Moody’s or another agency threatens a downgrade or actually makes one. This causes the country which faces the action to explain to the capital markets why the risks of investing in its debt are not so risky. Investors become skeptical, which drives up what the nation must pay in interest. Those higher interest rates make it nearly impossible for the country to fund its deficits.

Moody’s placed Portugal’s A1 long-term and Prime-1 short-term government bond ratings on review for possible downgrade. The credit agency listed among its reasons:

(1) Uncertainties about Portugal’s longer-term economic vitality, which will be exacerbated by the impact of fiscal austerity;

(2) Concerns about Portugal’s ability to access the capital markets at a sustainable price; and

(3) Concerns about the possible impact on the government’s debt metrics of further support for the banking sector, which may be needed for the banks to regain access to the private capital markets.

These bear an uncanny resemblance to comments about Ireland and Spain recently made by one or more of the three credit agencies.

Capital markets investors complain that the ratings changes come after the credit problems are already well known. The ratings agencies say, in response, that it is only prudent to issue comments until there has been a careful examination of each situation. Neither point of view matters much to Portugal. It will have to continue to fight for its financial independence as the pessimism about the fates of Europe’s smaller nations increases.

The EU has decided not to offer unconditional support for countries like Portugal. Germany, the largest economy in the region, says it does not have bottomless pockets. A decision by the country to offer a tremendous amount of capital to support its neighbors would eventually damage its own rating, Germany says. The comments have the power of being true. China, the largest investor in sovereign debt, has also said it is worried that the countries in Europe have not found a way to solve their financial problems. If China becomes reluctant to invest in the region, borrowing costs might even go higher.

It is obvious to say that downgrades will continue as deficits in the region grow and the interest rates that must be paid on the paper rise. It is equally obvious that none of the financial organizations in the EU have offered a solution to the problem which can calm investors.

All of these problems have caused a desperate search for solutions. But, there are not any. The lines have already been drawn. There are no huge and ready pools of money to put capital into nations like Portugal. The country’s eurozone neighbors will not help it. A default is nearly inevitable. It will be rescued, but by that time it will no longer be sovereign. The price will be too steep.

Douglas A. McIntyre

Moody’s also said that a slowdown in the financial and real estate sectors were the primary reasons for Ireland’s trouble. The downgrade decision comes about a year after the fact and the information is almost certainly already priced into Ireland’s bondsMoody’s downgraded Portugal’s debt from AA2 to A1 on July 13. It said that the nation’s austerity measures were not sufficient to offset an economic expansion which barely had a pulse. Moody’s reasoned that Portugal’s deficit could not be managed with high national costs and falling treasury receipts. Analysts in the global capital markets had known those things for months. It is the reason the Portugal had to pay high interest rates on its sovereign debt.

Ironically, the Moody’s downgrades come at a time when the large institutions that trade in sovereign paper have become more confident in the region. The value of the euro has risen sharply in the last month to $1.2949 and there are signs that the improvement is not over. Financial support for the region’s economies, a series of funds worth nearly $1 trillion,  have calmed the markets, as has a series of government spending cuts in Greece, Spain, Germany, and the UK. Most other countries in the region faced with large deficits will likely follow the same model.

The liquidity crisis in Europe is far from over. Bank “stress tests” for financial firms in the region may show up some weak balance sheets, but those are likely to be aided by central banks, meaning they are not fatal problems.

The credit ratings agencies, in this case Moody’s, have shown again that they are nearly useless in the analysis of sovereign risk because they make a great noise about things that the markets have known for a long time

Douglas A. McIntyre

24/7 Wall St. will look at the Twitter posts at Reuters Biz, WSJ, Financial Times, CNN Money, MarketWatch, CNBC, and 24/7 Wall St. each day to see which stocks are most frequently mentioned. It is clear that in this area of social media these tweet are a sign of which companies the Twitter universe is interested in. These financial sites are followed by a combined 625,000 Twitter users which makes them a sizeable sample of Wall St.’s interests. In some cases, we will publish the actual tweets from the sites.

Among the most tweeted stocks on StockTwits are Alcoa (NYSE: AA), BP plc (NYSE: BP), Apple Inc (NASDAQ: AAPL), EURUSD, GBPUSD, Research-In-Motion (NASDAQ: RIMM), and Vivus Inc (NASDAQ: VVUS).NYT: BP Says New Well Cap Installed – http://nyti.ms/dC7FIf

CNN Money: Apple 2.0: iPhone 4: The Consumer Reports fiasco http://bit.ly/cvznPn $AAPL

WSJ: BMW Raises Outlook http://on.wsj.com/atVdh0

CNN Money: Moody’s downgrades Portugal’s debt http://bit.ly/9V1sdL

MarketWatch: Alcoa swings to profit, raises demand outlook by up to 12% http://on.mktw.net/a7ojBA

Reuters Biz: Goldman may seek extension in SEC case: report http://link.reuters.com/jyc37m

DailyFinance: Moody’s Downgrades Portugal Debt http://bit.ly/cbvOWF

Douglas A. McIntyre

Reuters:   BP plc (NYSE: BP) will test a new oil cap in place.

Reuters:   The Wall St. reform bill is nearing a final vote

Reuters:   Most Americans lack faith in Obama.

Reuters:   American International Group’s (NYSE: AIG) board will meet to determine plans for AIA.Reuters:   Microsoft Corporation (NASDAQ: MSFT) said that PC-based tablets will be better than the Apple Inc. (NASDAQ: AAPL) iPad.

Reuters:   Avis-Budget (NYSE: CAR) topped the bid of Hertz (NYSE: HTZ) to buy Dollar-Thrifty.

WSJ:   A new oil drilling ban will hurt the industry.

WSJ:   Consumer Reports put out a bad review of the iPhone 4.

WSJ:   Slow business access to credit hurts the economy.

WSJ:   The US subpoenaed Wall St banks on mortgage securities.

WSJ:   Hewlett-Packard (NYSE: HPQ), Dell Corporation (NYSE: DELL), and Fujitsu LTD will sell Microsoft’s new Azure cloud computing product.

WSJ:   The growth in China’s property market slowed.

WSJ:   GlaxoSmithKline (NYSE: GSK) may have withheld information about its Avandia drug.

WSJ:   Florida banks want a pass on new government balance sheet regulations.

NYT   Debt collection lawsuits are crowding courts.

NYT:   China factories are competing for labor

FT:   The BP plc spill will cost UK and US in tax receipts.

FT:   Alcoa’s (NYSE: AA) earnings were stronger than expected.

FT:   China put 1 billion euros in Spain’s bonds.

Bloomberg:   Some European banks will dodge new capital rules.

Douglas A. McIntyre

“Moody’s decision to initiate this review was prompted by (1) the deteriorating (short-term and long-term) economic growth prospects; (2) the challenges the government faces in achieving its fiscal targets; and (3) concerns over the impact of rising funding costs over the medium term”

The news is likely to add to the near panic in the capital markets which have growing concerns about deficits and national debt in Spain, Portugal, Ireland, Greece. A large number of economists have said that Greece will not be able to avoid defaulting on its sovereign paper. Nouriel Roubini recently commented that the southern European nation would be best off to renegotiate its debt in an orderly fashion now.

Behind much of the concern about the financial future of the Eurozone and its weakest nations are 1)signs that banks in the region are starved for capital and that stress tests of many of the financial firms will show that they are in trouble and need capital, and 2) a realization that austerity measures may not work. Government decisions to cut costs and raise taxes could be undermined by the actions of powerful unions and angry voters.

The increase in taxes in the weakest economies may also prove to be regressive and could actually hurt the treasury receipts in each of the countries.

The entire Moody’s opinion:

London, 30 June 2010 — Moody’s Investors Service has today placed Spain’s Aaa local and foreign currency government bond ratings on review for possible downgrade.

Moody’s decision to initiate this review was prompted by (1) the deteriorating (short-term and long-term) economic growth prospects; (2) the challenges the government faces in achieving its fiscal targets; and (3) concerns over the impact of rising funding costs over the medium term.

If at the conclusion of the review, Spain’s ratings are lowered, it would most likely be by one, or at most two, notches, according to Moody’s. The rating agency intends to conclude its review within a three-month period.

The Spanish government’s Prime-1 short-term rating is not affected by this review. Spain’s falls under the Eurozone’s Aaa regional ceilings, which are not affected by the review of the Spanish government’s ratings.

RATIONALE FOR REVIEW

“Spain’s growth prospects are weaker than those of other Aaa-rated sovereigns,” says Kathrin Muehlbronner, a Moody’s Vice President — Senior Analyst and lead analyst for Spain. In the short term, the government’s accelerated fiscal consolidation combined with the higher borrowing costs currently facing the government, consumers, and businesses will likely depress growth.

From a longer-term perspective, it will take several years for the economy to adjust to the fallout from the collapse of the real-estate boom, to reduce the high level of private sector indebtedness to levels more in line with other EU countries, and to find new, internal sources of economic growth. Accordingly, Moody’s now expects GDP growth to average just slightly above 1% over the entire 2010-2014 period.

The weaker growth trajectory in turn complicates an already very challenging fiscal consolidation programme. “Moody’s believes that more fundamental adjustments to key spending items will be required in order to achieve the government’s budget deficit targets,” says Ms Muehlbronner. Moody’s own forecasts for Spain’s fiscal deficits are higher than the government’s targets. According to Moody’s projections, Spain’s debt-to-GDP ratio is likely to rise to about 80% by 2014.

Moody’s noted that the government’s efforts to put forward structural reforms — in the labour market, the banking sector and potentially also the pension system — are positive developments that could help revive Spain’s growth potential in the medium term. These proposals, however, have yet to restore investor confidence. As a result, the government’s funding costs remain elevated and its debt affordability ratio (the ratio of interest on the debt to government revenues) is likely to become increasingly out of line with those of other top-rated countries over time.

FACTORS TO BE CONSIDERED IN THE REVIEW

The review of Spain’s sovereign rating will assess the broader political commitment to structural reform and the likelihood that the reforms approved by parliament will be far-reaching enough to significantly stimulate long-term growth. Specifically, Moody’s will also review Spain’s upcoming 2011 budget plan, due to be presented in September, to assess whether the deficit target for 2011 can be achieved. The rating agency will also consider the contribution from the country’s regional and local governments towards the fiscal consolidation effort.

The outcome of the review could also be affected if the costs of recapitalizing Spain’s banking sector, which Moody’s currently believes to be manageable, were to turn out to be much larger than expected.

For further information, please see Moody’s Special Comment “Key Drivers of Decision to Review Spain’s Aaa for Possible Downgrade” available on www.moodys.com.

PREVIOUS RATING ACTION & METHODOLOGY

Moody’s last rating action affecting Spain was implemented on 29 July 2009, when the rating agency affirmed Spain’s Aaa local and foreign currency government bond ratings and their stable outlook. The last rating action on Spain prior to that was taken on 24 May 2006, when the rating agency affirmed the Aaa foreign and domestic currency country ceilings of the Eurozone. Prior to that, the last rating action on Spain was implemented on 13 December 2001, when Moody’s raised the government’s local and foreign currency bond ratings to Aaa with a stable outlook from Aa2/positive.

The principal methodology used in rating the government of Spain is “Moody’s Sovereign Bond Methodology”, published in 2008, which can be found at www.moodys.com in the Rating Methodologies sub-directory under the Research & Ratings tab. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found in the Rating Methodologies sub-directory on Moody’s website.

Douglas A. McIntyre

The cut in Greece would take its debt to “junk”

From the Moody’s note written by analsyt Pierre Cailleteau:

Ireland (Aa1, negative outlook): No significant rating action is expected in the short run. The negative outlook reflects the risk of a further, gradual deterioration in terms of both debt affordability – i.e. the share of government revenues used for interest payments – and finance ability – i.e. the cost at which Ireland could raise further debt. The rating is supported by the fact that both Ireland’s economic strength and its institutional strength compare very favourably to some of the countries in the southern periphery of EMU.

» Portugal (Aa2, on review for possible downgrade): We expect to conclude the review in the coming four weeks or so. A downgrade to Aa3 is probable; but an adjustment to A1 cannot be ruled out. It will depend on the tug of war between sharper fiscal adjustment on one side, and the higher cost of funding and continued anaemic growth prospects on the other.

» Greece (A3, on review for possible downgrade): We expect to conclude our review in the coming four weeks. The migration will most likely be substantial, probably within the Baa range; but an adjustment to below investment grade is also possible. This will depend on developments in the Greek economy once the fog of financial panic, support-mobilisation and street demonstrations dissipates. The country’s debt is large but not unbearable; however, the required adjustment is obviously very painful, and short-term economic prospects are clearly dismal – though not out of proportion with developments already seen in several European economies last year. Once we have concluded our review, we will publish a detailed explanation of our rationale for re-positioning the rating.

The Greek ratings cut would make a joke of the entire EU financial stability plan.  It seems that the legal attacks against Moody’s have made the ratings agency absurdly cautious.

Douglas A. McIntyre

Moody’s and S&P have begun to do a great deal of damage to the prospects that the sovereign debt crisis will be contained in Greece. This may be in a reaction to how badly they were burned by MBS ratings which were part of the cause of the credit crisis.

Moody’s and S&P are under pressure from investigations by the federal government and several state attorneys general. Almost all of these inquiries could end in fines and more regulation.

One reasonable reaction by the agencies would be excessive caution which, as the pendulum swings, may lead investors astray again. But, in this case it is only another way to cause investors to go astray.

Douglas A. McIntyre

“In light of the muted recovery, discretionary fiscal adjustment is now the principal means of repairing the damage that the global crisis has inflicted on government balance sheets,” Pierre Cailleteau, managing director of Moody’s Sovereign Risk Group, said in a statement according to MarketWatch. And, that is at the core of the problem in general and in the US in particular.

The American government is still for a deficit of over $1.5 trillion this year. If the economy does not recover, and with its tax receipts lackluster, the red ink could be as large again in 2011. The unemployment that creates low IRS collections also leads the government, at least based on its current philosophy, to ratchet up spending for the social safety net, including extended unemployment benefits.

The Administration and Congress jawbone the deficit issue, but there is no sign that they intend to do anything meaningful about it. Like almost all countries burdened by debt, the US hopes that rapid GDP expansion, which will happen at some point in the relatively near future, will cause tax receipts to fill the nation’s treasury again.

China’s premier Wen Jiabao recently spoke about a global double-dip recession as a possible outcome of the still-boiling financial crisis and high unemployment. Those are odd words from the mouth of a man who runs a nation which has nearly 10% GDP growth. But, even from Beijing he can see what Moody’s sees. The aggregate foreign debt of the world’s largest developed nations will grow for years.

Douglas A. McIntyre

We have noted before, as have many others, that this is a mere dance right now that is nothing short of a game to avoid a sudden financial collapse.  It’s almost like the Treasury hiring out counterfeiters to print $1Trillion to put into circulation so that it doesn’t have to officially count the funds as being in the money supply.

We still think some of these mergers will be mandated rather than preferred.  Is there a more appropriate day than Leap Day to put this out?  Maybe April 1.  The good news is that Ambac stock is now up on the day.  Maybe stock buyers are getting to buy stock with that counterfeit money.  We don’t want to see a market crash or a recession that turns into a depression either.  But some serious games are being played in the system right now, and all the players know it.

Jon C. Ogg
February 29, 2008

Barron’s was very negative on this one even last summer about the exposure to mortgages being overlooked.  Back then MBIA shares traded hands at $65-ish.  But now Barron’s is saying "the market has gotten too bearish on the bond insurer."   Barron’s now summarizes the situation at MBIA as: "MBIA was due for a setback. But at its current price, it’s being punished too severely for bond-industry problems." The entire article is online and you can see the other points there.

This more or less denotes that much more of the woes at MBIA is more in sympathy with Ambac Financial (NYSE: ABK) than to the exact exposure that MBIA has in reality.  This article does not at all indicate that Ambac will escape the storm like MBIA can. It also notes what we observed last week with MBIA’s new $1 billion in capital surplus notes with a 14% yield have fallen down to 75 cents on the dollar.  Its credit protection costs also jumped to previously unheard of levels.

Barron’s also points out that even though large value investors such as M.J. Whitman’s Third Avenue Fund, Davis Select Advisors, and Warburg Pincus are down significantly, they are now key investors in MBIA.  Another Barron’s attribute of this being cheap is that it notes "MBIA remains a profitable entity, but its shares are off nearly 90% from their highs." 

One key issue that Barron’s is hinging much of the contra-mortality of MBIA is that any future claims losses from principal and interest will be dribbled out a the 20-year (or in some cases 50-year) time period; hence "the present value of claims cost dwindles dramatically in relative significance."  This also notes that when Warburg Pincus ran its worst case stress test under "Armageddon-like housing and other economic assumptions" that its annual loss expenses came to no more than around $250 million per year under the most harsh conditions.  This even points to some claims of liquidation value being $30 to $40 per share, although we would caution that others are arguing that the death sentence for all of these has already been determined and the formal verdict just hasn’t been announced.

There are other things at work that could topple all of these companies, even if the original blame lies elsewhere.  The new issue for 2008 is "counterparty risk" and the implications of systematic counterparty failure are disastrous.  This is the new term that bears will use (and are already using) to put pressure on financial and other sector stocks, even if it is not a new term nor a new issue at all.  The reality is that the blowup at ACA would end up looking like a cartoon in comparison.

Frankly, an intervention via a government stimulus package may or may not help, and you can find the criticisms and support all over the place on that issue.  An intervention with a financial stimulus plan for the public may not be enough if there is actual counterparty failure and outright systematic default.  If a stimulus package is presented whereby the government acts as a backstop to prevent the counterparty defaults from being 100%, then this entire issue may be minimized drastically and the fears of a 1929 crash or 1987 crash would effectively be put to rest.  If some of the figures really do pan out the way some of the calculations we have seen, then the expected meltdown of these insurers could literally have dire consequences in the financial markets.  We have even noted the possibility of a 1,000 point drop in the DJIA.

Perhaps the single best tool to use outside of personal opinions derived from all the facts that can be gathered is to look at the trading volume.  The trading volume measured by inflows and outflows of dollars in stocks and sectors will tell you immediately what Wall Street is thinking.  So far that verdict IS that a death sentence is most likely.  The reality is that some firms have yet to implode.  If we start seeing counterparty defaults then we will see more waves of writedowns from major financial institutions.  To make matters worse, many of those institutions may not survive counterparty implosions that leave them on their own. 

We recently pondered a scenario where Warren Buffett and Berkshire Hathaway (NYSE: BRK-A) could save the day.  The reality there is that he would save the day if it ends up looking like a layup, but he won’t come to the rescue just because these need rescuing. This is also just one more piece of the puzzle in what we have deemed as financial mergers becoming mandated rather than preferred.

Right now the situation is deemed as almost entirely up to the ratings agencies like Moody’s and S&P after "negative credit watch" turned this further into another house of cards.  The worst case scenario very well may end up being another Enron situation, with the difference being that the widespread impact of the bond insurers failing having a much broader economic impact on the entire financial system.  It goes without saying that this holiday-shortened week will be more crucial for all the bond insurers.

Jon C. Ogg
January 21, 2008