Japan Addresses Threat of Lower Bond Ratings

In response to rating agency warnings of lower bond ratings, among other pressures, Japan’s budget strategists announced a 10% across-the-board spending cut for all ministries and agencies. They also said that this was only the first step in an all-encompassing budget overhaul.

Their goal is to cut more than 1 trillion yen ($11.42 billion) from the new fiscal budget that takes effect in April while still making more funding available for stimulus programs without going over their self-imposed 71 trillion-yen annual policy-spending limit.

Japan’s debt is the world’s highest among developed industrialized nations. If left unchecked, the debt could easily breach 200% of GDP. Yet the worldwide recession has created a difficult challenge for Japan with competing policy needs: to both significantly cut debt while maintaining stimulus for a delicate economic recovery.

The anticipated cuts will likely not impact grants to local governments and social security payments. The government will be holding open debates to decide how to allocate funds.

Japan’s Debt Problems Continue

It is anticipated that Japan’s ruling party’s poor showing in recent elections will lead to political gridlock that could thwart Japan’s efforts to gain control of the largest debt-to-GDP ratio in the industrialized world.

Standard & Poor’s is rating Japan long-term local and foreign currency debt AA, both with a negative outlook; however Moody’s and Fitch ratings are slightly more positive and are providing a stable outlook for both debts.

At the end of their fiscal year in March – Japan’s public debt was nearly twice the size of its economy, 883 trillion yen ($9,960 billion), or 192% of its GDP.

In comparison, Italy and Greece’s sovereign debt is estimated to be 115% of their economies, Germany’s is 72%, and the U.S.’s is 53%. The average for the world is 56% of GDP.

Financial Reform Act Includes New Rules for Ratings Agencies

The Dodd-Frank Wall Street Reform and Consumer Protection Act has passed into law. It immediately subjects ratings agencies to greater liability and limits their protection under the First Amendment that they had historically used to defend themselves from investors angry about highly rated securities that later turned sour.  Specifically, rating agencies can now be sued if the plaintiff can prove that an agency “recklessly” neglected to review key information when creating a rating.

The Securities and Exchange Commission (SEC) was also directed to find a way to alleviate the risk of conflict of interest at rating agencies who are paid by the issuers whose debt they rate. If after two years the SEC does not find a solution, they are required to implement the Franken amendment and to create a board that assigns a rating agency to a debt issuer. The issuer would still be free to hire their own rating agency in addition to the one it was assigned; however, the rating provided by the assigned agency must be made available to investors.

Eventually, federal regulators will be required to remove all credit rating references from their rules to reduce reliance on the credit rating agencies. Congress will hold hearings in 12 months to review this action.

Franken Amendment Dropped

House and Senate negotiators voted to drop Senator Al Franken’s (D-MN) proposal to eliminate conflict of interest from the way credit rating agencies are engaged. Franken’s amendment was initially adopted by a vote of 64 to 35.

The reasons were not ideological so much as they concerned implementation issues. Some of the chief sponsors of the bill, including Financial Services Committee chairman Barney Frank (D-MA) and Banking Committee chairman Christopher Dodd (D-CT) came out against the provision, warning of practical difficulties in making random assignments of rating agencies.

“Wall Street’s broken credit rating system played an enormous part in our economic meltdown, and it’s our duty as lawmakers to make sure that never happens again,” said Franken. “We know that conflicts of interest rewarded cozy relationships instead of accuracy, and we know how to fix the problem. The language agreed on by the conference committee means more time and more study than I think is necessary, but it also means definite action will be taken.” This stupid idea died. Good riddance.

Standard & Poor’s Striving to Change Bill

McGraw-Hill, which owns Standard & Poor’s, wants to change language in a Senate financial overhaul bill. It believes the current language would put credit-rating companies at a disadvantage in court.

McGraw-Hill Executive Vice President Ted Smyth issued a statement Wednesday that said the bill “creates a discriminatory pleading standard for credit rating agencies, with many unintended consequences for the market.”

Smyth was referring specifically to the portion of the bill that would enable investors to take legal action against rating firms that “knowingly or recklessly” fail to conduct a reasonable investigation of a company when developing ratings.

Instead McGraw-Hill argues that a credit rating agency could be sued for failing to predict a bankruptcy, for example, that occurred without fraud while auditors, lawyers, bankers and equity analysts would have no liability. The firm wants the provision altered to remove with this discriminatory language and instead retain the agencies’ current liability standard that requires that fraud be present.

If we are trying to create a Full Employment Act for class action securities lawyers, this will do it. Can’t we just use a simple, elegant age-old solution? Fully disclose any conflicts of interest and then its caveat emptor.

Legislative Spotlight Shifts to Financial Reform

Now that health care reform has been passed, President Obama is focused on financial reform and pushing for the formation of the Consumer Financial Protection Bureau, a new watchdog agency to protect the interests of American consumers.

Among other things, it would regulate credit cards, mortgages and nearly all other consumer loans; create transparency and accountability for credit rating agencies; and bring oversight to hedge funds.

“Safety and soundness is important, but the Fed also has a consumer role and it has failed miserably,” said Senate Banking Committee member Bob Menendez (D-NJ). “They didn’t take that part of their charge seriously.”

There are two versions in Congress right now: the House version, which would create a stand-alone agency with the power to write and enforce regulations, much like the Federal Trade Commission; and the Senate version, which would put the agency within the Federal Reserve and make its actions subject to veto by other federal regulators.

“Ultimately, I’d love to have a free-standing entity, but I think the reality is that it may not be possible in achieving the ultimate goal,” Mendez said.

It looks like the Senate version will be passed, but the last-minute changes still have to be hashed out.