Sovereign credit issues have been front-and-center in terms of recent headlines as cost of funds and the balance between growth and austerity becomes unhinged among the once-upon-a-time risk-free entities. What has had less play very recently is the crisis that is going in the banking systems of the world as investors are as loathed to take any exposure to an opaque and clearly insolvent group of organizations. Credit (and to a lesser degree - equity) markets have shown their disapproval as spreads are as bad (if not worse) than at any time before, and yet the ratings agencies have yet to act - especially in the US. All that is about to change as Reuters gently reminds us that S&P is about to update it bank credit ratings framework. The model is complex by nature but as we have seen time and time again, the agencies tend to lag prices (spreads) and in that case, we can expect downgrades as an early Christmas present.
The ratings will impact some of the largest globally systemically important firms. Credit markets currently have these trading at their widest levels of all time - in many cases beyond the previous crisis.
Regionally, the rise has been quite systemic (among the 30 most import global financials) but we note - rather surprisingly - that US has the largest average spread among the 4 regions. Perhaps even more reason to expect S&P to downgrade.
And while European banks are decompressing rapidly, the US majors have exploded since early January 2011 when S&P last announced the expectations of the ratings framework changes.
(Reuters) - Standard & Poor's plans to update its credit ratings for the world's 30 biggest banks within three weeks and may well mete out a few downgrades in the process, possibly surprising battered global bond markets.
Among the institutions that could be downgraded are Bank of America Corp (BAC.N), Citigroup Inc (C.N) and Morgan Stanley (MS.N), said Baylor Lancaster, an analyst at CreditSights Inc.
Spokesmen for the three banks declined to comment.
Some European banks could also be affected. On November 9, S&P downgraded its scores for the health of the banking industries in a number of countries, including Denmark, Sweden, Finland and the Netherlands.
The updates in ratings are part of a major overhaul of S&P's methods for scoring the creditworthiness of some 750 banking groups.
The agency, the subject of intense criticism because its positive ratings for mortgage-backed securities played a major role in inflating the housing bubble, has been working on the changes for more than a year.
The updates are part of a broad push by S&P to improve its products and repair its reputation as its parent, McGraw-Hill Cos Inc (MHP.N), divides itself into two publicly traded companies.
S&P has taken pains to prepare the markets for the changes, but when it actually releases results for individual banks some downgrades could surprise, analysts say.
"One reason there could be surprises is that the new ratings method is very complex and it has been very difficult to simulate results," said Beate Muenstermann, a London-based research analyst for the money management arm of JPMorgan Chase & Co.
One area for potential surprise lies in differences between actions the agency may take on bank holding companies compared with grades for their operating units. Another is variations between long-term and short-term ratings.
S&P posted an advance notice of the coming changes in March 2010 and in January 2011 outlined its initial plans and requested comments.
Earlier this month the agency published its final criteria and said it expects 60 percent of all bank ratings to stay as they are, while 20 percent will go up one notch, 15 percent will fall by one notch and less than 5 percent will drop by two or more notches. One notch is one-third of a letter grade -- for example, the difference between a rating of "A" and a rating of "A-minus."
S&P has not said what proportion of downgrades it expects among only the biggest banks. It has said to expect regional differences in the results for all banks. Western Europe fared worse than Latin America and Asia in the November 9 changes in scores for banking industries by country.
S&P estimated in January that there would be more downgrades, but the agency lowered some ratings while the plan was being completed and also eased some of the criteria.
The agency plans to first announce its results for the 30 biggest banks, possibly as early as late this month, and then begin quickly rolling out its ratings for smaller banks.
The agency has been discussing the often-arcane mechanics of the new methodology with banks and institutional investors and has posted explanations and tutorials on public pages of its website.
"S&P has been extremely good at guiding the market through this change in the methodology," said Muenstermann.
How the changes are perceived by regulators could prove to be more important to S&P than to the markets. Bond fund managers say the market has probably already priced in the information underlying S&P's research and judgments.
"The rating agencies tend to be laggards compared with prices," said Ryan Brist, a portfolio manager at Western Asset Management.
S&Ps changes may even foretell a coming upturn for banks, he said. "Historically, ratings agencies tend to change their methodologies after large downward price movements in the market."
John Croft, a portfolio manager and director of investment grade research at Eaton Vance, said, "They seem to be fiddling around with their methodologies more than opining about the underlying credit strength of issuers."
Still, Croft gives the agency credit for trying to do better than in the past. Past ratings proved too high on such financial companies as Lehman Brothers, ABN AMRO and Wachovia, which either failed outright or were forced into mergers with stronger rivals.
"They are trying to rectify some of the problems that they have had in the past and to the extent that they do that, it is good," said Croft.
The agency's performance is under scrutiny from regulators, who are designing ways to reduce the power and profits from the ratings business now enjoyed by S&P and its main competitor, Moody's Corp (MCO.N).
S&P made matters worse last week when its computer systems accidentally sent a note to some customers suggesting that the credit rating of the Republic of France had been downgraded in the midst of the European debt crisis.
S&P said later the error stemmed from a computer programing step it had taken last December with the banking industry country scores used in the first step of its new ratings method.
The impact of a downgrade can be very significant - aside from simply reducing investor appetite for risk (in its simplest form), it can trigger collateral calls and in a world where liquidity is hard to come by, and with the magnitude of funding (and rolling maturing debt) due over the next few quarters, we suspect this will be the catalyst for another leg down in equity prices as they snap back to credit's reality.