Long-term ratings trend turns south

The bias has shifted towards ratings downgrades in Asia and the three defaults so far this year are likely to be followed by more, according to Standard & Poor's.
In traditional East Asian culture, 2009 will be the Year of the Earth Bull. Ironically, however, a bear might better describe the coming year, as late 2007 to early 2008 marked the end of positive sentiment for both equity and credit in Asia-Pacific due to global financial market dislocations.

The actions by Standard & PoorÆs Ratings Services on corporate and government issuer ratings (i.e. non-structured finance) in Asia-Pacific during the 12 months to October 2008 anticipated the transition of the credit environment from marginally positive to strongly negative.

If we take JPMorgan ChaseÆs takeover of Bear Stearns in March 2008 as a turning point for global financial markets, the 12 months to October 2008 can be divided into three phases when it comes to Asia-Pacific credit: the three months to January 2008 as the ôupgradeö phase; February to April as the ôchangeoverö phase; and from May onward, the ôdowngradeö phase.

In the upgrade phase, the positive momentum from AsiaÆs strong economic growth outweighed the negative ramifications from the liquidity crisis in global debt markets for issuers in the region. Indeed, we said in the fourth quarter of 2007 that, going into 2008, the drivers for Asia-Pacific credit were well balanced with positive sentiments just ahead. (See commentary ôWill Asia-Pacific Credit Quality Stand Up In 2008?ö, published November 5, 2007) Consequently, rating upgrades in the region exceeded downgrades during this phase.

By February 2008, we believed that the credit upside potential for Asia-Pacific issuers had tempered, given continuing tight funding conditions in global markets. This opinion was reinforced by the Bear Stearns event in March 2008. During this changeover phase, the number of ratings upgrades and downgrades in Asia-Pacific was almost equal.

We perceived that the global credit environment had turned even more bearish by May 2008. This view was borne out four months later when global financial markets were shocked by the events affecting Fannie Mae and Freddie Mac, Lehman Brothers, American International Group, Washington Mutual Bank, Bradford & Bingley, Fortis Bank, Hypo Real Estate Bank, Glitnir Bank, Wachovia Corp, and Dexia. During this negative phase, rating downgrades in Asia-Pacific exceeded upgrades.

The end of a positive trend

The downgrade phase of 2008 (see chart 1) marked the end of a run ù which started in 2003 ù of upgrades exceeding downgrades on Asia-Pacific issuer ratings. During the upgrade phase to January 2008, corporate borrowers still benefited from the strong economic growth rates in the region, particularly in China and India. At the same time, the manageable levels of exposure to subprime securities of Asia-Pacific financial institutions spared them from having to make substantial write-downs on investments. (See ôUS Subprime Impact Limited On Rated Asia-Pacific Banks And Insurersö, published August 3, 2007.)

Ratings in Asia-Pacific had a net positive bias during the upgrade period (see chart 2). In the changeover period of February to April 2008, the ratings portfolio was neutral, with positive and negative biases roughly canceling each other out. For the downgrade period of May 2008 onward, the ratings portfolio showed an increasingly net negative bias. As of October 28, 2008, ratings with a negative bias represented 18.9% of the total portfolio while those with a positive bias made up 5.0%. This translates to a negative-to-positive bias ratio of 3.8 to 1, implying that ratings are four times more likely to be downgraded than upgraded.

Higher defaults materialise

Reflective of the net negative bias in the Asia-Pacific portfolio, there have been three defaults of rated issuers so far this year (until October 28). In comparison, there were two defaults each in calendar years 2007 and 2006, and one in 2005.

The defaults in 2008 relate to two confidentially-rated issuers located in Asia (ex-Japan), and Hong Kong-based 3D-Gold Jewellery Holdings on October 15. 3D-Gold had missed a debt payment to banks following its discovery of a possible overstatement of trade receivables and inventory. Prior to their defaults, the two confidentially-rated issuers were rated non-investment grade, while 3D Gold was rated 'BB' and on negative watch. We anticipate that additional stressed issuers, especially those rated non-investment grade, will default in the coming year.

Ratings mix remains largely unchanged

The three distinct phases of net upgrades, roughly neutral, and net downgrades during the 12 months to October 2008 had the effect of largely neutralising each other in terms of changes to the mix of rating categories for issuer ratings in the Asia-Pacific (although, of course, different issuers were upgraded or downgraded).

The percentages of ratings in the æAAÆ and æAAAÆ categories, taken together, and in the æBBBÆ category to total issuer ratings were slightly down. On the other hand, those in the æAÆ category were slightly up, while those in the æBBÆ and below categories were flat (see chart 3). As of the end of October, there were 1,068 issuer ratings in Asia-Pacific.

That there have only been slight changes in the rating category mix is not surprising. In any given month, usually only a small fraction of the ratings population changes. A large portion of ratings upgrades or downgrades would be within the same rating category. Such changes û a notch or two û would therefore not be reflected in chart 3.

Terry Chan is a senior director with Standard & Poor's in Melbourne.
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