Friday, October 22, 2010

The Mother of All Negative Credit Watches

The rating service, Fitch, has just put most of the U.S banking sector on credit watch, with negative implications. The move is made as the result of the belief by Fitch that the banking system may lose government support for different grades of its debt, based on a new proposed rule by the FDIC,that comes about because of the Dodd-Frank Act.

Below is the statement issued by Fitch:
Today, Fitch Ratings issued a number of separate press releases placing on Rating Watch Negative most U.S. bank and bank holding companies’ Support Ratings, Support Floors and other ratings that are sovereign-support dependent.

The two companies mostly impacted by this announcement are Bank of America Corporation and Citigroup, Inc. This is due to the fact that both entities’, and their related subsidiaries’, Issuer Default Ratings (IDRs) and their respective senior debt obligations have benefited from support provided by the U.S. government.

At the present time, Fitch’s long-term ‘A+’ IDR ratings for Citigroup and Bank of America incorporate a three-notch uplift for the long-term rating and a two-notch uplift for the ‘F1+’ short-term ratings. If Fitch determines on a go forward basis that support from the sovereign state can no longer be relied upon it is not certain that Fitch would immediately lower the IDRs of Bank of America or Citigroup to their unsupported rating levels. Over the near to intermediate term, Fitch’s fundamental credit assessment of Bank of America and Citigroup will continue to consider existing support already received, such as debt still outstanding issued under the Federal Deposit Insurance Corp. (FDIC’s) Temporary Liquidity Guaranty Program (TLGP), in its ratings of those institutions. As a result, the IDRs will continue to incorporate support received during the crisis, as well as improvements in intrinsic financial profiles and expectations for continued improvement.

Each of these companies has maintained a ‘1′ Support Rating, translating into a Support Rating Floor of ‘A+’, since the depths of the recent financial crisis after each firm received and benefited from extraordinary direct support from the U.S. government. Fitch’s rating criteria calls for the assignment of the ‘higher-of’ either the companies’ Support Rating Floor of ‘A+’ or its perceived fundamental stand-alone IDR rating (excluding support), which is currently ‘BBB+/F2′ for both affected companies. Since Fitch is placing on Rating Watch Negative all U.S. bank and bank holding companies’ Support Ratings and Support Rating Floors, the IDRs of Bank of America and Citigroup and their respective sovereign support dependent ratings are also placed on Rating Watch Negative. The IDR and issue-level ratings for all other banking companies, except for Bank of America and Citigroup and certain related affiliates, are unaffected by today’s actions since the current IDR ratings are all above their current Support Rating Floors.

Today’s actions follow Fitch’s interpretation of the recently released Notice of Public Rulemaking ‘Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act’ (proposed rule or NPR), which was issued by the FDIC on Oct. 12, 2010. The proposed rule will govern the way the FDIC implements the resolution of financial institutions, such as bank and insurance holding companies or other non-bank financial institutions deemed to be systemically important, an authority granted to the agency by Dodd-Frank. The NPR reiterates that under no circumstances should taxpayers ever be called upon to bail out systemically important financial institutions in the future, nor be exposed to loss in the resolution of these companies. While the NPR also reiterates the FDIC’s mission of resolving institutions in a manner that ‘maximizes the value of the company’s assets, minimizes losses, mitigates [systemic] risk and minimizes moral hazard,’ it nevertheless makes clear that creditors, including senior bondholders, should bear their proportion of the loss in an orderly resolution. This more stringent mandate to impose losses on senior unsecured creditors calls into question the very core of Fitch’s Support rating framework, the likelihood of full and timely payment in the event that the rated institution faces serious financial deterioration in the future.

Resolution of the Rating Watches will be based in part on language from the final rule once formally adopted as well as Fitch’s view on how the final rule will impact its view of support. The FDIC’s proposed rule is likely to mean that should intervention be necessary some creditors, namely senior debt, subordinated debt, and preferred and common shareholders will incur losses consistent with their treatment as if the entity filed a Chapter 7 (liquidation) bankruptcy petition. Importantly, Fitch has not imputed sovereign support in its ratings for bank holding company creditors, i.e. most U.S. bank holding companies carry a ‘5′ Support rating.

Fitch believes that the NPR is one of many across numerous jurisdictions globally to govern how policy makers and regulators may address failing or failed institutions in the future. Recently introduced resolution regimes in some countries in Europe have so far provided similar wide-ranging powers to the banking authorities to impose losses on bank creditors but have, nevertheless, left open the possibility of taxpayer support.

The proposed NPR appears to divide senior creditors’ claims by maturity and stated purpose and introduces a number of considerations for Fitch’s ratings of these systemically important institutions. Fitch notes that some obligations, including short-term senior debt and certain other creditors such as ‘commercial lenders or other providers of financing who have made lines of credit available to the covered financial company that are essential for its continued operation and orderly liquidation’ are specifically differentiated from senior bondholders in the NPR. Should this carve out provision remain as part of the final rules, Fitch would need to consider how best it would rate the segregated obligations.

The proposed rule, as required by U.S. law, is subject to a public comment period of at least 30 days from publication in the Federal Register so it is important to note that material changes to the proposal could occur before enactment. Once implemented, it is believed that the proposed rule will serve as the road map by which the FDIC implements its expanded authority in the resolution of a systemically important failed institution.

In the past, systemically important institutions that became troubled typically received some form of federal support and/or regulatory forbearance that allowed them to continue operating through a rehabilitation period, with creditors and shareholders often becoming significant beneficiaries. The FDIC has used a ‘least cost [to the deposit insurance fund] resolution’ approach in carrying out its resolution activities since the Financial Institutions Regulation, Reform and Improvement Act (FIRREA) of 1989. This approach is preserved in the NPR and is consistent with the Dodd-Frank mandate of maximizing the value of assets and minimizing losses. The proposed rule additionally preserves many tools for the FDIC to use to further incorporate the requirements of Dodd-Frank that resolutions mitigate systemic risk and minimize moral hazard.

Fitch has long recognized through its Support Ratings the role that support plays in global banking. In most developed markets, governments have historically taken a dual approach to assuring the stability of their financial infrastructure including strong regulatory oversight on the front end and backstopping critical components of the system in times of duress. The proposed rule for implementing Dodd-Frank preserves a wide array of tools for the FDIC to resolve systemically important institutions while also mitigating systemic risk and financial contagion. Under the proposed resolution approach, select creditors may benefit from some forms of support under certain circumstances and where, in the judgment of the FDIC, the alternatives would ultimately put the system at greater risk. That said, whereas bondholders, both senior and subordinated, and even shareholders, have benefited from support in the past, direct support for these creditors is effectively prohibited under Dodd-Frank

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