Capital Markets

Not in the Mood

In Europe, Moody’s expects almost uniformly negative pressure on ratings, with more severe consequences for those on the low end of the rating scale.
John ZhuJanuary 23, 2009

Ratings agencies are under intense criticism for their perceived slow recognition of the financial excesses that led to the current crisis. In their defence, they argue that ratings are supposed to be smoothed over the business cycle. But according Jean-Michel Carayon, group credit officer for corporate finance EMEA at Moody’s, in the current uncertain and volatile environment “it’s becoming a major challenge to rate companies because there is great uncertainty about the timing of the cycle.”

In a presentation this week on corporate credit trends in Europe, the Middle East and Africa, Carayon explained that the ratings agency is now developing models for a number of distinct macroeconomic scenarios, all of which have some “material probability” of being realised. Moody’s initially thought “global healing” would be the theme for 2009 and 2010, but this has evolved into “stagflation,” or “low inflation and mild output contraction” in 2009 and “very low growth” in 2010. “If current policies by government fully succeed, a ‘global resiliency’ [scenario] might be possible,” Carayon added. That’s a big “if.”

Carayon clarified that Moody’s has not seen any indication that the region is headed towards its worst case scenario, “global disintegration.” This scenario envisages developed economies slipping into a prolonged funk along the lines of Japan in the 1990s: deflation, an “L-shaped” recession lasting to at least 2010 and no meaningful improvement in the credit markets.

Even if this doomsday scenario is unlikely, the latest statistics shared by Moody’s were scary enough. Companies with a “negative outlook” or “under review for possible downgrade” increased to almost 30% of Moody’s ratings universe in the fourth quarter of last year, compared with less than 20% at the end of the previous quarter. This means that ratings under review for downgrade are now more than 12 times higher than those under review for upgrade (compared to five times higher in the third quarter of last year).

Under these circumstances, it’s no surprise that European default rates are unlikely to remain near current levels, around 2% in December. Carayon said that the main driver of defaults in 2009 will be covenant breaches, especially for high-yield issuers with little headroom. Around 75% of these issuers are subject to at least one covenant, compared with only 45% of investment grade issuers (who are more likely to secure waivers from banks if they run into trouble). Moody’s expects the default rate for European high-yield corporate debt will shoot up to 18.3% over the next twelve months, rising above forecasts for the global (15.1%) and US (15.3%) default rates.

This will be bad news for all CFOs, including those at relatively healthy companies, as the lines blur between investment and non-investment grades. The cost of debt has “significantly increased,” Carayon concluded, “not only for speculative grade issuers, but also in the low investment grade range.”