Standard & Poor's Ratings Services' corporate credit ratings reflect both company-specific and general market risks to the extent that such risks affect a company's ability to service its credit obligations. The generally benign economic and financial conditions in recent years have helped create a stable credit risk environment. But now, those conditions are beginning to change, albeit not yet to a degree that clearly signals a major shift in the financial landscape. Some market participants are speculating that the difficulties in the U.S. subprime mortgage market may yet spill over into other markets and lead to a more general deterioration in credit quality. We believe some spillover is likely--and is already occurring to a limited extent--but we think it is important to keep the current situation in perspective when attempting to gauge the risk that widespread troubles will extend to other markets.
Lessons from the past 20 years make it clear that instability in one market can quickly spread to others--and do in unpredictable and alarming ways. These same lessons, however, also demonstrate that modern markets adjust rapidly to crises and tend to limit the damage before uncontrollable systemic disruption takes hold. The global markets have grown such that they are now less vulnerable to general liquidity scares triggered by isolated disruptions. The prevalence of mark-to-market accounting, credit-default swaps, and other tools of modern finance allows risk to be repriced quickly as conditions change. This rapid repricing, paradoxically, tends to aggravate short-term instability. But drawing attention to problems as they emerge forces managers to restructure troubled portfolios or entities before dangers can reach explosive proportions and threaten a broad-based implosion of credit quality.
The risk-management and liquidity practices of large financial institutions and industrial corporations obviously do not protect them fully against volatile exposures. But these practices have improved enough that the investment-grade companies we rate generally have the systems and skills to identify potential threats to their solvency and isolate the effect of such threats.
For instance, U.S. corporate defaults reached their highest levels in decades during the 2001 recession, yet no major financial institutions were threatened, and the general economic recession proved to be relatively mild. Four years earlier, the Asian financial crisis wreaked havoc on regional economies and set into motion a far-ranging series of events that included currency dislocations, the Russian default, and, eventually, the collapse of Long Term Capital Management, a major hedge fund whose core backers included large financial institutions in the U.S. and Europe. But once again, these events ran their course with limited consequences, outside of Asia, on leading economies or on the credit quality of major companies or financial institutions.
There is presently no concrete evidence to suggest that problems in the subprime mortgage market will reach the magnitude experienced during these earlier crises, much less that they will evolve into more general or severe systemic instability. But it is also not possible to say with certainty that the problems are fully contained. The effects of the turmoil in the U.S. mortgage markets have already made themselves felt elsewhere; the widely publicized problems at two bond funds managed by U.S. investment bank
Bear Stearns Cos. Inc. have reverberated in other parts of the world. In Australia, funds managed by
Macquarie Bank Ltd.,
Basis Capital Pty. Ltd., and Absolute Capital Group Ltd. have suffered severe losses, and the German bank
IKB Deutsche Industriebank AG has forced its CEO to resign, all because of exposure to the U.S. subprime mortgage market. No one can rule out the possibility that more such incidents will surface before the global markets have fully digested these exposures.
In the U.S., growing investor caution is forcing a contraction in the market for collateralized debt obligations (CDOs) and may hinder highly leveraged industrial companies from managing their refinancing needs with the same flexibility they had in the recent past. In a recent research report, Standard & Poor's Managing Director Diane Vazza pointed out that for the first time, more than half of Standard & Poor's ratings on U.S. corporate entities, including financial services companies, now fall below investment grade (see "
U.S. Ratings Distribution: A Speculative-Grade World," published Aug. 1, 2007, on RatingsDirect, the real-time Web-based source for Standard & Poor's credit ratings, research, and risk analysis). For industrial companies alone, this percentage is well beyond 50% and has been increasing steadily for years.
In an ongoing series of commentaries titled "
Special Report: The Leveraging of America," our Industrials analysts have documented this trend in depth, highlighting the role that LBOs, leveraged mergers, and other forms of recapitalization have played in increasing balance sheet leverage and reducing credit quality among U.S. industrial companies. We have believed for some time that this leverage-driven decline in ratings was foreshadowing a likely increase in corporate defaults. This scenario has not materialized to date, in part because the extraordinary liquidity in the market has cushioned financial risk affecting leveraged companies. Our ratings in the leveraged sector fully reflect the likelihood that such liquidity conditions are not permanent, so the market should not be surprised if defaults among leveraged companies begin to rise.
As we did in 2001, Standard & Poor's is closely reviewing potential vulnerabilities to liquidity stress and situations where maintaining the current ratings depends on a divestiture or other strategic restructuring that current liquidity disruptions could delay or impair.
At the same time, we believe many other issuers remain well-insulated from external shocks. Despite the current market instability, for instance, we have during the past two weeks raised the ratings on two major financial institutions. On July 30, we raised our ratings on
Morgan Stanley to AA-/Stable/A-1+ from A+/Positive/A-1 and on Aug. 2, we raised our ratings on
Deutsche Bank AG to AA/Stable/A-1+ from AA-/Positive/A-1+. In both cases, the upgrades reflected improvements in the firms' fundamental credit profiles and indicated our confidence that the world's strongest financial institutions are resilient enough today to withstand significant cyclical systemic stress without experiencing destabilizing consequences.
Analytic services provided by Standard & Poor's Ratings Services (Ratings Services) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor's may have information that is not available to Ratings Services. Standard & Poor's has established policies and procedures to maintain the confidentiality of non-public information received during the ratings process.
Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or third parties participating in marketing the securities. While Standard & Poor's reserves the right to disseminate the rating, it receives no payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
