Moody's gives Aaa ratings to Icelandic banks

If ever there was an example of pre-crunch financial folly this is one. The credit rating agency Moody's rolled out a new method of rating banks to factor in the liklihood of the governments stepping in to bail them out if they went bankrupt. It was met with uproar but as bailouts an every day occurance, they can claim some justification...Well they could have, if there method didnt give the highest credit rating to the Icelandic banks - the biggest banking calamaties of the credit crisis! As far as Iceland was concerned, they were too big to fail but as the analyst I interviewed pointed out, there wasnt much Iceland could do.


***Moody’s bank review shakes up ratings world (2 March 2007)***

Rating agency Moody’s Investor Services is initiating a bold roll out of rating actions for banks and other deposit- taking institutions. And the early results are causing some consternation in the fixed income sector.

The review incorporates joint-default analysis (JDA) in Moody’s ratings and recognises the likelihood of systemic national government support as well as support from regional and local governments, parent banks, and cooperative or mutual banking groups.

The roll out is taking take place by region, on a weekly basis, with Nordic, Baltic and other European banking credit reviews already announced.

So far, the methodology has resulted in multiple notch upgrades for a number of banks in the region, reflecting implicit government support.

A number of eyebrows have been raised, and investors have singled out the newly acquired Aaa status of volatile Nordic credits such as Glitner and Kaupthing.

"Moody's have put an enormous level of importance on government support for banks, how else can they explain how the Icelandic banks are rated so far above more diversified institutions," said an investor.

“Given liquidity issues of the banking system and the interest rate environment, exactly how Kaupthing Bank can have the same rating as Gilt (UK Treasury) is strange to me,” said another investor.

Glitner saw its spreads tighten by 20 basis points earlier in the week following the upgrade before widening by 10 the following day.

“It appears to just be a generic review of the banking sector and places very little emphasis on individual credit quality,” said a further investor.

Ken Hanton, senior analyst, fixed interest credit research, nabCapital agrees that many factors influencing implicit support can be difficult to quantify. “By overestimating the external support an issuer, in these cases banks, would receive in a time of stress - the Moody's model appears to have the capacity to generate ratings which on a comparative basis won't make intuitive sense,” said Hanton.

Moody’s defends its methodology, which is its says is based in empirical evidence.

“Our views reflect 30 to 40 years of observing global credit markets, and evidence supports that in many instances governments will step in and offer credit support” said Brian Cahill, managing director Australia, Moody’s Investor Services.

Cahill adds that previous ratings underemphasised external support of credit quality and the JDA ratings better reflect the reality of bank defaults.

Some observers are sympathetic to Moody’s initiative.

“Its understandable that once you lend out money the only thing you are concerned about is getting your money back. Central banks would never openly state that they would support banks but it is our experience that many banks are far too big to fail,” said a fund manager.

“Japan is the best recent example as the system that required a material amount of government support. In the main and with the economic conditions they faced, governments and banks engineered fairly successful outcomes. However, there were instances of subordinated debt converted into preference shares. It can get muddy on the level of external support you are likely to receive as you go down the pecking order,” said Hanton.

One has to ask on a sovereign’s ability to support a banking system when the cracks begin to appear. Notwithstanding their high sovereign ratings, does Iceland have the same capacity as Japan did to bail its banking system out?"

According to a nabCapital research report, the methodology will result in a two-tiered pricing that will differentiate between real Aaa’s and implicitly supported Aaa’s.

“Investors will naturally place a premium on an issuer who in their own right has a very strong credit profile, over one who isn’t as strong and has a higher chance or requiring external support,” said the report.

With the Moody’s Aaa rating appearing not to take this into account, Hanton thinks the market might end up placing a greater reliance on the other agencies ratings.
But deviations of pricing within ratings bands is nothing new to the market, says a fund manager.

“Corporates, and banks within the A rating band trade at very different spreads so markets are able to differentiate credits within rating bands. Moody’s is saying, why muse about implicit support? it should just be reflected in the rating ” he said.

The response of the other rating agencies have been muted, but they are likely to be keeping a close watch.

And so too is the market. “Moody's have tried to re-invent the wheel but risk making themselves redundant,” said an observer.

Announcements about ratings actions for the big Australian banks are expected on 23 March, with ANZ, Commonwealth Bank, National Australia Bank and possibly St George expected to be assigned Aaa ratings.