Precipitated by the fall of two California utilities and Enron Corp., Moody’s Investors Service said Friday it will increase its global analytical focus on the credit risk implications of “rating triggers” written into a borrower’s debt securities or other contracts because they may cause unintended and “highly disruptive consequences” for both borrowers and lenders. In some cases, warned Moody’s the rating triggers could lead to “mutually assured destruction” including defaults and bankruptcies.
In a special report by Moody’s, the credit ratings service stated, “the presence of rating triggers may result in downward rating pressure depending on the severity of the triggers, the underlying facts and circumstances surrounding the credit, and the rating level of the issuer.” The rating agency will concentrate particularly on triggers intended to set off default, acceleration, or ‘puts’ in back-up credit lines, bond indentures or counterparty agreements when the issuer’s credit rating falls below a certain level.
Such triggers are commonly found in agreements of issuers that are rated low investment-grade or on the cusp of investment-grade — “where they are most lethal,” Moody’s reports. The report stated, “Moody’s will identify, where possible, the existence of rating triggers in each issuer’s financial structure. Our analysis will examine whether those issuers whose agreements contain particularly risky rating triggers have the wherewithal to survive a downgrade to the specific trigger level and the consequences of the trigger. We will incorporate the serious negative consequences of those triggers in our ratings and in our research.”
Moody’s report, “The Unintended Consequences of Rating Triggers,” emphasized that rating triggers can often backfire on the creditors expected to be protected by them, as well as the borrowers who provided them. Moody’s warns that “investors who think they might be protected by a rating trigger in their respective agreements may well find — as in recent cases — that there is no protection because the trigger could potentially cause a default or bankruptcy adversely affecting ALL creditors.”
The report further explained that rating triggers can result in a precipitous decline in confidence and liquidity. For example, a back-up revolving credit that goes away or a large bond that is “puttable” in the event of a downgrade below a certain level, are potentially life-threatening in a stress scenario. “The loss of liquidity when a downgrade occurs may be stressful for the borrower, precisely at the time when the company is least able to deal with an associated loss of investor confidence,” Moody’s said, adding that “rating triggers can be highly destabilizing because all parties may not behave in a rational fashion.”
The report acknowledged, however, that there is a complex array of rating triggers running the gamut from benign to potentially destructive. Among the relatively benign mechanisms, the Moody’s report explained rating triggers tied to credit facility pricing grids, which are “relatively harmless means to reset pricing on a borrower’s obligations according to changes in credit quality.”
The report also discussed triggers which can, depending on the situation, be more perilous. These include triggers tied to springing liens, collateral releases, releases of guarantees and covenant fall-aways in indentures, as well as third-party agreements. In some cases, says Moody’s, rating triggers can have the perverse effect of discouraging beneficial corporate actions such as spin-offs or merger activity.
The Moody’s report noted that the most potentially destructive rating triggers are those that dictate default or acceleration upon a rating downgrade. The report provides case studies of the disruptive role played by such triggers in the deterioration in the credit worthiness of Pacific Gas & Electric Co., Southern California Edison Co. and Enron as well as Xerox Corp.
Terms written into loan agreements, bond indentures, and other contracts, including mergers and acquisitions, stipulating that “all bets are off” if a company’s credit rating sinks to a specified level often do not provide the intended protection to creditors, and can in fact be harbingers of “mutually assured destruction” Moody’s concluded in the report.
The report, which explores the rating triggers that led to the demise of companies such as PG&E, Southern California Edison, Enron and Xerox over the past year, concluded that when a such trigger is pulled it can result in a precipitous decline in liquidity and investor confidence likened to a run on the bank.
“Such triggers can be highly destabilizing because all parties may not behave in a rational fashion,” says Senior Credit Officer Pam Stumpp, one of the authors of the report. Because the existence of triggers can have such devastating effects on a company’s liquidity, the rating agency says that it has adopted a worse-case scenario approach to evaluating the existence of some triggers and incorporating them into an issuer’s ratings.
The effect rating triggers may have on a company’s rating depends in large part on the type of trigger used, as well as the company’s individual circumstances and its general rating level. Some triggers, such as credit agreements, that can raise the cost of the company’s outstanding borrowings or require the company to post additional collateral, can be relatively benign, as many companies will likely have the cash on hand or sufficient back-up liquidity to meet these additional demands.
However, other triggers, which accelerate the payment of outstanding debt, allow debt holders to put the full value of their obligation back to the company, or that throw the company into technical default, can create a situation in which only the strongest companies may be able to survive.
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