Moody's methodology change sparks controversy

The first effects of Moody's widespread re-rating of European financial credits caused widespread consternation at the end of last month, apparently influencing credit market pricing and demand for basket credit derivatives trades.

Each week until April 11, Moody's will announce ratings actions in different regions prompted by a decision to increase recognition of the likelihood of external support from a parent bank, mutual banking group or government.

The revised methodology also includes a scorecard approach that seeks to bring consistency and clarity to the way the agency estimates banks' financial strength.

One analyst estimates that Moody's will upgrade more than 200 banks to Aaa globally. Among the first was the Reykjavik-based Kaupthing bank, re-rated to Aaa after market close in New York on February 23. Over the next four days the spread on its 10-year senior debt narrowed from 56 to 38 basis points.

As a result, "it's likely that Icelandic bank credits will be included in a majority of basket trades for the foreseeable future", said Stuart Wain, head of credit solutions at JP Morgan in London, adding that by including relatively high-yielding Icelandic credits instead of some other Aaa rated credits, structurers will be able to generate some extra yield in basket trades.

But most analysts greeted the change with dismay. Some believe that any change in methodology that results in the majority of banks being rated Aaa undercuts the usefulness of Moody's ratings. Others question whether Moody's can rely on failing banks continuing to be bailed out in the future.

Moody's did not respond to Risk's request for comment.