The Return of the Downgrade Cycle

06/06/11 Laguna Beach, California – “Downgrading” is in a bull market.

If you google the phrase “credit downgrade,” your query returns 264,000 responses. But when you google “credit upgrade,” you get only 52,600 responses. Clearly, downgrading is in an uptrend.

The downgrade craze emerged slowly in the summer of 2007, as the housing boom was shifting into bust mode. By September of 2007, the ratings agencies had downgraded only $85 billion worth of mortgage-backed securities (MBS). But within one year, that number would soar to nearly $2 trillion.

And these weren’t your run-of-the-mill downgrades from AA to A, or some such. These were epic downgrades unlike anything the financial world had ever seen. More than half the nation’s 32,000 asset-backed securities (ABS) with credit ratings received downgrades. Thousands of ABS plummeted from AAA to “junk.”

The credit crisis of 2008-9 ensued. But then the Fed and Treasury joined hands to fix the whole mess. At least that’s the official storyline.

Unfortunately, the Federal Reserve and Treasury did not vanquish the downgrade cycle; they merely swept the downgrades into a different venue, like San Francisco cops sweeping the homeless from the Financial District to Market Street.

Over the last few months, the ratings agencies have been working overtime to downgrade everything from corporate credits to state governments to foreign governments. Even the US government itself, is “under review for possible downgrade.”

Clearly, something is out of whack. When so many participants in the global economy possess so little ability to repay their debts, something is clearly broken.

But maybe there’s a way to break this cycle – not with austerity and repayments, of course. That path is hopeless. Perhaps we could break the cycle by downgrading the metrics, rather than the borrowers.

Why not begin rating credit risk “on the curve?” Absolute standards are so…well…absolute. Based on absolute accounting standards, for example, the Greek government fully deserves its “junk credit” status. But surely there are other credits around the globe that are even worse than Greece. If Moody’s and S&P were rating on the curve, Greece might receive a “D,” rather than a failing grade. Imagine how much better Greek bondholders would feel…until the day of Greece’s inevitable default.

But that’s just our perspective…as glass-half-full guys. Back in the real world, where absolute standards – and a wee bit of politics – determine credit ratings, the trends are disconcerting, if not downright alarming.

“Rating activity during the first three months of 2011 marked the ninth consecutive quarter in which downgrades in the municipal sector exceeded upgrades,” a recent report from Moody’s observes. “With negative outlooks assigned to all major municipal sectors, the trend is likely to prevail for all of 2011.”

According to the report, the first quarter saw 66 municipal downgrades and 17 upgrades, a ratio of 3.9 to 1 – the second highest downgrade-to-upgrade ratio since the first quarter of 2002, trailing only the fourth quarter of 2010 when the ratio measured 4.6 to 1.

“We expect downgrades to continue to exceed upgrades throughout 2011 for states and local governments and school districts as states cope with the effects of weak revenue growth, significant spending obligations, and the loss of federal stimulus funding,” Moody’s concluded. “Local municipalities will struggle to maintain structural balance in an environment of declining state aid, lower assessed valuations, and fewer budgetary options.”

Meanwhile, sovereign credits are capturing most of the downgrade headlines – Greece’s Icarus-like plunge into “junk” status being the most conspicuous example. Based on top-down data, sovereign credits remain healthy, as upgrades continue to exceed downgrades. But theoretical credit-worthiness cannot conceal actual credit-unworthiness forever. Sovereign credits worldwide are struggling to maintain a semblance of creditworthiness, at least in appearance, if not in fact.

They are losing their struggle.

A Daily Reckoning prediction: The sovereign downgrade/upgrade ratio will deteriorate over the next several quarters.

But don’t get us wrong. We are not throwing stones at sovereign credits or municipal credits. We are throwing stones at credit, itself. No asset in the financial world illustrates the Second Law of Thermodynamics better than bonds. They degrade toward a chaotic condition faster – and more reliably – than any other asset class.

Bonds are a promise to pay. But the history of the bond market is a history of broken promises. That’s because borrowing is easy. Re-payment is difficult. The near-extinction of the American AAA credit illustrates the point.

In the early 1970s, about 60 US companies possessed a AAA rating. A decade later, that number had tumbled to 30. By the early 1990s, the ranks of AAA credits had dwindled to nearly 20, and when the new millennium dawned, only nine AAA companies remained. Seven companies managed to retain this prestigious ranking until 2009, when Berkshire Hathaway and GE slipped into the AA ranks.

Today, only five US companies can boast a AAA rating:

• Automatic Data Processing (ADP)
• Exxon Mobil (XOM)
• Johnson & Johnson (JNJ)
• Microsoft (MSFT)
• Pfizer (PFE)

The downgrade cycle is still gathering momentum. Bond buyers beware.

Eric Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research —  institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

View articles by Eric Fry

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