MOODY’S INVESTORS SERVICE made a dramatic and rapid revision to its joint default analysis (JDA) in March following widespread complaints that it had created a ridiculous disparity between senior unsecured bank ratings and the underlying intrinsic financial risk of the same banks. Few could make sense of the dramatic changes, which raised several banks’ senior debt ratings close to or at the sovereign level – as well as creating numerous other anomalies.

The strength of the market’s ridicule of Moody’s was quite extraordinary. Bankers asked if the JDA acronym stood for joke default analysis, research pieces with titles such as Moody’s makes an Aaas of itself were published. Normally diligent bank analysts spent time devising disparaging commentary on Moody’s for internet-based Bollywood movies.

Moody’s proclaimed that its new methodology was highly transparent and straightforward, but it opened up a philosophical chasm between itself and the other ratings agencies, including Standard & Poor’s, Fitch Ratings and Dominion Bond Ratings Service.

"The market has expressed the view – going back to the post Enron era – that it would like replicable, understandable, transparent methodologies that could get a third party pretty close to where the rating ends up," Chris Mahoney, chairman of Moody’s credit policy committee, told Euromoney.

So the agency embarked upon creating a quantitative model that replaces the traditional analytical process that the market was used to. Rather than rating the creditworthiness of banks, Moody’s was now rating the possibility of default, and a narrow definition of what constitutes default at that.

But the divide, between Moody’s ratings and what the market was used to, was so deep that it briefly seemed likely that DBRS and Fitch especially, would have little difficulty in making major gains at the expense of their rival. In light of the fierce market reaction it is not surprising that Moody’s was willing to shift its position.

"We spoke extensively to the market about the model and got what we thought [was] very good buy-in," says Mahoney. "In retrospect we didn’t share any hypothetical outcomes with the market, which might have helped people understand where this would lead. I think that is where we could have done a better job."

The furore started raging on February 23, when new ratings for 23 banks in 15 countries in the Nordic, Benelux and CEE regions were unveiled. All were already strong institutions, many rated A1 or above. But following the implementation of JDA some 16 were rated triple A. It was a remarkable upturn in their fortunes given that previously only four banks had enjoyed the top ranking from Moody’s.

Moody’s planned to re-rate more than 1,000 banks in more than 90 countries. The results from the early JDA results implied that it would have ended up with 200 triple-A rated banks, where once there was a handful. Furthermore, there would also have been many, many more strong double-A rated banks.

Icelandic shock

The most obvious shock was the surprising emergence of Aaa ratings for Icelandic banks. This was remarkable, not least because the Icelandic banks had suffered a loss of investor confidence almost exactly a year ago when concerns about rapid asset lending growth came to the fore. As a result Kaupthing, Glitnir and Landesbanki endured the unusual experience of not being able to get extendible notes extended in the US market.

Although those concerns have dissipated, few were able to accept Moody’s arguments that Iceland’s banks present the same risk as the US government and are less risky than a global, systemically important financial institution such as ABN Amro (which, strangely, Moody’s upgraded to just Aa1 from Aa3). This was a result of the mechanistic nature of Moody’s criteria. So a relative minnow from Iceland, with a large 20% plus share of the retail deposit market, was given a 100% probability of support and therefore a triple-A rating, but ABN Amro was not. Incredibly, Icelandic banks’ sub debt was ranked the same as ABN Amro senior debt. Such anomalies made a mockery of the agency’s suggestion that it wanted a triple-A rating to mean the same in every context. Even those who were the immediate beneficiaries of Moody’s munificence could not quite believe their luck.

"This exceeded our expectations and is broadly positive for Glitnir and the other Icelandic banks," said Bjarni Ármannsson, CEO of Glitnir, in a comment his bank gleefully sent out to the world.

Who can blame him? A four-notch upgrade overnight when nothing fundamental has changed is beyond the wildest dreams of most bank CEOs. The views of investment bank analysts and FIG bankers on this remarkable turnaround were scathing, to say the least.

"Ratings should be a relative ranking of creditworthiness," says Simon Adamson, analyst at CreditSights. "If it’s telling you purely about default risk, in these very narrow terms, a lot of the usefulness of the ratings is taken away, so they become virtually worthless for what the market wants to use them for. It also means they are not comparable with the ratings put out by the other agencies."

CreditSights, an independent credit research firm, decided to drop Moody’s European bank ratings from its analysis because of the lack of comparability, flawed methodology, doubts about the agency’s definition of default (including timeliness of payment), the notching of subordinated and hybrid securities and the treatment of holding companies.

There was also consternation about contingent liabilities that Moody’s had implicitly placed on sovereigns’ balance sheets.

Shouldn’t the analysts be thinking about if these possible bailouts are reflected in the sovereign’s ratings? Furthermore, there must be serious doubts about whether or not Iceland’s banks could be bailed out by the government, given the extent of their non-domestic operations.