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Effects Credit Rating Pressure: Effects on Stable Value Issuers

The public spotlight trained on the securities industry in the wake of several high profile bankruptcies over the past couple of years - Enron, WorldCom, et al. - has perhaps burned most hotly on the necks of the major credit ratings agencies. The rapidity with which some of these issuers' debt fell from investment grade to default has led to criticism of the ratings agencies for their apparent failure to give investors advance notice of impending doom. This criticism has appeared both in market commentaries and in SEC hearings convened for the sole purpose of assessing the current state of the ratings business. This has a number of implications for the Stable Value industry.

One consequence of the criticism is the shift towards more conservative actions and reactions on the part of the ratings agencies. While there have been no formal public statements of revisions to their ratings-assignment methods, a conservative shift can be inferred from a couple of new developments. One is the treatment of ratings triggers - contractual clauses requiring the restructuring or accelerated repayment of debt or the posting of collateral in the event of specified rating actions. Following the bankruptcy of Enron - whose implosion was partly due to the cascading liquidity strain that can follow the activation of a ratings trigger - the ratings agencies have begun to assess the weight triggers add to a company's debt, even refusing to rate some new issues that have triggers. This wariness is not limited to the ratings agencies.

Another area in which ratings agencies may be becoming more conservative is in their initial ratings and subsequent rating revisions. An indication of a conservative shift is the number of downgrade ratings in 2002. There were a record number of ratings downgrades last year. Standard & Poor's, for example, downgraded 1123 issuers globally in 2002, compared to 266 upgrades, for a ratio of 4.22. During the same period, the number of defaults actually fell compared to 2001, and is expected to decline further in 2003. However, the ratio of downgrades to upgrades for the first quarter of 2003 was 4.65, an increase over that for 2002. The combination of a decrease in the number of defaults and an increase in the number of downgrades suggests that ratings agencies may be more sensitive to negative pressures and quicker to effect downgrade. The ratings agencies' increased responsiveness, even if only with regard to downgrades (nothing suggests ratings agencies have become quicker to make upward rating revisions), may benefit asset managers by giving an early warning sign to issues that may be in trouble. At the same time, though, given the overall downward migration of credit ratings, Stable Value portfolio managers will find fewer issues that meet plan sponsors' high-quality investment guidelines.

Plan sponsors themselves are affected by criticism of the ratings agencies. Not only has the number of acceptable investments declined, but the number of potential Stable Value players has also been reduced due to credit events. Notwithstanding bear market declines in portfolio values and claims-related drains on insurance companies' capital, insurers' credit ratings have also been negatively affected by the ratings agencies' apparent conservatism and proclivity to downgrade. Insurer downgrades have contributed to the reduction of the number of GICs being sold, as most purchasers seek GIC providers of at least a double-A credit rating. Similarly, plan sponsors' investment guidelines might proscribe entering into Stable Value agreements with single-A rated carriers or wrap providers, thus effectively barring such firms from participation in the Stable Value market.

Banks have not suffered the same credit degradation as insurers. Upgrades of S&P-rated U.S. banks outpaced insurance companies. For banks there were 4 upgrades and one downgrade and for insurance companies there were 39 downgrades and five upgrades. Despite their relative credit strength, several banks have also left the Stable Value market. Unlike insurers who have been edged out of the market due to inadequate credit ratings, banks have generally departed for internal reasons - insufficient market share or strategic realignment following mergers and restructuring.

The major ratings agencies predict improvements in issuer creditworthiness this year, and the critical light cast on the agencies will doubtless wane. Whether as the direct response to criticism, or the result of increased sophistication following criticism, the agencies' more conservative rating methods will probably become the norm. Investors within and outside the Stable Value industry can only hope that, as the ratings agencies respond to public criticism and adapt to changing markets, their ratings paint an increasingly accurate and predictive picture of the credit landscape.

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