Mirable Dictu! Moody’s to Adjust Bank Ratings Downward for Regulatory Arbitrage

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It’s hard to imagine anyone will take tough-sounding stances by ratings agencies seriously, but Moody’s, in a chat with the Financial Times, says it has (finally) taken notice of how banks play games with regulatory capital requirements. Sheila Bair noted in an interview at the Atlantic economy summit in March that in retrospect, one comparison that flushed out banks that were likely to get in trouble was that the were in compliance with risk weighted capital rules but also had very high levels of leverage (simple equity to total assets measures).

The Moody’s step takes place by updating its risk models to adjust for bank phony baloney. I’d also be thrilled if they started adjusting ratings for lack of transparency, but we’ll take what we can get. And this adjustment isn’t mere lip service; a wave of downgrades is coming based on this change.

Notice that the Moody’s rating action and model change will pressure the other ratings agencies to follow suit. I’d really get a kick out of it if Moody’s were to start to issue industry commentary that discussed at length how banks were gaming capital requirements. Heretofore, that sort of discussion relegated to the nether regions of discourse, which these days is the blogosphere, academia, and foreign TV. Remember, when Bill Black said on the Bill Moyers show that the initial stress tests in 2009 were a sham, not a single reporter called him up, even though that charade continued for another month. Even if the revised ratings don’t adequately reflect the level of bank chicanery, this change will make it much more mainstream to talk about regulatory arbitrage, both in general and in detail.

Key sections of the Financial Times account:

The credit rating agency announced it was placing 17 banks on review for a downgrade earlier this year, citing “vulnerabilities” in the companies’ vast and volatile capital markets businesses….

But in an interview with the Financial Times, Moody’s banking analysts said the agency was updating its financial ratings to take into account the historical tendency of banks to leverage their balance sheets and arbitrage global financial rules, often to the detriment of the banks’ own health and the safety of the wider banking system…

Moody’s caution could see all 17 banks downgraded when the review is finally completed, expected to happen in mid-June. Three of the banks, Credit Suisse, Morgan Stanley, and UBS, face as much as a three-notch downgrade; 10 face a two-notch slide and four a one-notch drop.

We’ll see just how serious these model adjustments are when the ratings come out next month. And there may be another layer of kabuki here. We were sympathetic to the argument that Standard & Poor’s was manipulating the debt rating of the US to escape liability for its role in the crisis (recall the huge scare in late summer 2011 that the downgrade would be The End of the World As We Know It?). This move to recognize how capital rules are undermined by the banks is welcome but overdue. One has to wonder if at least some of the motivation is to put the official critics of the ratings agencies on the back foot.

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  1. LadyLiberty

    Moody’s was just as bad as the S & P

    3.43pm: Ray McDaniel, the chief executive of Moody’s who will be appearing alongside Buffett, is preparing to eat a large slice of humble pie.

    In written evidence just released, McDaniel is highly apologetic over his firm’s role in the credit crunch, admitting that Moody’s performance in giving top-grade ratings to subprime mortgage-backed securities was “deeply disappointing”.

    “Moody’s is certainly not satisfied with the performance of those ratings. Indeed, over the past few years, there has been an intense level of self-evaluation within our organisation,” says McDaniel, whose written testimony in full is here.


    1. Yves Smith Post author

      You are missing the point. Seeing people or organizations as all bad or all good is a cognitive bias. Google “halo effect”.

      For instance, I think Ron Paul is batshit and I would not vote for him as President. But I still appreciate and applaud his anti-war, pro-Fed transparency/accountability stance.

      The ratings agencies can do good by putting pressure on regulators. This is unexpected and could be useful.

      1. LucyLulu

        Related to this and other recent posts:

        Somebody needs to put pressure on regulators because it sure as heck won’t come from within our own government system. A perusal earlier revealed the current status of appropriations for DOJ. These are subject to modification, the bill hasn’t yet gone to the House floor, but it seems to reflect the current penny-wise and pound-foolish short-sightedness of our current Congressional leaders. The following is an excerpt from the ‘minority view’. Note that while overall funding is increased for DOJ, the only divisions that have a positive return on investment are underfunded receive cutbacks. Surveillance and cybersecurity efforts get more than asked requested. Perhaps in a CYA move (or because Maxine was being such a PITA, go Maxine!) the door is left open for additional funding for mortgage and MBS fraud investigations. Even if the Democrats were inclined to crack down on financial institutions, Republicans will obstruct by withholding the necessary funds. Geez, not only do they not support raising taxes, they don’t support requiring those who owe taxes having to pay them!

        For the Department of Justice (DOA the bill provides $27.42 billion, an increase of $11 million above the FY 2012 level, but $44.3 million below the request. When including the request by the Department to transfer $365 million in mandatory Crime Victims Fund receipts to a number of discretionary grant programs, the bill provides a total of $409.3 million less than proposed by the Department.

        The bill provides funding at or near the requested level for the Department of Justice law enforcement agencies, including an increase above the request for the FBI to augment key capabilities related to cyber investigations, surveillance, and gang enforcement. Earlier this year, FBI Director Mueller warned that cyber attacks are becoming one of the biggest threats to America’s safety, possibly surpassing the threat level posed by terrorism. We believe that the Director is absolutely correct, and we are pleased that the Chairman has provided $23 million above the request for this priority. This additional funding is desperately needed in order to protect our nation, and we thank Chairman Wolf for his leadership in this area. (snip)

        Unfortunately, the bill provides no cost-of-living increases for the litigation divisions of the Department of Justice. The litigation offices, as a whole, received no funding increases in FY 2011 or FY 2012, and the funding level in the bill is $11.7 million less than the FY 2010 level and $40.2 million below the request.

        Without annual funding increases to cover inflationary costs, the litigation divisions are able to do less each year. The Civil Division returns $7 to the Treasury for every $1 we appropriate, by defeating unmeritorious claims against the United States and through recovering monies lost through fraud, waste, and violations of consumer protection laws.

        Under the House funding level, the Environment and Natural Resources Division (ENRD) could lose 12 attorney positions, and reduced resources could impact the ability of ENRD to vigorously pursue litigation against parties potentially responsible for the Deepwater Horizon oil spill.

        The Tax Division could lose up to 56 attorneys (14 percent), requiring the Division to decline approximately 2,000 cases and preventing the Division from pursuing affirmative litigation involving collections and bankruptcy cases. On average over the last three fiscal years, the Tax Division has annually collected $335 million in outstanding taxes, interest, and penalties through affirmative litigation.

        After a significant effort in FY 2010 to restore its base enforcement capacity, the Civil Rights Division has been hit particularly hard over the past few years, losing all of the ground it gained in FY 2010 to restore its capacity to protect civil rights and voting rights, enforce laws against hate crimes and human trafficking, and engage in other efforts to protect vulnerable individuals. Flat funding for the litigation offices in FY 2013 would cause the Civil Rights Division to fall even further behind.

        The bill also fails to provide the proposed program increases for financial and mortgage fraud enforcement by the litigation divisions. It provides only a portion of the increase proposed for the FBI for financial and mortgage fraud enforcement, and potentially makes available only a small portion of the funds proposed for the U.S. Attorneys for this purpose. We were pleased to hear Chairman Wolf state, during Committee consideration of the bill, that he is open to considering additional funding for financial and mortgage fraud enforcement at the FBI as we move further through the process. We believe the final allocation available to the subcommittee will be at or near the Senate level, and we hope the majority will also work with us to provide the requested financial and mortgage fraud enforcement funding for the litigation divisions and the U.S. Attorneys in the final bill.

      2. LucyLulu

        Seeing people or organizations as all bad or all good is a cognitive bias. Google “halo effect”.

        Oh my, are you calling our “black and white thinking” into question? For some of us the ability to hang onto reality rests solely upon the threads of our cognitive dysfunctions.

        JK…… :)

        1. Mel

          TVO’s latest Big Idea is an hour of Iain McGilchrist on the ideas behind his book The Master and his Emissary.

          Looks interesting. Thesis is that society lately has reinforced use of left-brain processes (schematic, abstract, logical, un-self-critical) far beyond their worth. Seems related to the Dimon story as well: “But VaR is a particularly troubling example, more so because it is sufficiently, dangerously simple minded enough that regulators and managers a step or two removed from markets have become overly attached to its deceptive simplicity.”

          The problem of how to manage an operation that you don’t understand is still … a problem …

      3. leapfrog

        I suppose I am guilty as charged. I see all insolvent TBTF corps who hand out taxpayer-funded bonuses to their C-executives as BAD. Don’t know that I can adjust my thinking there.

      4. Nathanael

        I’d pay more attention if it came from Fitch or Best, which investors still listen to.

        S&P and Moody’s have really no credibility and this seems like ass-covering.

  2. G3

    So what about the income for Moody’s via fees from the banks? Didn’t Moody and other ratings agencies get bucket loads of money from the banks for good ratings? Will Moody’s end up in the poor house now?

    1. wendy davis

      Along those lines, I’d mentioned in the comment stream on one of my diaries at my.fdl recently that I thought I remembered
      that the big banks could essentially shop around for better ratings if they didn’t like the first one. Am I remembering correctly? Or were bribes, I mean contributions, what determined all outcomes?

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