses. This, combined with their risk management through the financial crisis, has resulted in lower earnings volatility. Capital and structural liquidity are sound for this group, and their direct exposure to stressed European sovereigns and financial institutions is contained."

Bloomberg View, an editorial commentary I listened to on New York radio Monday morning, perhaps before it realized what was developing Monday, remarked that the rating agencies have become backward looking measures. The report went on to talk about the steps Wall Street and banks have taken to sure up their balance sheets and risk management over recent months, stating that investors are looking to the current situation, which is better than what the rating agency's report reflects. Certainly, Moody's and S&P, owned by McGraw-Hill (NYSE: MHP), have been playing catch-up in a major way since the real estate bubble burst. Also, the initial reaction of the market seemed to say the agencies are irrelevant, as also covered by Bloomberg in this article.

However, Moody's appears to be right this time. Furthermore, the latest situation at J.P. Morgan Chase certainly supports that possibility. On Sunday evening, the Financial Times offered some interesting insight on the subject, which I believed and reported illustrated one reason why the market could reconsider its initial disinterest in Moody's changes. On that, I was right. The FT article shows real changes in business activity because of the Moody's report, with Bank of America, Citigroup and the other institutions operating under Prime-2 short-term ratings suffering losses of business to the likes of The Toronto-Dominion Bank (NYSE: TD) and PNC Financial Services Group (NYSE: PNC). That hits the bottom line. The risk to investors is not limited here either, because in many cases when more than one rating agency lowers the credit worthiness of a firm, institutions must find new business partners in order to honor their charter's and promises to investors in their funds or investment instruments.

The shares of the banks in question were off sharply Monday, with BAC lower by a severe 4.3% at the close of trading. Investors were already reconsidering their initial reaction to the Moody's report. The four banks within that "Third Group" were each off sharply, with Morgan Stanley down 4.7%, Citigroup lower by 4.4% and Royal Bank of Scotland cut 3.4%. The "Second Group," grouped based on slightly lower assessed risk, included Barclays down 4.3%, BNP Paribas SA (OTC: BNPQY) lower by 5.8%, Credit Agricole SA (OTC: CRARY) down 5.7%, Credit Suisse in the red by 3.8%, Deutsche Bank down 4.9%, Goldman Sachs lower by 2.6%, Societe Generale (OTC: SCGLY) down 6.9% and UBS off 4.4%. The second group's European based institutions did worse for obvious reasons. You can see the graduation of risk as we move to the day's performance of the "First Group", as defined by Moody's. HSBC was only lower by 1.3%, while J.P. Morgan Chase fell just 1.9% and Royal Bank of Canada fell 2.3%. With European concern driving the market, Moody's mention that these firms carry "noteworthy" ties to the region's woes clearly weighed heavily.

I covered specific recommendations for Bank of America and Citigroup in previous articles, including from a valuation perspective. This report is meant to show that the opinions of the rating agencies, and certainly Moody's, might be worthy of some respect despite their egregious faults through the financial crisis. Standard & Poor's is a subsidiary of McGraw-Hill and Fitch is the joint subsidiary of FIMALAC (OTC: FMLCF) and Hearst Corporation. For more research like this, follow me at Seeking Alpha.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.