Wednesday, December 17, 2008

CEG Downgraded by Moody's to Baa3

Moody's cut CEG's credit rating this morning:
Moody's Investors Service on Wednesday lowered Constellation Energy Group's senior unsecured rating to Baa3 from Baa2 and kept Constellation's ratings under review for possible downgrade. The move follows an earlier announcement that Constellation and MidAmerican Energy Holdings have decided to terminate their proposed merger agreement. Constellation also said it reached a deal to sell a 49.99% interest to √Člectricite de France. "The rating downgrade incorporates the risks associated with CEG's decision to continue the restructuring of its sizable commodities business as a standalone entity, a near-term liquidity profile that appears weak in light of current volatile market conditions and the ramifications of the sale of a minority interest in its crown jewel assets" said Scott Solomon, Moody's vice president.
Baa is investment grade, but this year, CEG has slipped from Baa1 to Baa3.   The crisis that led to the Mid American offer was due to the implication of a credit rating cut to margin requirements for energy derivative positions.  From the SEC filing:
The actual amount of collateral that Constellation Energy would be required to post in the event of a multi-notch downgrade fluctuates based on market conditions and contractual obligations at the time of a downgrade. Management also announced an intention to sell the company’s upstream gas business and to sell or recapitalize its international coal and freight intermediation business, all as part of a broad effort to reduce the capital demands and perceived volatility of a portion of the company’s commodities business by reducing exposure to commodities counterparties, releasing a significant portion of posted collateral and monetizing certain derivative positions. Management took these actions after determining in early August that the amount of additional collateral Constellation Energy could be required to post in the event of a downgrade of its credit ratings was greater than previously estimated. On August 11, 2008, in its second quarter 2008 Form 10-Q, Constellation Energy reported the revised estimates of such potential additional collateral posting requirements as of March 31, 2008 at $129 million for a one-level downgrade, $844 million for a two-level downgrade and $3.23 billion for a three-level downgrade. The Form 10-Q also reported that as of June 30, 2008, these amounts were $386 million, $1.37 billion and $4.57 billion, respectively, and as of July 31, 2008, the amounts were $106 million, $681 million and $3.37 billion, respectively.
The "multi notch" downgrade was 2 notches or from Baa1 to Baa3. This is the exact downgrade that occurred today.  Per the 3rd quarter 10-Q, the results of a rating downgrade were: 1 level to Baa3 - $171 million  2 levels to Ba1 - $2.2 billion.  However, the report later stated:
The estimated collateral obligation amounts above have declined compared to those reported in our quarterly report on Form 10-Q for the quarter ended June 30, 2008. This decrease is due to changes in open positions, price movements, and posting of additional collateral requirements resulting from our credit ratings being downgraded in the third quarter of 2008. As of October 31, 2008, incremental downgrade collateral postings for a one level and two level downgrade have changed to $178 million and $1,865 million, respectively.
It's hard to say where they would be a month and a half later regarding their reduction of this exposure, but with any sort of prudent management and the decline in energy prices, one would hope that the amounts would be materially reduced.  From June 30 to October 31, the exposure from a downgrade to to Baa decreased from $4.57 billion to $1.87 billion.  

CEG is in a position where it needs to be able to fund a downgrade to "junk" in order for it to maintain its investment grade rating.  Not particularly unusual in the credit world where the criteria for a rating is the absence of the possible need for cash, and vice versa.  

The CEG energy traders had another month and a half to reduce their exposures, and have the Buffett billion (at the rate of 14%), an immediate infusion of $1 billion from EDF of $1 billion, and the proceeds of the asset sale of an additional $3.5 billion, less whatever they intend to repay.  

Moody's has no upside in optimism.  However, it is not at all unreasonable to think that any and all issues regarding collateral calls from energy trading are either solved or being solved.  Otherwise the board would have been highly imprudent in recommending the EDF proposal in an environment where all attention is being focused on that particular issue.  

A ratings upgrade to Baa1 wouldn't seem out of the question -- offering significant upside to the class A preferreds as well as the common stock.   

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