CEO bonus compensation usually begins and ends around some form of equity scheme, which can motivate executives to manipulate results in any given quarter. “Annual bonus plans can destroy value by providing incentives to withhold effort, to shift earnings and cash flow unproductively from one period to another, and to manipulate earnings counterproductively in other ways,” write Kevin J. Murphy and Michael C. Jensen in their working paper, CEO Bonus Plans: And How to Fix Them.
One proposal: Make CEOs subject to “negative bonuses” that would draw down from a bonus bank when performance measures aren’t achieved.
Crowdsourced ratings do have a measurable impact on diners’ behavior, with a positive review being especially beneficial for independent restaurants, according to a new HBS working paper Reviews, Reputation, and Revenue: The Case of Yelp.com.
Harvard Business School professor Michael Luca determined that each ratings star added on a Yelp review translated to anywhere from a 5 percent to 9 percent effect on revenues (depending on the control variables and means of estimation)—more than he had expected.
Even more interestingly, within that number not all restaurants were created equal. Chain restaurants, in particular, were largely unaffected by the ratings, while the greatest effect was shown for independent restaurants. That makes sense according to economic theory, says Luca, since diners presumably already have some knowledge about chain restaurants, but can benefit from more information about their neighborhood spots.
Yelp is somewhat of a substitute for traditional forms of reputation. People are not using Yelp to find out about McDonald’s.
But Luca says the big chains should not be comforted by the findings. Indeed, he believes the data suggests that local eateries are starting to siphon off customers from the “Big Boys.” Why? The Applebee’s and the T.G.I. Friday’s of the world have been safe bets for diners because their fare is of an expected quality and their menu well-known—thanks in part to big-budget advertising behind the chains. But review sites are leveling the playing field by allowing consumers to learn as much about independent restaurants as they know about the chains. “This is one reason why consumer demand is shifting from chain to independent restaurants in the period following the introduction of Yelp,” Luca writes.
Fitch Ratings says that one-in-three rating proposals for new structured finance (SF) deals need a substantial overhaul before the agency can proceed with assigning new ratings to the transaction. In particular, Structured Credit proposals based on collateralized debt obligations (CDOs) raise more warning flags than more traditional instruments such as mortgage-backed securities.
Since launching its Transaction Filtering Committees (TFCs) in 2009, Fitch has received 849 preliminary SF rating proposals, 31.5% of which required substantial credit or structural issues to be addressed before the rating process could proceed. In addition, Fitch has rejected nearly one in 10 proposals outright, designating them as unrateable.
Fitch provides detailed analysis of its filtering committee results in the report Strengthening the Ratings Process. In total, Fitch has classified 8.7% of transactions as ‘Red’ or unrateable. Fitch designates the the aforementioned 31.5% as ‘Amber’, which means that the deal requires specific issues to be addressed if the rating process is to continue.
The Structured Credit (CDOs) teams classify transactions as ‘Amber’ or ‘Red’ at a much higher rate than the cumulative global average – 38% of transactions in Structured Credit were classified as Amber compared to 31.5% for the larger Structured Finance group while 22.3% of Structured Credit proposals were Red (compared to 8.7%). These results are to be expected as these teams routinely see more esoteric, innovation and higher risk proposals than other groups.
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In addition, these figures are conservative as they exclude transactions which were declined by the agency at a very early stage due to specific credit or criteria issues. The results are broken down by group (RMBS, ABS, CMBS, and Structured Credit) and by region (North America, EMEA, Latin America, and APAC). Fitch also discusses the rejection rates by group and examines quarterly rejection rates.
Irrespective of the outcome of a TFC, Fitch will not automatically rate the transaction. For example, issues raised for ‘Amber’ transactions may prove ultimately insoluble. In fact, only a quarter of such transactions were ultimately assigned a rating. Even for ‘Green’ transactions, only 57% were eventually assigned a rating often due to new issues emerging that were not highlighted during Fitch’s TFC.
Creation of CDS clearing houses should benefit emerging-market debt, since CDS offer a channel for holders to hedge their positions, argues Oxford Analytica.
The European Parliament and EU states on October 18 agreed to impose an EU-wide ban on naked sovereign debt credit default swaps (CDS) from November 2012.
Since 2009, US and EU regulators have sought to gain more oversight over the CDS market, following severe losses suffered by financial institutions writing CDS, particularly the American Insurance Group (AIG). Momentum behind this reform continued as the crisis in euro-area sovereign debt emerged, with CDS positions seen as inhibiting transparency.
Lack of coordination between regulators about how to implement in detail the agreed changes in the CDS (and other over-the-counter, OTC, derivatives) market has implications not just for the use of CDS in the euro area, but also emerging economies.
Contract standardisation, increased margin and capital requirements on members, as well as publication of clearinghouse data, will increase transparency. Emerging-market debt has become a mature asset class and CDS activity in it will continue to grow, though sovereigns will voice unease and could implement measures against it, as has happened in the EU.
For details, see CDS support emerging-market debt
A severe stress scenario of a double dip recession and an interest rate shock would result in rating downgrades for several European sovereigns, according to a new scenario analysis by Standard & Poor’s. In such a scenario, current EU and IMF support mechanisms may be insufficient, S&P adds.
If our severe stress scenarios come to pass, we believe it would likely lead to the downgrade of France, Spain, Italy, Portugal, and Ireland.
It likely would also prompt the recapitalization of numerous banks in Spain, Italy, and Portugal (banks in Ireland have already been dealt with). Furthermore, issuers and transactions closely related to governments and domestic economies would likely suffer materially and could see significant downgrades.
According to our calculations, the current funding mechanisms sponsored by the EU and the IMF would be able to support the borrowing requirements of Greece, Ireland, and Portugal, and a small sliver of the requirements for Italy and Spain under benign economic conditions. We believe this safety net, however, would be insufficient if conditions were to deteriorate along the lines indicated in our stress scenarios, prompting a higher level of support for Italy and Spain. Under such a situation, the additional cost for the remaining guarantor countries could cause them to look for alternative forms of support.
Although our scenarios take into account various debatable assumptions, we believe that they illustrate the likely general direction under given conditions. Beyond the likely downgrade of a number of sovereigns if such events came to pass, our scenarios suggest that current support mechanisms may not be sufficient if conditions deteriorate beyond current expectations.
For details see Stressing The System: Assessing The Capacity Of The EU And IMF To Support A Eurozone Under Strain
Fitch Ratings says that the major Portuguese banks remain vulnerable to sovereign developments.
Portugal’s two-year economic recession, lack of access to the wholesale funding markets and uncertainties as to how the euro zone crisis will be resolved will have a direct effect on Portuguese banks’ short-term financial strength and long-term prospects
The Long-term Issuer Default Ratings (IDR) of the major domestic Portuguese banks Caixa Geral de Depositos (CGD), Banco Commercial Portugues (Millenium bcp) and Banco BPI are underpinned by Fitch’s assessment of sovereign and international support, and are currently on their Support Rating Floor of ‘BBB-’ and on Rating Watch Negative in line with the sovereign. Consequently, any further downgrade of Portugal’s sovereign rating will be mirrored by the Long-term IDRs of these banks.
The IDRs of Santander Totta SGPS and its bank subsidiary, are driven by an extremely high probability of support from their parent, Banco Santander SA (’AA-’/Negative), in case of need.
While the major Portuguese banks will continue to actively repricing their lending and cutting costs, Fitch expects that further funding and liquidity pressures and asset quality problems will weigh on banks’ performance. More positively, the banks are focusing on more profitable international operations and are using non-recurrent gains from asset sales to support net income. Fitch expects all the major Portuguese banks to remain profitable in H211, but they will have to continue reducing costs in order to support profits in 2012.
For details, see 2012 Outlook: Major Portuguese Banks
Fitch Ratings believes that the performance of the Chinese economy remains a key determinant of European corporate performance. Any significant slowdown could deprive European exporters of an important source of revenue expansion, and cause many to rethink emerging market growth strategies.
While Asian revenues account for only 17% of European manufacturers’ growth, on average, Asian growth has been one of the few rays of light in a generally bleak corporate revenue picture. It accounts for both a disproportionate share of revenue improvement and has played a large part in many companies’ investment and growth strategies. Much of this Asian growth reflects Chinese expansion.
China’s National Bureau of Statistics released figures today that show a slowing of GDP growth to 9.1% in Q3 from 9.5% in Q2. This is in line with Fitch’s forecasts which show a deceleration in growth to 8.7% for 2011 and 8.5% for 2012.
If GDP continues to track these forecasts there should be limited, if any, effect on European corporates.
However, a key uncertainty is how China will manage the twin challenges of domestic inflation – notwithstanding evidence that it may have peaked – and slowing economic growth in much of the developed world. This unstable backdrop increases the risk that the Chinese authorities will be unable to orchestrate another soft economic landing, although this scenario is not Fitch’s expectation.
Standard & Poor’s expects the US economy to limp along at half speed, rather than sink into recession.
We expect real GDP to rise 1.7% in 2011, which is still almost one half the 3% rate in 2010. For 2012 and 2013 we expect just 1.5% and 2.2% growth. None of this seems enough to make a dent in the unemployment rate, which will likely remain above 8% through 2013.
Housing continues to hobble along, with home sales barely above 2009 lows, despite near-record low mortgage rates. Housing starts and sales are slowly increasing after last year’s tax credit hangover, but we don’t expect the pace to pick up anytime soon. In fact, we expect the overhang of unsold homes to get bigger as foreclosure delays ease, and we think prices are likely to weaken further through the year.
Consumer sentiment readings continue to remain in recessionary territory in September, threatening demand and the hope that consumer spending will help fuel the recovery. This is not surprising amid the unemployment rate frozen at 9.1% and median incomes falling to a 14-year low.
However, other data have given us a more optimistic diagnosis. The Japanese earthquake-related supply disruptions continued to recede in September, and businesses were still investing, despite worrisome headline news. Even the Bureau of Labor Statistics (BLS) provided some hope (though not much) by reporting relatively upbeat job gains in September with upward revisions for the prior two months.
The Rust Belt continues to recover, remaining one of the bright spots due to improving business investment conditions. Business investment strengthened in August, as companies began to replace old machinery, which was collecting dust during the financial crisis. Even construction improved in August, owed in part from the recovery in manufacturing. Additionally, consumers finally opened up their pocket books in August, maybe spending some of their savings from lower gasoline prices.
But while private demand has started to strengthen, we don’t expect growth to be significant this year. And with the jobs market remaining soft, the sovereign debt crisis spooking investors, and the potential for U.S. government dysfunction to lead to something more severe, consumer spending and business investment will remain sluggish.
For details see S&P’s U.S. Economic Forecast: A New Lease On Life?
Fitch Ratings expects fewer big banks to be rated AA, with global and universal banks and investment banks especially vulnerable to downgrade. In recent days Fitch has downgraded several big banks, such as Lloyds, Royal Bank of Scotland, and UBS.
Fitch also has placed the following ratings on Rating Watch Negative:
Bank of America Corporation –Viability Rating (VR) ‘a-’.
Barclays Bank plc –Viability Rating ‘aa-’; –Long-term IDR ‘aa-’; –Short-term IDR ‘F1+’.
BNP Paribas –Viability Rating ‘aa-’; –Long-term IDR ‘aa-’.
Credit Suisse AG –Viability Rating ‘aa-’; –Long-term IDR ‘aa-’; –Short-term IDR ‘F1+’.
Deutsche Bank AG –Viability Rating ‘aa-’; –Long-term IDR ‘aa-’.
The Goldman Sachs Group, Inc. –Viability Rating ‘a+’; –Long-term IDR ‘a+’; –Short-term IDR ‘F1+’.
Morgan Stanley –Viability Rating ‘a’; –Long-term IDR ‘a’; –Short-term IDR ‘F1′.
Societe Generale –Viability Rating ‘a+’.
Fitch considers the potential for these negative rating actions to be warranted by the structural challenges these firms’ business models face. These challenges stem from intensified regulation, heightened funding costs, intense competition to remain a top tier player, and changing risks in an industry of constant and rapid innovation and interconnectedness with developments in the rest of the industry and the global economy.
In a Special Report Rating Banks in a Changing World Fitch summarizes its view on several high level themes that continue to affect banks and their ratings. Such themes include the macroeconomic environment and sovereign context, the evolving regulatory regime, changing support frameworks as well as the evolution of bank business models in light of these and other factors.
Although some of the themes will manifest themselves over an extended period of time, the collective impact of these factors implies revised ratings for some banks, particularly large and currently highly rated ones.
In Fitch’s view there will be fewer banks globally whose credit profiles are consistent with Issuer Default Ratings (IDRs) in the ‘AA’ rating category or above, and more whose profiles are consistent with the ‘A’ category.
Global universal banks and investment banks, with their relatively greater exposure to capital markets operations and reliance on (short-term) wholesale funding, are particularly affected although tensions also exist in other markets.
For further details see Fitch’s commentary Fitch Reviewing Global Trading and Universal Banks; Places Seven on Rating Watch Negative, Fitch Places Five Major European Commercial Banks on Rating Watch Negative, Fitch Lowers UK Support Rating Floors; Downgrades Lloyds, RBS to ‘A’ and Fitch Comments on Support for Euro Banks; Takes Various Support-Driven Rating Actions.
Fitch Ratings has lowered its Support Rating Floors (SRF) for systemically important UK banks to ‘A’ from ‘AA-’ and ‘A+’. As a result, Lloyds Banking Group plc’s (LBG) and Royal Bank of Scotland Group plc’s (RBSG) Long-term Issuer Default Ratings (IDR) have been downgraded to ‘A’ from ‘AA-’. Separately, Fitch has also placed Barclays plc’s IDR and Viability Rating (VR) on Rating Watch Negative (RWN).
The revision of the SRFs reflects Fitch’s view that support dynamics are changing in the UK. The banking system is not only large relative to the UK economy, but there is also more advanced political will to reduce the implicit support for the country’s banks, building on The Banking Act 2009 and, more recently the various policy recommendations of the Independent Commission on Banking (ICB).
Although Fitch has affirmed the ‘1′ Support Ratings of the largest UK banks, indicating that support for these banks is likely to remain high until elements of the UK banking sector complete their rehabilitation and some of the more practical aspects of bank resolution can be implemented, the lower SRF indicates that the potential for the provision of extraordinary support for senior bank creditors is relatively less certain than before.
Most smaller UK banks and building societies already have the lowest Support Ratings of ‘5′, reflecting Fitch’s opinion that support for senior creditors cannot be relied upon.
The downgrades of LBG and RBSG reflect the revision of their SRF as their current VRs are below that (both at ‘bbb’). Both of these banking groups have shown steady improvement in their risk profiles and prospects over the past two years and, assuming there is no major fallout from the euro zone crisis, for example, ought to be able to achieve higher VRs over the medium- and long-term. Fitch preserved a one notch difference between RBSG’s Long-term IDR and its major subsidiaries in the US and Ireland but equalised the short-term IDRs of these entities with that of the group to reflect its expectation that the support will remain stronger in the short-term.
Barclays IDRs and VRs reflect the group’s strong UK franchise, broad business mix, robust profitability, solid liquidity and sophisticated risk management. They also consider the earnings and risk volatility in its investment banking division, Barclays Capital (BarCap). The RWN on Barclays IDRs and VRs reflects Fitch’s view that global trading and universal banks have business models that are particularly sensitive to market sentiment and confidence, that are complex and exposed to greater volatility. They will be resolved in a reasonably short timeframe.
With the exception of Barclays, where Fitch’s rating actions are taken in light of the agency’s full criteria, all other rating actions have considered only the parts of the criteria that deal with support.
In Fitch’s rating framework, a bank’s intrinsic creditworthiness is reflected in its Viability Rating, while the potential for extraordinary sovereign support is reflected in its Support Rating Floor. Its IDR is the higher of the two.
A full list of rating actions is available here.
(Moody’s also downgraded 12 UK financial institutions on Oct 7. A free download is available here.}