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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Blog

Mar 23

Written by: Donald van Deventer
3/23/2009 10:06 AM 

Today, March 23, 2009, Moody's Investors Service joined Standard & Poor's in erasing GE's triple-A rating from the record books.  Moody's had maintained its Aaa rating on GE since 1967, and Standard & Poor's had held GE at the AAA level since 1956.

As we noted in the March 20 post, the average behavior of the rating agencies over 282,000 observations of their (specifically S&P) past ratings behavior leads one to the conclusion that, by their own standards, GE would currently be rated BBB (Baa2).  Why are the rating agencies deviating so significantly from the standard that prevailed over this huge sample from 1995 to October 2004?  Many market participants have noted that only downgrades from AAA/Aaa and from investment grade to "junk" status result in bond price movements upon the announcement of the ratings change because of the large number of investors with legacy ratings-related investment policies.  In the case of the current downgrades of GE, the market seems to have anticipated the downgrade well in advance.  Why is the current downgrade so timid if BBB/Baa2 is the level that average behavior by the rating agencies would generate?

In March 9's post "Ratings Chernobyl," Robert Jarrow and I note the comment from Ed Emmer, former head of corporate ratings at S&P, that the rating agencies feel a special burden to avoid "Type 1" error, the error of being more harsh in rating companies than the reality, because of the damage this can do for the rated firm.  In GE's case, however, the market and the U.S. government have moved so strongly in advance of the rating agencies that there is no risk of Type 1 error at all.  The U.S. government had had to intervene to support GE's commercial paper issuance and, as noted March 20, credit default swaps at GE are already over 700 basis points.  Instead, my guess is that the rating agencies are worried about another backlash from moving the rating by too many notches at once.  They continue to argue in public that "smooth" adjustments and stability of ratings is highly prized by those who use them, in spite of the obvious corollary that smoothness and stability can only be purchased with a decline in accuracy.

In GE's case, credit quality has fallen considerably from its heights and S&P and Moody's have revealed their commercial judgments: S&P can move at most one notch (to AA+) in the initial downgrade and Moody's can move at most 2 notches.  To reach the ratings level of BBB/Baa implied by past rating agency behavior, Moody's has another 7 notches to go, and S&P has 8.  Only a dramatic reversal of the current recession will spare them this long march to BBB for GE.

Donald R. van Deventer

Kamakura Corporation

Honolulu, March 23, 2009