The Future of "AAA" Ratings: Who Has It & Who Will Lose It

Media reports questioning whether the United States will keep its “Triple-A Rating” in the future are frequent.  The fear of endless budget deficit spending and quantitative easing have only added fuel to the fire that the country’s prized Triple-A rating is at risk.  Getting a Triple-A rating from Moody’s or Standard & Poor’s is not easy and losing one can be a serious psychological blow.  This is particularly the case for other governments, corporations, municipalities and mortgages which can no longer get adequate insurance.

Some countries and companies still have Triple-A ratings, which go by “AAA” at S&P and by “Aaa” at Moody’s.  Very few investors want to see the United States lose its Triple-A rating. At the same time, many know very little about how the highest rating works and the challenges that lie that entities face in maintaining it.

A Triple-A Is What?

Moody’s and Standard & Poor’s are the two major ratings agencies, followed by Fitch and A.M. Best, DBRS, and Egan-Jones.  To keep this simple, we’ll focus mostly on Moody’s and S&P.

S&P says that an issuer rated “AAA”  has an extremely strong capacity to meet its financial commitments.   Of course,  issuer credit ratings may be changed, suspended, or withdrawn and can be either long-term or short-term.  There are plenty of moving parts here.

“If the starting conditions are adverse, then the credit must have the capacity to withstand further deterioration of extreme magnitude,”  S&P says.

Some of those events taken into consideration were the Great Depression, the Asian Contagion of the late 1990’s, other international sovereign debt scares, both World Wars, and more going all the way back to late 1700s.

Governments & Sovereign Nations, “Under ‘AAA’ We Stand!”

Moody’s lists its largest “Aaa” rating sovereign debt issuers as the United States, France, Germany, and the United Kingdom.  Moody’s noted just in January that, despite the rising debt levels, these countries still have debt metrics compatible with their Aaa ratings. Three listed as “Aaa” in the Asia-Pacific region are Australia, New Zealand and Singapore.

In December 2010,  Moody’s noted that unless there are offsetting measures to the extensions of the Bush Tax Cuts, the overall stimulus package would be “credit negative” for the U.S.  Moody’s also noted that it increases the likelihood of a negative outlook on the US government’s “Aaa” rating during the next two years.

China is supposed to be the growth engine of the world and many feel that it has the best currency if it were to de-peg from the U.S. dollar.  Even after a recent S&P ratings upgrade, the sovereign nation debt from The Peoples Republic of China is rated as “AA-.”  That is still well above the “BBB” minimum hurdle for an “investment grade,” but it is not yet at the safest “AAA” rating.

S&P rates  fewer than 20 nations as “AAA” on all three metrics of Sovereign local currency ratings, Sovereign foreign currency ratings, and the Transfer and convertibility assessment. These are (as of December 2010) listed as Australia, Austria, Canada, Denmark, Finland, France, Germany, Guernsey, Isle of Man, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, the United Kingdom, and the United States. Many nations have a “AAA” rating in one or more but not all three of the metrics, and not all the “AAA” ratings are listed as “Stable.”

The Economist also published in January 2011 in its Economist Intelligence Unit “The Country Risk Service” and it listed Norway was the only “AAA” rating under its own metrics.  The sovereign rating is meant to measure “the risk of a build-up in arrears of principal and/or interest on foreign- and/or local-currency debt that is the direct obligation of the sovereign or guaranteed by the sovereign.”  The United States was “AA” on this list, along with Canada, Denmark, Finland, Germany, Hong Kong, Netherlands, Qatar, Sweden, and Switzerland.  The Economist rating system is really more of a “living within your means” test rather than whether or not debts will ultimately be paid.  The “AAA” rating from The Economist is the capacity and commitment to honor obligations not in question under any foreseeable circumstances, while the “AA” is the capacity and commitment to honor obligations not in question.

Current Corporate Triple-A ratings

In the 1980’s there were more than fifty Triple-A rated non-finance companies.  That is now down to only four at S&P.  Automatic Data Processing, Inc. (NYSE: ADP), Johnson & Johnson (NYSE: JNJ), Exxon Mobil Corporation (NYSE: XOM) and Microsoft Corporation (NASDAQ: MSFT).

Microsoft Corporation (NASDAQ: MSFT) recently issued a $2.25 billion bond deal, and S&P quickly assigned its “AAA” rating.  Moody’s gave a “Aaa” rating on the new debt issue as well.  Microsoft has perhaps the lowest cost of borrowing of any major company.  Despite the rise of Apple Inc. (NASDAQ: AAPL) and smartphones and tablets posing a threat, Microsoft has incredible metrics.  Interestingly enough, Fitch Ratings gave ‘only’ the new issue a rating of “AA+.”

Automatic Data Processing, or ADP,  is a surprise on the list due to a cyclical nature of its operation.  The big stand-out name, however, is Exxon Mobil.  Its “AAA” rating seems a shoe-in.  Even its huge acquisition of XTO for some $41 billion did little to jeopardize its rating because its  market cap is the largest in America.  The company was smart because it did the deal for roughly $31 billion in stock plus it assumed $10 billion in debt.

J&J is one we are more concerned about than the ratings agencies.  Moody’s said that it is still well above the Triple-A hurdle.  The risk is the endless recalls.  Moody’s did address this but seemed to have more concern that J&J might make acquisitions or might spend too much on buybacks.  The rating remains “AAA” and its rating outlook is “Stable.”

Recent High-Profile “Losing the ‘AAA’ Ratings”

Many companies through time have fallen from grace  in the “AAA” and “Aaa” ratings. General Electric Co. (NYSE: GE), Berkshire Hathaway Inc. (NYSE: BRK-A, NYSE: BRK-B), and Merck & Co. (NYSE: MRK) all lost their Triple-A ratings.

GE lost its S&P “AAA” rating at the bottom of the market in March 2009 after about three months worth of debt downgrade telegraphing.  The financial leverage from its GE Capital and the risks associated with being tied to business and the consumer were the reasons.

Berkshire Hathaway was first downgraded by Moody’s in April 2009 based upon falling equity values, capital cushion reductions, and all the other woes during the Great Recession.  Fitch was actually the first to cut Berkshire. Merck lost its Triple-A rating from both Moody’s and S&P after it had to withdraw Vioxx as the litigation risks mounted from endless lawsuits.

Mortgages & Municipal Bonds, Where “AAA” Dares to Go…

There is another issue with the so-called Triple-A rating that has probably been highlighted recently by the likes of Meredith Whitney.  Municipalities and pools of mortgage securities often carry a Triple-A rating due to default insurance or due to assurance of a larger entity.  What happens if the insurance company goes bust?  And now how safe are Fannie Mae and Freddie Mac as “assurance” entities?  There is not enough reinsurance risk out there to cover all the U.S. municipalities and mortgage pools in the event of widespread default. Not even close.  Since 2008, you have seen wave after wave of credit rating downgrades in mortgage-backed securities, CDOs, and even in municipalities.  When mortgage and bond insurers like Ambac Financial, Assured Guaranty and others reach a point that they cannot issue new coverage, you know what can happen to the underlying credit ratings of insured bonds.

Considering any pool of mortgages and any municipal bond as a “AAA” and “Aaa” rating today may seem counter-intuitive on a standalone basis without outside guaranty by insurers or government agencies.  Still, there are many.  Too many to count.  Many of these ratings have already changed and many will change through time.

THE FUTURE OF “AAA”

Having a Triple-A rating in the future is going to be far more difficult than in the past.  Microsoft now has a 20-year model and then some.  Apple Inc. (NASDAQ: AAPL) sits on far more cash but it really has no long-term debt obligations that have been sold off to corporate and institutional investors.  It is very likely that Apple would carry a Triple-A rating, but it is currently not rated in the same manner as other companies.  Another company that is in the same boat… Google Inc. (NASDAQ: GOOG).

Future mortgage and municipal ratings will likely have  higher standards.  Much depends upon the economy.  Some also depends upon regulation and politics.  The ratings agencies missed the boat so badly ahead of even during the Great Recession that trusting “AAA” does not mean what it used to.  Meredith Whitney has even applied for a new ratings agency status, and with her history it is easy to assume that she would not be willing to hand out any “AAA” ratings too easily.

Some of the companies which have lost their Triple-A ratings may be able to recovering them down the road.  Getting those ratings back will be no easy task.  Ditto for mortgage and municipal issuers.  As far as the future number of sovereign nations with “AAA” ratings, logic probably dictates a fewer number as well.

The “AAA” debate will continue ahead. Stay tuned…

JON C. OGG