The SEC has just release for comment (within an aggressive 30 day period), their proposal for improving the process at credit rating agencies (NRSROs). 

One suggested change is:

Require credit rating agencies to publish performance statistics for 1, 3 and 10 years within each rating category, in a way that faciliates comparison with their competitors in the industry.

Shockingly, this adds a hint of competition to an industry that is an oligopoly.  It is a slow move towards the word most hated and feared by Moody’s, S&P and Fitch - COMPETITION.   In a capitalist economy, lack of competition can lead to inefficient and ineffective markets….something that is still endemic in the NRSRO industry today.

We firmly believe this disclosure is a step in the right direction.  It might even get investors to realize how truly imperfect credit ratings are, and how important independent credit research is.  It should also be a stark reminder to investors that ALL portfolios with credit risk are subject to losses which can indeed be anticipated and analyzed in advance. 

Unsurprisingly, we are called upon to provide such quantitative analyses for our client portfolios.  Each portfolio exhibits a different expected loss distribution, but all portfolios’ credit loss distributions tend not to be ‘normal’ and are subject to severe negative spikes in losses in certain ‘unusual’ cases. 

Given the current and expected state of the economy, perhaps it is time for analysis of expected loss distributions in your company’s portfolio?

Last December, in a blog entry entitled, "Credit Risk: Prepare for What Will Come Next" we warned of focusing on the ‘headlines’ of sub prime problems without considering "good old fashhioned credit risk".  We noted:

‘What’s the next shoe to fall in the credit risk arena?’ may not be the correct question.  Perhaps ‘What and how many shoes?’ is a better question.

Now, Moody’s has confirmed our thoughts with a recent report, as noted by Reuters:

A record $772 billion of U.S. corporate debt may be put on review for downgrade this quarter as financial firms stumble and rising commodity prices take a toll on industrial companies, according to Moody’s Investors Service.

The previous record for downgrade reviews was $543 billion in the third quarter of 2001, a year of massive bankruptcies as accounting scandals and recession toppled corporate giants. Downgrade reviews for this quarter are on pace to top the $593 billion reported for all of last year, according to a report released late on Wednesday.

We’ve been in recent meetings with some investment managers who see value in the investment grade corporate market because spreads are predicting defaults in excess of those seen back in 2001.  Alas, these managers may be too sanguine if Moody’s predictions, which are pointing to worse credit conditions than 2001, come to pass.

The report goes on to say: 

"Three clear trends have stood out among U.S. issuers subject to recent downgrade reviews: financial firms hurt by holdings of toxic structured financial products, industrial firms squeezed by rising commodity prices, and firms with direct exposure to the discretionary spending of the U.S. consumer," according  to Moody’s statistical economist Benjamin Garber.

In the case of financial firms, the reliance on leverage is endemic; and for firms with direct exposure to discretionary consumer spending, leverage has been a strong contributing reason for revenue gains. 

The rising tide of credit risk will make your investment managers’ tasks more difficult.  However, it is incumbent upon insurers to carefully question, understand and monitor the process or credit risk management at those investment management firms.

And, as noted in our earlier blog:

Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve.  We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.  

There are many different ways to perform such an analysis.  However, using credit rating transition matrices, credit default swap spreads, long term credit default performance as well as stress testing that performance is a good start. 

It is much better to be prepared now than surprised later.