Markets don’t always reflect the truth, but this time they did.
One day after Moody’s Investors Service cut the credit ratings of 15 major U.S. and European banks, and hours after front pages around the world proclaimed the downgrades to be Big News, the markets stopped, sighed, shrugged and moved on. In fact, they rallied, with stocks and bonds of U.S. banks jumping by more than 1 percent. The reaction is reminiscent of the events of last August, when the U.S. government’s borrowing costs fell after Standard & Poor’s stripped the country of its AAA credit rating.
Once upon a time, the proclamations of credit-rating companies and the resulting market moves tended to go in the same direction. Back in 2005, downgrades of General Motors and Ford caused the companies’ bonds to drop and whipped up a tempest in financial markets.
What gives? First, there’s the obvious. At least in the U.S., banks have generally been building up their capital and cash reserves and paring down their holdings of soured loans and securities. So the downgrades contrast with recent experience.
Second, and more important, ratings are by their nature backward-looking. They fall only after the problems of a borrower are obvious and demonstrable. So they should catch markets by surprise only if investors haven’t been doing their homework.
Consider the rationale of Moody’s for its latest bank downgrades, which affected such big institutions as Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co., Goldman Sachs Group, Deutsche Bank AG and Barclays Plc. The rater’s analysts noted that the banks, all of which have big trading operations, “have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities” -- meaning that a market crash could cause them to lose so much money they would be unable to pay their creditors.
The observation isn’t wrong. It’s just more than four years too late. The financial crisis of 2008 was enough to alert investors to the risk: The cost of default insurance on Goldman Sachs, for example, more than doubled when Bear Stearns failed in March 2008, quadrupled when Lehman Brothers Holdings Inc. went bankrupt in September 2008, and remains more than six times its pre-crisis level. Moody’s downgraded Goldman by one level in December 2008, and it took until now to do a second, two-level downgrade. The situation for all the other downgraded banks is similar.
If markets are recognizing that credit ratings are old news -- and possibly even conflicted, given that the raters are paid by the entities they rate -- the development can only be seen as desirable. We’ll all be better off if financial regulators (who allow the ratings to affect measures of bank capital), pension-fund managers (who use the ratings to define their funds’ investment strategies) and lawmakers do the same.
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