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Saturday, November 27, 2010 11:03 AM

S&P Rating vs. CDS Implied Rating of European Sovereign Credit; Huge Flaws in the Bond Rating Methodology

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An interesting article by Index Universe shows how Ratings Differences Highlight Eurozone Risk.

The article compares risk as measured by a Standard and Poor’s rating vs. a CDS rating that is calculated based on credit market derivatives. A table highlights the differences.

Where the CDS-implied rating is better than that given by S&P, the difference is a positive number. When the CDS-implied rating is worse, a negative number is the outcome.
Some of the differences are enormous.

For those interested in various Bond ETFs, there's much more information in the three page article. Here is the table from page two.

Ratings Key
S&P Domestic
AAA 1 Denmark AAA AAA 0
AA+ 2 Finland AAA AAA 0
AA 3 Germany AAA AAA 0
AA- 4 Norway AAA AAA 0
A+ 5 Sweden AAA AAA 0
A 6 Switzerland AAA AAA 0
A- 7 Austria AA+ A -1
BBB+ 8 Czech Rep. AA+ A+ 3
BBB 9 Slovakia AA+ A+ 3
BBB - 10 Slovenia AA+ AA 1
BB+ 11 Netherlands AA+ AAA -1
BB 12 Estonia AA+ A 4
BB- 13 UK AA+ AAA -1
B+ 14 Poland AA A 3
B 15 Turkey AA BB+ 8
B- 16 France AA AAA -2
CCC+ 17 Russia AA- BBB+ 4
CCC 18 Belgium BBB AA+ -7
CCC- 19 Bulgaria BB+ BBB -2

Croatia BB+ BBB -2

Italy BB+ A+ -6

Lithuania BB+ BBB -2

Iceland BB BBB -3

Romania BB BB+ -1

Latvia BB BB 0

Hungary BB- BBB- -3

Spain BB- AA -10

Ukraine B+ BB- -1

Portugal B A- -8

Ireland B- A -10

Greece CCC- BB+ -8

Huge Flaws in the Bond Rating Methodology

In Steer Clear Of Bond Ratings Paul Amery for Index Universe writes ...
Ratings agencies are too slow to react to deteriorating creditworthiness, and when they do react, cuts tend to come in one fell swoop. In Greece’s case, the ratings cut to junk by Moody’s in June was one of four “notches” in one go, for example (from A3 to Ba1).

With Ireland's rating brought down yesterday by Standard and Poor’s from AA- to A (two notches on the scale), the issuer is now only four grades above junk status (Moody’s, by the way, still has Ireland at Aa2, three levels above the equivalent S&P rating). Since pressure on government finances is increasing everywhere, you can expect several other issuers to face downgrades, risking the sudden removal of more bonds from ratings-based benchmarks.

Finally, and perhaps worst, ratings methodologies are not consistent across the markets. It’s easy to find lower-rated issuers with bonds offering a higher yield (and higher risk, theoretically) than higher-rated ones, something that doesn’t make sense.

The worst abuse of the ratings system, of course, was the widespread grade inflation in structured finance securities during the credit bubble, with the AAA label incorrectly attached to bonds that both risked and then produced a severe loss of capital.

Even though the structured finance market is now comatose, contradictions abound in the way simpler (bullet) bonds are rated. For example, Russia (rated Ba2 by Moody’s) is paying a yield of around 4.75% on its ten-year dollar debt, while Aa2-rated Ireland (that’s nine credit ratings better than Russia, according to Moody’s) has a current yield of 9.15% on its ten year euro-denominated bonds. Something’s badly wrong here. You need to adjust (slightly) from a dollar yield curve to one in euro when making this comparison, but a glaring inconsistency remains.
I have pointed out many times before that Moody's, Fitch, and the S&P are horrendously slow in modifying debt ratings.

Moreover, enormous discrepancies between Russia and Ireland bond yields shows political bias by the ratings agencies.

Inconsistencies between the "Big Three" make matters even worse.

Break Up the Credit Rating Cartel

The current rating process is fatally flawed and the only way to fix this mess is something I bring up at every opportunity: It's Time To Break Up The Credit Rating Cartel
The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO). It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years.

Establishment of the NRSRO did three things (all bad):

1) It made it extremely difficult to become "nationally recognized" as a rating agency yet all debt had to be rated by someone who was already nationally recognized.
2) In effect it created a nice monopoly for those in the designated group.
3) It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating.

Government sponsorship of organizations and intervention into free markets always creates these kinds of problems. The cure is not an executive shuffle, third party verification or half-measures and more regulation that mask over the issues by splitting functions within an organization.

The SEC created this problem by creating the NRSRO. The problem is easily fixable. It's time to break up the cartel by eliminating the rules that created it. Moody's, Fitch, and the S&P should have to sink or swim by the accuracy of their ratings just like everyone else. Ratings would be a lot better if corporations had to live or die by them. Free market competition, not additional regulation is the cure.
Mike "Mish" Shedlock
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