‘Fallen angels’ should represent a rare and exotic spectacle in the credit universe. But in the past year, as the US and Europe have reached the bottom of their credit cycle, the rate at which once-robust credits have fallen off a credit rating cliff has shocked investors – and thrown doubt on the foundations of credit analysis and credit modelling.

It’s not just the collapse of Enron, a sort of credit supernova – that could be dismissed as an outlying event. More disturbing is the continual stream of well-regarded companies that either have fallen into bankruptcy or become significantly impaired. (Recent sentiment in the credit markets that the credit cycle had bottomed out seems to have been put on hold until the equity markets decide what they are going to do.)

Fear that something has gone systematically wrong in the risk modelling of quality credits hasn’t stopped some fierce competition for lending to credits of a high calibre – spreads for certain kinds of high-quality credits remain relatively narrow. But it has created a dangerous sense of uncertainty about the rate of deterioration of a credit once it loses its lustre, particularly where a corporation was once regarded as a ‘growth’ entity or where its accounting results are less than transparent.

Allan Yarish, MD, credit portfolio management at Royal Bank of Canada, says the fallen angel phenomenon is important for banks because it’s teaching them that credit risk exists at every level of credit rating. For some years in the mid-1990s, he says, there simply were no investment grade defaults, and it was tempting for banks to assume massive exposures in the belief that these presented a very remote chance of default. But it’s now clear that high-quality credit events are much less remote than had been supposed, while the threat of multi-notch downgrades mean that banks can no longer sit on a credit exposure that shows signs of weakening in the hope that the company can work things out.

For the moment, Yarish says, it’s too early to be sure whether the ‘fallen angel’ phenomenon is a long-term systematic phenomenon or whether it will prove limited to the trough of the credit downturn. But he says it has already altered how his bank thinks about high-quality credits in that its credit officers feel much warmer towards corporations that they feel they understand well through relationship banking. Conversely, for other kinds of high-quality credits, it inevitably raises the level of uncertainty and the costs of underwriting.

Credit analysts say it’s a bit too early to run any robust quantitative test on the extent of the problem, such as comparing Fortune 500 investment grade defaults in this credit cycle to similar events in the last downturn a decade ago. But they say that the phenomenon is real and will eventually show up in the rating agencies' transition ratings matrices.

Standard & Poor’s (S&P) said in a statistical analysis of default in 2001, published in February 2002, that it expected “the percentage of investment-grade issuers that default during 2002 will most likely be higher than the historical average”, though not necessarily as high as in 2001. Meanwhile, banks such as the UK’s Barclays have found themselves setting aside higher-than-expected level of loss provisions. Meredith Coffey, director of analytics at the Loan Pricing Corporation, says that some of the growth in the secondary market for bank debt is partly because “banks are offloading a growing percentage of fallen angel debt, which is showing up in the overall statistics”.

Coffey’s working definition of a fallen angel – “investment grade credits who have rapid multiple rating drops, not necessarily into default” – explains why credit analysts are perturbed by the problem. In the run-up to the present credit crunch, rating agencies and other credit analysts were reasonably successful in anticipating the historically high number of overall defaults that would occur in this economic cycle among low-quality credits (especially among companies that used short-term debt instruments to gain finance). But they were much less successful at spotting the vulnerability of higher-quality credits to a sharp drop in the equity markets, and to a crisis in shareholder confidence in corporate governance and funding liquidity.

Solomon Samson, chief rating officer for corporate credits at S&P, says that this crisis of confidence is now helping to drive the phenomenon. He says that, while it's not really possible to quote quantitative data yet on the extent of the problem in credit modelling terms, it's his sense that the deterioration of quality credits has indeed been unusually fierce in this credit cycle. And he warns: “The number of fallen angels is still a moving target and might yet get worse.”

The potential for a deeper downside comes from the ‘snowball effect’ already evident in the markets, says Samson. As each fallen angel grabs the attention of investors and fund holders, the market becomes less and less happy to extend credit and to give companies room to manoeuvre, he says. Companies that might deserve to be refinanced can find themselves shut out of the market in a liquidity crunch that has a momentum of its own. The snowball effect makes it difficult to predict the potential for more casualties in the coming months, and it explains why rating agencies and credit analysts are looking at the relationship between the equity and credit markets with renewed vigour.

Such a shift can’t come soon enough for one well-known credit modelling expert, who prefers not to be named. “Until recently, with my eyes closed I could hardly tell the difference between a credit analyst report on a company and the report of an equity analyst,” he says. When leverage was relatively low, he says, it might have made sense for credit analysts to worry about the general health of the company and its future profitability. But when leverage racked up in the late 1990s, the real issue in both high and low quality credits became the problem of how any plausible volatility in revenue was related to levels of debt. The implication is that, while equity analysts have attracted most of the public criticism, credit analysts were the dogs that did not bark.

Duncan Sankey, head of credit research at Nomura International in London, rejects the idea that credit analysts might be the guilty party lying behind the leveraged equity boom of the late 1990s. He says that this misunderstands the role of the credit analyst, which is to look for relative value in the credit markets in a way that is analogous to the role of equity analysts. Credit analysts aren't there to transmit the philosophy of the bank credit risk manager to the credit market.

For the moment, according to Sankey, “the rating agencies are firmly in the line of fire”. But he applauds a recent attempt by Moody's to build liquidity risk assessment into its analyses, and points out that the agencies will survive the jibes because, in the end, there is no obvious alternative to their benchmarking role in the credit markets. But he worries that criticism from a jittery market might make the agencies a bit too trigger-happy.

In the past six months, the hunt has been on for what went wrong in fallen angel credit assessments. In the post-Enron panic, many analysts identified ratings triggers – clauses in funding arrangements that mean corporations have to pay back or collateralise funds in the event of a downgrade – as one of the key mechanisms likely to trigger liquidity crises at highly leveraged companies. Last month, S&P released a survey of rating triggers and other contingent calls that might affect the liquidity of 1,000 leading companies. The results seemed to offer the markets some reassurance, though the survey depended on companies being honest about their funding mechanisms. S&P said that only 3 per cent, or 23 companies, of the sample had entered into funding agreements that by nature or scale could turn a moderate decline in their credit quality into a liquidity crisis.

S&P's Samson argues that this is a much lower number than some panicked analysts were suggesting in the months after Enron. However, while he argues that the rating triggers issue is not as general a risk factor as some had feared, he says the ratings trigger effect might well have become pervasive without the sharp shocks of the past year. Now, he claims: “We may have nipped it in the bud.”

Nomura’s Sankey warns that in the near to medium term, “credit spreads will decouple from rating averages if investors lose faith in the accuracy and stability of ratings”. He thinks that in the future the market will prove a lot bolder in its questioning of whether the rating agencies re-rate entities too slowly or – under pressure to raise their game generally – too quickly.

So far, the fallen angel problem has been weaker in Europe than the US – leading some credit analysts to wonder whether a queue of them might be waiting in the wings. Sankey says this might prove the case, though he says the 'national champion' factor is a complicating factor in Europe. At some level, government support is almost guaranteed for key European corporations, such as Italy's Fiat, even though such support is implicit and there might be no direct government ownership.

Meanwhile, the phenomenon is not proving all bad news for banks. Sankey says the markets' perception overall is that banks have “got a lot more savvy on risk managing their lending and on diversifying their business this time round”. From now on, he says, credit analysts and rating agencies will become much more aware of the importance to companies of alternative liquidity, in the form of committed, undrawn lines of credit unmuddied by 'material adverse change' clauses and the like. RBC’s Yarish comments that the tightening of credit lines has so far been more of a “quantity reaction” to restrict the supply of credit lines, rather than a price response that will improve their profitability. But Sankey feels that soon banks might well be able to “demand their pound of flesh for giving liquidity away”.

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