More focus has likely been placed on our global economy as a whole than in any other time in modern history. As a society, we carefully watch and speculate about what our lives will hold in June, come autumn in September, then winter in December, and even farther into 2021 and beyond. When the emergency stay-at-home orders and travel bans are lifted, how safe will it be to travel abroad, to shop at the grocery store or mall, or to go to our places of worship? What happens if the economy re-opens and the crisis grows, necessitating another sudden shutdown? Over 90% of the U.S. population is estimated to be currently under stay-at-home guidelines, and the U.S. economy went from unprecedented “full force” at the beginning of March to an abrupt halt by April.
The U.S. Department of Labor indicates that unemployment claims received over the past four weeks are up to 22 million, with another 5.2 million individuals filing for unemployment for the week ending April 11, creating an estimated unemployment rate of 17.9%. Current estimates suggest that the unemployment rate will continue to grow between 19% and 20% in May 2020, which will create an unemployment rate on par with those seen during the Great Depression, and by comparison, doubling the 10% high during the Great Recession. On a positive note, most economists believe the recession is likely to be “V” or “U” shaped and relatively short compared to past economic downturns, which developed from problems within the economy over multiple quarters.
As rating agencies evaluate the COVID-19 impact to the credits they rate, they look to economists to help assess what the long-term effects of the pandemic will be. S&P Global Ratings (S&P Global) acknowledged in mid-April that its economic forecast from March underestimated the economic impact. Based on new forecasts released, S&P Global revised outlooks on April 17, 2020, from “positive” to “stable” on various long-term and underlying ratings due to the economic pressures due to COVID-19, and the recession resulting from business closure measures.
At the beginning of April, S&P Global adjusted all U.S. public finance sector outlooks to “negative” in recognition of the far-reaching impact of the COVID-19 crisis, and the continued uncertainty. However, of the 18,000 credits that S&P Global rates, only six issuers have been downgraded due to pandemic-related impact, according to S&P Global last week. By adjusting outlooks rather than the rating, rating agencies provide the market with notice that there is a one-in-three potential that the rating may be adjusted over a period of up to two years. This allows issuers to maintain ratings as the rating agency monitors its financial position and the revenue stream pledged to repay the security.
Moody’s Investors Service (Moody’s) recently noted that while it believes unemployment will significantly decline as the economy improves, there will be certain industries that are likely to be impacted in the longer term, such as small businesses and the those sustained by leisure, hospitality and retail companies. These impacted industries will cause the unemployment rate to remain higher than pre-recession rates towards the end of 2020. Moody’s has placed four states, Hawaii, Illinois, New Jersey and New York, on negative outlook, and adjusted two states’ outlooks, Oklahoma and Louisiana, from positive to stable.
With the last recession, inflated securities ratings were cited as contributing forces to the financial crisis. After the Great Recession, rating agencies became subject to heightened regulation when the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010. A recent article in The Bond Buyer discussed whether the regulations imposed, which required rating agencies to develop criteria and methodologies, allow for rating agencies to properly evaluate the credits during this period where issuers are likely to see short-term liquidity pressures, and potentially, defaults that will later be remedied along with debt service payments to be made, albeit possibly late.
While none of the rating agencies have announced adjustments to methodologies or rating criteria stemming from this pandemic, there will certainly be internal and external scrutiny on what is measured by the applicable rating criteria and how transparent the “real risks” associated with the credit will be through their application. Each major rating agency, including S&P Global, Moody’s, Fitch Ratings and Kroll Bond Rating Agency, is providing regular and in-depth market updates as their teams scrutinize and analyze the markets and the securities they rate. Rating agencies are challenged by balancing communicating short-term credit risks to the market, with the need to determine whether any of the short-term credit pressures lead to long-term and enduring issues for these securities and issuers. However, perhaps a distinguishing factor in the credit analysis compared to the 2008 market collapse is how apparent the current credit risks are to investors, particularly the short-term risks, unlike the complex asset-backed mortgage securities that were much less transparent and difficult to evaluate with the prior recession.
One thing is certain: rating agencies, economists and the market alike will learn from this historic quarter and the upcoming quarters to follow. What was foreseeable? Should ratings have been adjusted in the short-term for rating pressure, or is a different rating structure needed to capture risks to investors that are related to short-term liquidity? Perhaps these questions will be better addressed once the economy is on the other side of the “V” or “U” of this recession.
For more information on this topic, or to learn how Baker Tilly public sector specialists can help, contact our team.