[A-List] Germany: credit ratings angst

["Michael Keaney" <michael.keaney@xxxxxx>]

S&P ruffles German corporate feathers
By Florian Gimbel
Financial Times FTfm: December 8 2003

A war of words has been raging between Standard & Poor's, the US rating
agency, and three major German companies. Until last week, the row over how
corporate pension funds should be treated had barely been heard outside the
corporate board rooms of Germany AG.

Then, two German academics published a report. If it wins acceptance, then
it could, by some estimates, undermine the financial health of some of the
world's biggest companies, including General Motors and British Airways.

It all started in March this year, when S&P changed the way it viewed
pension fund obligations. In doing so, it downgraded the credit ratings of
seven companies. This was highly significant - since S&P's ratings are used
by investors to determine a company's credit worthiness.

In the case of ThyssenKrupp, the steel manufacturer, and one of Germany's
industrial jewels, the rating was downgraded to junk status.

Angry at this sudden change, ThyssenKrupp, in association with two other
downgraded companies - Linde, an industrial gases group, and Deutsche Post -
commissioned Wolfgang Gerke, a professor at Friedrich-Alexander University
of Erlangen-Nuremburg, and Bernhard Pellens, a professor at Ruhr-University
Bochum, to undertake a study.

More than six months later, the two academics have produced a 140-page
analysis.

It does two things. It rejects S&P's ratings system, deeming it
inappropriate for the German corporate system. But more than this, it raises
a big question mark over the way the pension funds of US and UK businesses
are treated for balance sheet purposes.

Under S&P's new system, ThyssenKrupp saw its long-term bonds accorded a a
sub-investment grade, or "junk", rating. It has led to a marked increase in
the company's financing costs.

S&P shrugged off the company's initial protests, pointing to the "debt-like"
character of pension obligations. But it faces a tougher challenge from the
academics.
Prof Gerke, who advises the German government on pension reform, accepts
that pension obligations should be part of the assessment of a company's
insolvency risk. But he insists that S&P's method discriminates against the
German "book reserve" system, which allows companies to fund their pension
liabilities through returns on operating assets.

This system was one of the cornerstones of the so-called German "economic
miracle" after World War II because it allowed companies to retain their
assets within the business.

This approach contrasts with the Anglo-Saxon model, which is based on
investment returns from financial assets held in separately constituted
pension funds governed by boards of trustees.

"After the War, German companies didn't have a domestic capital market that
could help them to do the job," says Prof Gerke.

"I'm personally a big supporter of the idea that German companies should set
up external pension funds, but that doesn't mean that one should
discriminate against the old model."

To be sure, companies such as ThyssenKrupp were given an unfair advantage
under the old S&P method, where pension obligations were largely
disregarded. It meant that pension provisions were simply stripped out of
the balance sheet, leaving the company with comparatively more equity and -
therefore - lower insolvency risk.

Under its new method, S&P interprets pension provision as debt on the
balance sheet. In theory, this mirrors S&P's treatment of provisions for
deficits in external pension funds. Yet it contrasts with the methodology of
Moody's and Fitch, two S&P rivals, which add only a portion of German
companies' pension obligations to debt.

Some leading analysts, too, question S&P's thinking. "It is misleading to
suggest that these German companies would fund their pension obligations
entirely from debt over time," says Alistair McCreadie, a London-based
analyst at ABN Amro.

Prof Gerke's report illustrates the impact of S&P's change of method on a
model company with internally funded pensions, using a quantitative
analysis.
It shows that the S&P method leads to an "unfair comparison" between a
relatively low-risk German "book reserve" model and a comparatively
high-risk Anglo-Saxon pension fund model, which is dependent on the
investment returns of financial assets.

It recommends that S&P give companies with internally funded pensions "a
calculation advantage" by assuming that their equity is bigger than it
really is. Alternatively, it recommends that S&P conduct a systematic,
quantitative assessment of external pension fund risks.

"We are not oblivious to the risk of equities," says Emmanuel
Dubois-Pelerin, a methodology expert at S&P. "We are taking these things
into account through a qualitative assessment of the pension fund risk."

Prof Gerke suggests that a thorough quantitative analysis of US and UK
pension funds could lead to further downgrades of companies such as General
Motors whose pension funds have been hit by the market downturn.

S&P claims that its new calculation method is "widely accepted". Others,
however, are not so sure.

ABN Amro believes that credit markets are taking a different view.

"Of the 12 European companies that S&P put on credit watch at the beginning
of the year, all of them have seen a recovery in their bonds - after an
initial sell-off," says Mr McCreadie.

"We took that as a sign that the market is ignoring S&P's methodology
change."

Pension provisions, pension funds and the rating of companies - a critical
analysis. For copies of the report see
www.bankundboerse.wiso.uni-erlangen.de