international analysis and commentary

Sovereign ratings: should we care?


Rating agencies collect, analyze and disseminate information on the creditworthiness of obligors. In the case of corporate borrowers or structured products, rating agencies have access to private information when carrying out their credit analysis. Market participants do not have access to the same information – and, even if they did, may not find it economically viable to collect and analyze it for tens of thousands of individual obligors – indicating that they should take note of the ratings assigned to such instruments.

The situation changes substantially when looking at sovereign obligors. Consider the recent downgrade of the United States by Standard and Poor’s. S&P does not have access to any more information than the average market participant; it forms an educated opinion based on public information in the same way that any investor would. This same information is also analyzed by other research teams that also disseminate their views on the credit quality of the US.

So why the undue emphasis on what S&P has to say? It may have considerable expertise when it comes to analyzing sovereign debt, but so do the economic research teams of JPMorgan and Goldman Sachs, to name a few, to say nothing of a dozen or so independent economic forecasting agencies. You could argue that one educated guess is as good as another.

S&P’s downgrade of the US is a salient example, but it is not the point. The same argument applies to other countries and also to the other major rating agencies, like Moody’s and Fitch. More to the point, it applies to the ongoing debate on European sovereign ratings – a debate that was, once again, triggered by downgrades.

Over the past months a favorite argument of politicians has been to accuse the rating agencies of incompetence, in a misguided attempt to provide reassurance on the state of their economies. But the competence – or lack thereof – of the rating agencies is not the point. They, together with other market participants, are simply expressing a point of view. The real question is why an unfavorable review from a rating agency has such a knock-on effect on markets in the first place.

S&P’s downgrade of the US sent markets in a tailspin – certainly an impressive response to a single credit opinion. The market reaction to research calls by JPMorgan and Goldman Sachs pales by comparison. But sovereign ratings are not special; they are no more valuable than any other well-informed guess by a major market participant. The reason for the difference has nothing to do with the source of the opinion and more to do with the way in which the opinion is used.

To really understand what is happening, one needs to look away from the rating agencies and instead focus on central banks, clearing houses and investment managers. Even the largest investors in sovereign bonds, such as pension funds, are often obliged to comply with minimum ratings criteria. A downgrade that results in bonds becoming ineligible under these criteria can therefore result in a sharp fall in demand for purely mechanical reasons: investors may find themselves turned into forced sellers, depressing market prices from one day to the next despite their own credit view not having changed.

The implications do not stop with individual investors. Downgraded bonds attract a higher collateral requirement with clearing houses – or, indeed, stop being eligible as collateral altogether. These changes make weaker sovereign bonds more expensive to trade and diminish their liquidity even further.

Even central banks are not immune to this problem. Until recently, the European Central Bank would only accept high-grade European sovereign bonds as collateral. A sovereign downgrade could have resulted in the bonds of lowly-rated European sovereigns no longer being eligible for use in financing operations with the ECB. This would, in turn, have had a knock-on effect on the demand for sovereign bonds from commercial banks, which rely on this type of ECB funding.

It becomes increasingly clear that while there are repercussions to sovereign downgrades, the full extent of the market reaction is self-inflicted: markets react to investment practices that place undue emphasis on ratings. Central banks and clearing houses may once have argued that relying on ratings fostered transparency, because of the independent nature of the credit assessments being provided, but that same reliance became increasingly difficult to defend as it threatened to cut off sovereigns’ and banks’ access to funding. In fact, once the full repercussions of its own rules became clear, the ECB did the only logical thing: it changed the rules.

The ECB’s about-face was the right thing to do to prevent a meltdown of the European financial system. However, it does call into question the wisdom of ratings triggers for sovereign bonds – not just for central banks, but for all market participants. Central banks, clearing houses and most investment management companies are sophisticated investors with the ability to form an in-house view of sovereign creditworthiness, without blindly relying on external ratings. Market participants should educate their investment decisions by listening to the views of many market participants – including the rating agencies, but without placing undue emphasis on them.

Some steps in this direction have already been taken. For example, clearing houses currently review their margin requirements based on larger information sets than just credit ratings. But this is not enough: new financial regulation is required to avoid placing undue emphasis on sovereign ratings and to help prevent self-fulfilling credit spirals. Policy makers would better serve their nations by promoting such reform – that appropriately weakens the perverse effect of sovereign downgrades – than by accusing the rating agencies of incompetence and fear-mongering for simply fulfilling their role and providing a third-party opinion on sovereign debt.