Saturday, July 11, 2009

Rating Agencies Finally Get The NRUC Wake Up Call

When Zero Hedge first discussed the plethora of problems at National Rural Utilities Cooperative Finance Corporation (aka NRUC) over 4 months ago, two things happened very quickly: the company's CDS blew up from 100 bps to over 250 bps overnight, and the company promptly issued a derogatory press release ridiculing everyone and everything associated with Zero Hedge (they were the first but certainly not the last). Immediately thereafter, liked under the advice of counsel, NRUC promptly retracted the press release but not before The Business Insider managed to keep a record for posterity. Among the amusing points NRUC's PR touched upon were the following:

On March 8, an anonymous blogger who goes by the alias Tyler Durden (the same name as Brad Pitt’s psychopathic character in the movie “Fight Club”) wrote an unflattering opinion of CFC securities in his blog “Zero Hedge.” The blog, which circulated across the Internet, complained that CFC’s credit default swaps (CDS) were trading too tightly to U.S. Treasuries, a sign of strength. [TD: Looks like the analysis the "circulated across the Internet" hit on a nerve or two, as investors were focused not so much on certain psychopathic characters but rather on the fundamental risk I had exposed, and the company's CDS exploded by 150% in a matter of minutes.]

“The blogger repeats the same old allegations made a few years ago, which are every bit as flawed today as they were then,” said Mike O’Brien, CFC vice president of Corporate Communications. “We do not believe the blogger’s report reflects an understanding of our financial condition or our results of operations, cashflow, ability to service our debt obligations or the strength of our loan portfolio.”

As the Company's CDS has flatlined at a level well over double where it was before Zero Hedge analyzed NRUC, I am not so sure just how flawed my allegations may have been. I will not recap my initial thesis here: interested readers can read the full analysis here (and follow up reports here, here, here and here) and decide for themselves just how ridiculously cheap the company's CDS is, even in a case when the US backstops every single asset in the history of utility cooperatives.

What is notable is that whereas no self-respecting PR department should care about Zero Hedge's deranged ramblings (not so sure about CDS traders), and only a real rating agency like Egan-Jones has NRUC rated objectively (single B), one of the "Big 3" woke up on Friday in an action that could pose substantial challenges to NRUC's PR department. Fitch, which rates NRUC's MTNs at A and its Sub Notes at A-, came out with a report in which it noted it was putting NRUC on Rating Watch Negative: basically a guarantee it will downgrade the company in a matter of weeks (Don't look for the report on the website's "ratings" section; somehow only the laudatory reports make it on NRUC's home page).

Here are the main issues that Fitch notes it is concerned about:
  • National Rural’s funding profile has migrated towards a higher reliance on secured funding, thereby reducing the available collateral supporting unsecured creditors.
  • National Rural’s leverage ratios remain elevated relative to historical measures.
  • National Rural has a sizable ($1.2 billion) amount of debt maturing in August 2009.
Interestingly, these mirror almost verbatim the main concerns Zero Hedge expressed in March with regard to the company's ongoing viability: i) Insufficient allowance for Bad Loans, ii) Growing debt/equity ratio, and iii) Liquidity Crunch/$5.7 billion in Near-Term debt maturities .

And while NRUC immediately issued a retort to Fitch in which it did its best to spin all three points in a somewhat positive light, at this point it is conceivably far too late to change the impending downgrade. And as everyone knows, rating agencies do everything in groups, meaning the company must now hold its breath for comparable downgrade reviews by Moody's and S&P.

Now who cares about ratings: we all know the rating agencies are a joke, right? The problem is the avalanche of events that would ensue if even a Fitch were to give the company a several notch downgrade (best case study is AIG, whose collateral calls upon the RA downgrade almost destroyed the world). I paraphrase from my initial report:
Downgrade Triggers

This is where the NRUC story becomes eerily reminiscent of AIG's. The company is in many ways held hostage by its current rating under both Moody's, S&P and Fitch. This is manifest in three places:

1) The company's $3 billion REDLG notes (as already mentioned) have a rating agency trigger. As page 13 of the 10-Q notes:

The $3.0 billion of notes payable to the FFB contain a rating trigger related to the Company's senior secured credit ratings from Standard & Poor's Corporation, Moody's Investors Service and Fitch Ratings. A rating trigger event exists if the Company's senior secured debt does not have at last two of the following ratings: (i) A- or higher from Standard & Poor's Corporation, (ii) A3 or higher from Moody's Investors Service, (iii) A- or higher from Fitch Ratings and (iv) an equivalent rating from a successor rating agency to any of the above rating agencies. If the Company's senior secured credit ratings fall below the levels listed above, the mortgage notes on deposit at that time, which totaled $3,811 million at November 30, 2008, would be pledged as collateral rather than held on deposit. At November 30, 2008, National Rural’s senior secured debt ratings were above the rating trigger threshold.
It becomes obvious why the Rating Agencies are instrumental to the company's longevity: a 3 notch downgrade from the current senior secured rating of A/A1/A would severely limit the company to government funded liquidity in the form of the $3 billion in REDLG notes it has on the balance sheet currently.

2) As Moody's notes on page 11 of its report, NRUC has $9.2 billion notional amount in interest rate exchange agreements, which has rating triggers, this time based on the company's senior unsecured credit rating from Moody's or S&P:

"If NRUC’s rating for senior unsecured debt from either agency falls below the level specified in the agreement, the counterparty may, but is not obligated to, terminate the agreement. Upon termination, both parties would be required to make all payments that might be due to the other party. If NRUC’s senior unsecured rating from Moody’s or S&P declines to Baa1 or BBB+, respectively, the counterparty may terminate agreements with a total notional amount of $1.919 bllion. If NRUC’s senior unsecured rating from Moody’s or S&P falls below Baa1 or BBB+, respectively, the counterparty may terminate the agreement on the remaining total notional amount of $7.314 billion."
The prospect of having to terminate $9 billion in swap would likely have reverberations across both of NRUC's income and cash flow statements.

3) Lastly, the increasing reliance the company has on government funding in the form of CPFF borrowing, makes it critical that the company does not lose A-1/P-1/F-1 rating which is the cutoff for CPFF eligibility. As noted NRUC currently has over $1 billion in CPFF borrowings (a number that could grow by an additional $2.9 billion soon, see below) which it would have to find alternative ways to finance if two or more of the rating agencies turn hostile on the company.

So while NRUC is welcome to take pot shots at Zero Hedge, it may consider actually fixing its business, in which one would need a microscope to make a conclusive determination (and even then the answer would be quite surprising) of whether the cost of capital is lower than the return on capital. The fact that Fitch is finally waking up to this simple fact should be sufficiently alarming to the executives in the Herndon, Virginia headquarters. The rating agencies have recently embarked on an expiation campaign (well, S&P... Moody's not so much) and the race to the bottom downgrade could be one which leaves NRUC a in smoldering heap of electric and telephone poles (at four digit % LTVs no less) all the while its balance sheet records 37 cents in bad loans allowances.

Disclosure: no positions in any NRUC securities currently or in the past. Sphere: Related Content
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