Relationship Benefit in Credit Ratings

August 7, 2011

President Signs S. 3850, the "Credit Rati...

President Signs the "Credit Rating Agency Reform Act of 2006". Image via Wikipedia

S&P downgraded the USA from AAA to AA+. For me, this downgrade is a no-brainer. After all, the rating is an estimation of the probability that the USA will not service its debts. Either because it is not able to or it is not willingly to follow it’s obligations. Given that all US debt is dollar denominated, it seems inconceivable that it cannot service its debt. But given the chaos in the congress its very possible that it one day may not be willingly to do so. „AAA“ indicates that this chance of this happening in the next year is 0.01% or once in 10,000 years. That seems very optimistic to me.

Therefore, from my perspective, the downgrade is no surprise. The only questionable thing is: Why not much earlier? The congress gone insane is not new. One possible answer come from Prof. Thomas Mählmann’s latest research publication „Is There a Relationship Benefit in Credit Ratings?„. He finds for the rating agency S&P that

This paper documents the existence of relationship benefits in credit ratings. In
particular, the paper shows that firms with longer rating agency relationships have
better (i.e., closer to AAA) credit ratings. […] controlling for observables, the firms with longer relationships, while having higher ratings, do not have lower default rates.

In other words, the ratings of bond issuers with a long lasting relationship with S&P, have higher default rates than equal ratings of new customers of the rating agency. In case of the USA that means: you shouldn’t have taken the AAA too serious in the first place, given the relationship length of a century or so.

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Top 10 List of Countries‘ CDS-Speads as of 5th of August 2011

August 7, 2011

While people are awaiting a market massacre following the USA downgrade to AA+ by S&P, I felt it’s about time to update my regular list of country risk premiums.

  • While tomorrow everyone will surely watch the CDS spread of the USA, on Friday there was no mayor movement before closing. Compared with a month ago (8th of July 2011), it widened only 1BP. So either the downgrade did leak or it left the markets completely unimpressed. I’d guess the later.
  • Once again strong increases took place in the Eurozone countries, with especially worrying increases for Cyprus (the spread more than doubled to 809BP), Spain (+40% to 414BP), and Italy (+66% to 373BP).
  • Nearly all other Eurozone countries saw also widening spreads, most worryingly France and Belgium were reminded that nobody is untouchable in this crisis. The only Euro members with narrowing spreads were Greece, Portugal and Ireland that profited from the recent bailout, but stayed at pathological levels. The savings in funding costs for these countries was rather small, so I wonder if the bailout was in the interest of the European people as it likely increased the average funding costs across all countries.
  • Some non-Euro countries like Sweden and Poland also saw widening spreads. Probably due to significant exposures to the Eurozone in their banking systems and because they will be hit by a recession in Europe.

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