A Poor Choice, Standard and Poors Makes up Numbers (NYSE: PNC) (NYSE: USB)

NEW YORK - Subsidiary of McGraw-Hill, Standard and Poors has been having a little fun since August when it downgraded the U.S.A from AAA to AA+. This moved raised a number of eyebrows. The people who don't understand economics looked at the U.S.'s $14 trillion of debt and said, that sounds right. The people that understand economics like Buffett said "The U.S.A should be AAAA." He said this because unlike in the European Union if the U.S. is ever in trouble it can print money. This means the chances of the U.S. defaulting are zero and only investors can lose money investing in U.S. bonds if inflation is to high. This is also unlikely since this allows the U.S. time to right its ship without solving its problems with inflation.

S&P erred here and erred again and again. It definitely raised eyebrows when it downgraded Wells Fargo last week and this week it has done one worse. PNC Financial had its long term debt rating from A to A- and U.S. Bancorp had its rating slashed from A+ to A. The concerning factor for USB and PNC is why are they being downgraded.

S&P says it has a new criteria. Looking at this criteria it appears to be a bunch of qualitative statements they are making up to judge risk. Finally, they mention some numbers. S&P says they calculate the business's risk. To do this they make up two numbers. The first one they make up is tier 1 capital. Apparently the banks numbers are not good enough for S&P and they adjust the number. My guess is they minus out everything just so they can downgrade companies. Then they look at risk weighted assets. A bank over 15% is considered very strong and one of 10 to 15% is considered strong. PNC is the only major U.S. Bank to have a tier 1 ratio of above 10%. However the numbers are not standardized across banks. For instance Royal Bank of Canada says its $300 billion of loans only have a risk weight of $100 billion so its as if they only owned $100 billion of loans. While PNC says its $150 billion of loans have a risk weight of $150 billion. RBC says its $250 billion of securities only $16 billion of it have risk of going down while PNC says about 80% of its securities have a chance of going down.

So how can RBC have an AA- rating from S&P and give PNC and USB lower ratings when if they followed a consistent criteria, RBC would be ranked far lower down on their scale.

The next rating is S&P makes up normalized losses and compares it to pre-provision income. S&P says its calculates normalized losses. Well from normalized losses, PNC would need to take $1 billion in provisions a year and a high average modelled using a T statistic would be $1.6 billion. PNC currently earns $8.4 billion of pre-provision income a year and has a coverage ratio of over 5. Which is well higher than any example S&P gives.

PNC and USB, should not have been downgraded and S&P erred again. In 2008 they erred by not downgrading anyone an error of omission. Now they are just making errors and hurting their credibility and the financial markets by making poor decisions.