So much for the conspiracy theories! Moody’s, which is 20% owned by Berkshire Hathaway, today downgraded the long term issuer rating of Berkshire two notches from Aaa to Aa2, and the Issuer Financial Strength (IFS) rating of most of the insurance subsidiaries one notch from Aaa to Aa1. After taking this action, Moody’s declared Berkshire Hathaway’s ratings outlook to be “stable”. For those who have signed up for a free account with Moody’s, the text of the action can be found here.
Late to the Party?
Moody’s appears to be a bit late to the party when it comes to examining Berkshire Hathaway’s credit rating. Fitch Ratings was the first to take action on March 12 when it cut Berkshire’s Issuer Default Rating to AA+ from AAA, kept the insurance subsidiaries rated at AAA, but placed a negative outlook on all entities. Standard & Poor’s issued a negative outlook on March 24 but reaffirmed Berkshire’s AAA rating for the time being. Far from being influenced by Berkshire’s minority ownership, Moody’s appears to have taken the harshest action so far, albeit close to a month after Fitch first took action.
I suppose that some may think that the late reaction may have been due to the influence of Berkshire’s ownership on Moody’s management, but this seems very unlikely. Buffett himself has been quoted as saying that he’s had no contact with Moody’s management:
“It would be wrong if we tried to pressure Moody’s but that’s never happened,” Buffett said in an interview in May 2008. “I have no contact with the management of Moody’s. I can’t recall ever calling them in my life.”
It seems obvious to me that no leverage would be used in this situation. Not only would it directly contradict Buffett’s own statements but it would be completely out of character with Berkshire’s code of business ethics.
“We’re Not Irrelevant!!!”
The general sense that I get from the Fitch and Moody’s downgrade actions and from Standard & Poor’s negative outlook is that the ratings firms are desperately trying to prove that they are again relevant after many embarrassing cases where AAA ratings were assigned to mortgage backed securities and the fact that American International Group enjoyed a AAA rating until the disastrous events of September 2008. As a result, harsh actions are being taken in the case of Berkshire Hathaway despite what I consider to be dubious logic at best. Indeed, Fitch clearly stated current macroeconomic factors make AAA ratings inappropriate for ANY financial oriented enterprise. Given that ratings are supposed to be an aid to predicting future defaults, it would have been beneficial for the ratings firms to have this revelation at this time last year rather than now.
Moody’s Makes a Weak Case
Let’s take a brief look at the case made by Moody’s in today’s action. The statement starts out with the obvious: Berkshire’s security holdings have declined in market value over the past year and many of the operating companies have been impacted by the recession:
“Today’s rating actions reflect the impact on Berkshire’s key businesses of the severe decline in equity markets over the past year as well as the protracted economic recession,” said Bruce Ballentine, Moody’s lead analyst for Berkshire. For National Indemnity, falling stock prices have reduced its investment portfolio value and, in turn, its capital cushion relative to ongoing insurance and investment exposures. For some of Berkshire’s non-insurance businesses, the recession has caused a meaningful drop in earnings and cash flows, particularly for businesses tied to the US housing market, construction, retailing or consumer finance. “These extraordinary market pressures have reduced the excess cushion available from National Indemnity and the other affected operations to support potential funding needs of the parent company,” said Mr. Ballentine.
While it is obvious that Berkshire’s holdings of marketable securities have dropped in value, as I reported at the end of March, it is far from clear to me that the level of decline has sufficiently impacted statutory capital levels such that the risk of default on Berkshire’s contractual obligations has increased to any material degree. The question for the ratings firm is not whether Berkshire’s shareholders have experienced a decline in the value of their holdings but whether Berkshire’s creditors might face a higher risk of default. Despite the decline in the equity portfolio, the combination of the remaining market value and the earnings power of the operating companies combine to make it inconceivable that a default would occur.
Moody’s does recognize that many subsidiaries are uncorrelated to the overall economy and will continue to perform well. There is also mention of the underwriting record of the insurance subsidiaries. I find the reference to the volatility created by Berkshire’s widely misunderstood derivatives portfolio to be perplexing based on the features of those derivatives and the fact that any cash outlays related to the derivatives will occur after most outstanding Berkshire notes will mature. The analyst appears to be concerned with the mark to market impact of the derivatives, but this has nothing to do with liquidity or ability to fulfill contractual obligations:
The company has several businesses that are relatively uncorrelated to the general economy and that continue to perform well. These include the diversified utility group under MidAmerican Energy Holdings Company along with certain manufacturing and service businesses. Berkshire’s insurance segment continues to generate healthy underwriting gains — on average over time — and the firm is reducing its aggregate exposure to natural catastrophes in light of the reduced capital position at National Indemnity. Other challenges facing the company include the potential for increased credit losses at Clayton Homes, the manufactured housing lender, although the credit performance remains well above industry norms. Berkshire is also exposed to heightened volatility in its earnings and capital base related to market value fluctuations within its large portfolio of equity derivatives.
Ratings Firms Credibility Seriously Harmed
Following the ratings debacles during the economic downturn, it is notable that the ratings firms still receive as much attention as they do. However, the reality is that the actions of the ratings firms do matter. I believe that Berkshire’s funding costs may have increased to some extent due to these actions, although the exact cause is hard to pinpoint.
Although Berkshire is not subject to posting higher levels of collateral on derivatives contracts due to the downgrades, many other firms are not in a similar position. The actions of the ratings firms have significant impact yet the track record over the past year does not inspire any confidence whether one is feeling safe with an affirmed AAA security or nervous due to the downgrade of a AAA security. A number of reform proposals have been circulating regarding the role of the ratings firms and it will be interesting to watch how these efforts play out in the coming months.