In a widely anticipated move, Standard & Poor’s today revised its outlook on Berkshire Hathaway from stable to negative. Standard & Poor’s reaffirmed Berkshire’s AAA rating for now. This action follows the March 13 downgrade of Berkshire by Fitch Ratings which I wrote about earlier this month. Ever since the Fitch action, there has been intense speculation regarding whether Moody’s and Standard & Poor’s would make a similar move. Let’s examine the reasoning used by Standard & Poor’s today and compare it to the reasoning used by Fitch earlier this month.
Focus on Statutory Capital
Fitch focused primarily on two factors to justify the downgrade on March 13. Macroeconomic factors were cited as a reason to doubt the worthiness of any financial firm for AAA status given the volatility of the global economy. Berkshire’s derivatives exposure was cited as a factor that increased Berkshire’s risk of default even though the derivatives in question do not carry significant collateral requirements or counterparty risk. Indeed, Berkshire’s derivatives continue to be widely misunderstood by most observers.
Standard & Poor’s did not mention the global economy and did not specifically cite the derivatives exposure. Instead, the focus was on a weakening of Berkshire’s statutory capital levels over the past year:
“The decline in equity values in 2009 has reduced the statutory capital of the insurance operations, and a preliminary analysis of the group’s capital adequacy indicates that the group’s capital is no longer redundant at the ‘AAA’ level,” said Standard & Poor’s credit analyst John Iten. In December 2008, we said that we would consider revising the outlook to negative if capital markets continued to deteriorate, investment-related losses reduced capital below the ‘AAA’ level, and Berkshire was not able to rebuild capital back up to that level within a reasonable time frame.
The analyst points out that Berkshire’s 2008 year end level of statutory capital was still consistent with AAA levels but erosion in the market value of investments so far in 2009 calls into question whether statutory capital levels will remain adequate over the twelve month horizon of the outlook. I have been following Berkshire’s holdings during Q1 and conducted an analysis of likely changes in Berkshire’s portfolio at the end of February. Clearly there have been large losses on paper, although some of these losses have been mitigated by market movements over the past week.
Downgrade Possible But Not Certain
Standard & Poor’s notes that the outlook could be revised back to stable from negative if statutory capital levels recover over the coming months, either through recovery of investments or a build up of capital through retention of earnings:
If the value of the group’s substantial equity investment holdings were to stabilize or improve during this period, or if it appears that the group will be able to rebuild its capital position back to a level commensurate with the current ratings within a reasonable period of time (typically one to two years) through earnings or other means, we could revise the outlook back to stable.
The analyst goes on to note that a one notch downgrade could result if statutory capital levels are not increased or do not appear likely to recover back to the “AAA Level”. However, some strong statements are also made regarding Berkshire’s unique strength at the holding company level:
Under Standard & Poor’s group ratings methodology for insurance groups, the most senior rating on a holding company is normally three notches below the financial strength ratings on the core operating insurance companies, reflecting regulatory barriers to the upstreaming of capital from a regulated insurance company to fund holding company obligations. In Berkshire’s case, there is currently no difference between the holding and operating company ratings because of the substantial amount of earnings and cash flow available from the company’s noninsurance affiliates.
The analyst notes that if Standard & Poor’s does proceed with a downgrade of the insurance company ratings, the downgrade to the holding company would likely not be more than a notch or two below the operating company’s level. This would reflect Berkshire’s unusual strength compared to other insurance groups rated under the same methodology.
Standard & Poor’s is obviously not incorrect to watch Berkshire’s statutory capital levels when making ratings decisions. However, based on Berkshire’s track record of disciplined underwriting, very conservative reserving, large cash holdings, and the strength of the wholly owned subsidiaries, it is very hard to see any scenario in which a default is remotely possible. If any financial firm in America deserves a AAA rating, it is Berkshire Hathaway.
While Fitch based its downgrade on very faulty logic related to derivatives exposure, Standard & Poor’s at least seems to be focusing on the right variables and took a more moderate step by initiating a negative outlook rather than jumping the gun with an immediate downgrade.
The full text of Standard and Poor’s news release can be found here. However, it is necessary to submit a free registration to the Standard & Poor’s site in order to view the document.