BackSilicon Valley Bank’s distress wasn’t reflected in credit ratings
Ratings firms gave high marks to regional banks shortly before failures
PremiumCredit-rating firms held regional banks in high regard—until two of the biggest banking failures in U.S. history.
Rapid collapses at Silicon Valley Bank and Signature Bank cast doubt on whether bondholders will ever be repaid. Uninsured depositors worried they would lose their money before regulators stepped in to guarantee those funds.
When the banks failed, both had high marks from ratings firms. Though Wall Street and regulators have also often struggled to predict meltdowns, the collapses marked the latest blemish for the firms’ track records for warning of financial distress.
Last week, the threat of a Moody’s downgrade prompted emergency fundraising efforts by Silicon Valley Bank. Those events spooked depositors, helping spark a run on the lender. Moody’s downgraded some of its ratings on Silicon Valley Bank and its parent company on March 8, but not below investment grade, and it affirmed its strong assessment of the bank’s short-term deposits.
The ratings industry frequently draws ire from Wall Street and regulators, particularly after failing to identify the risks leading to the 2008 financial crisis. Critics say the firms’ business model—in which they get paid by the institutions they rate—creates a conflict of interest. Some ratings-industry veterans say bank meltdowns in particular can happen quickly, and that ratings firms struggle to act in time.
“The ratings need to have changed, but the rating agencies can’t keep up because they’re too bureaucratic," said Christopher Whalen, chairman of Whalen Global Advisors, who formerly led bank ratings at Kroll Bond Rating Agency. “The process for a downgrade is too cumbersome."
Investors and depositors rely on ratings firms such as S&P Global Ratings and Moody’s Investors Service to evaluate companies’ ability to pay to back funds they owe. The firms’ grades on financial institutions aim to judge the creditworthiness of debt and deposits, helping bondholders and customers evaluate banks.
In some other cases, investors and debt issuers have complained that ratings firms are too harsh on some of the debt they rate. An early warning of trouble at a bank, for example, can frighten depositors and instigate a collapse. But acting too late can leave customers and investors in the dark about potential losses.
In S&P’s global bank outlook for 2023, published in November, the firm said the U.S. banking sector was in good shape and that risk was declining. Moody’s annual outlook, published in early December, described a stable outlook for North American banks, although it warned they could face headwinds in a slowing economy.
“Moody’s repeatedly highlighted emerging risks for U.S. regional banks beginning in June 2022 as interest rates began to rise," a Moody’s spokesman said. “We monitor our credit ratings on a continual basis, and we took quick action to adjust our ratings on specific U.S. regional banks as credit conditions warranted."
An S&P spokesman referred to company materials that said that ratings sometimes change because of inherently unpredictable events and are just one input into investors’ decisions.
Signature Bank had investment-grade labels from three ratings firms when it failed.
“The idea of getting a lot of warning time on a distressed bank from ratings agencies, it’s just not going to happen," said Mark Adelson, who was chief credit officer at S&P from 2008 to 2011.
On Monday, after the banks failed, Moody’s revised the outlook for the U.S. banking system to negative. It also put six banks under review for potential downgrades. The firm also downgraded Signature Bank to junk and removed its coverage. S&P on Wednesday downgraded First Republic Bank to junk status, citing the risk of customer withdrawals.
On Thursday, Moody’s analyst Ana Arsov said that a new Federal Reserve emergency-lending facility helped stabilize the system and should limit the number of future ratings actions from the firm.
Overoptimistic ratings for some mortgage securities helped fuel the global financial crisis 15 years ago. Lehman Brothers itself carried solid ratings until days before its bankruptcy filing. S&P later said that Wall Street’s rapid loss of trust in Lehman would have been difficult to anticipate.
After the 2008 crisis, regulators strengthened their oversight of the ratings industry. But agencies continued to compete for market share by giving higher ratings to their competitors’ clients. They also sometimes missed out on future deals after downgrading an issuer.
In the current banking upheaval, other safeguards also came up short. Silicon Valley Bank skirted regulators’ evaluation of the health of its funding base, after lobbying for banks of its size to be exempted. External auditors also gave the bank a clean bill of health.
Banks were already rushing to plug the hole left by fleeing deposits last year while suffering their first annual net losses since 1948. Total borrowings by U.S. banks have risen above $2 trillion this year for the first time since early 2020, St. Louis Federal Reserve data show.
Wall Street stock analysts can move faster than ratings firms, but they held an average price target of $261.85 a share on Silicon Valley Bank’s now-worthless stock before its collapse—near its market value at the time.
Banks’ relative stability may have given analysts false comfort, said John Kim, chief executive of credit-investment firm Panagram Structured Asset Management.
“Positive biases toward institutions that have traditionally been safe can sometimes cause [ratings firms] to overlook potential problems embedded in those institutions," he said.
Aptus Capital Advisors, managing roughly $4.3 billion of assets, owned shares of First Republic and Western Alliance Corp. before cutting exposure last week, said David Wagner, an Aptus portfolio manager.
“Now, it seems obvious that bank balance sheet issues and deposit outflows would worsen," Mr. Wagner said. “But we didn’t see it either, and we had money on the line."
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