How Reliable Are Sovereign Debt Ratings?

Global Interdependence Center CFA Society of Philadelphia Conference held at the FED of Philadelphia

How Reliable Are Sovereign Debt Ratings?

Debt Ratings Agencies: Their Role in the Global Debt Capital Markets – Past, Present and Future February 29, 2012 Norbert Gaillard, Ph.D. Independent Consultant gaillard@alumni.princeton.edu

How Can We Assess Reliability?

 Stability of Sovereign Ratings,  Quality and Accuracy of Sovereign Ratings.

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Quick Look at the Past: the Wave of Sovereign Defaults in the 1930s 1/2  Difficulty in anticipating the debt crisis,  Pro-cyclicality of sovereign ratings.

1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Fitch UP 20.75 25.00 17.91 4.94 16.67 23.76 0.00 0.00 2.88 18.63 21.65 16.48 15.29 5.63 1.52

Moody’s UP 9.80 9.23 2.74 3.80 4.35 0.00 0.99 0.97 0.00 2.94 8.82 0.00 0.00 1.18 0.00

Source: Gaillard (2011).

Poor’s Standard UP Stat. UP 2.13 9.09 1.47 1.54 2.74 0.00 12.50 2.74 0.00 5.88 0.00 1.89 1.98 3.81 0.95 0.00 0.00 0.00 3.96 20.59 21.05 13.40 0.00 11.46 2.20 0.00 0.00 4.82 0.00 17.44

Fitch DN 41.51 1.56 0.00 0.00 4.17 0.00 60.00 93.07 17.31 6.86 2.06 3.30 12.94 7.04 0.00

Moody’s DN 0.00 4.62 1.37 1.27 3.26 3.88 10.89 84.47 38.83 26.47 3.92 0.00 6.45 0.00 2.33

Poor’s Standard DN Stat. DN 4.26 4.55 0.00 1.54 0.00 0.00 0.00 1.37 0.96 1.18 4.85 4.72 32.67 30.48 49.52 50.47 21.15 33.01 23.76 9.80 11.58 10.31 7.53 1.04 6.59 7.53 15.12 6.02 23.26 20.93 3

Quick Look at the Past: the Wave of Sovereign Defaults in the 1930s 2/2 ď ś Very low default rates for the Double-A and Triple-A categories, ď ś Five-year default rates for the Single-A category reached 19%-25%.

European countries

Date of default

Greece

1932

Bulgaria

1932

Yugoslavia

1932

Romania

1933

Germany

1934

Hungary

1934

Poland

1936

Austria

1938

Lat. Am. countries Bolivia Brazil Peru Chile Dominican Rep. Panama Salvador Colombia Cuba Guatemala Uruguay Costa Rica

Date of default 1931 1931 1931 1931 1931 1932 1932 1933 1933 1933 1933 1936 4

Comparing the Rating Changes of the Three CRAs, 1 January 2001 – 1 January 2011  Pro-cyclicality of sovereign ratings: Fitch Moody’s UP UP 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

12 16 23 24 19 13 12 10 3 15

Source: Gaillard (2011).

9 27 19 7 12 20 17 8 11 15

S&P UP 17 16 21 29 24 21 25 11 3 22

Fitch Moody’s DN DN 17 10 9 2 8 2 3 17 18 9

7 6 8 3 4 1 1 9 17 9

S&P DN 18 14 12 10 7 7 5 29 25 15

Fitch Moody’s Ratio Ratio UP/DN UP/DN 0.71 1.60 2.56 12.00 2.38 6.50 4.00 0.59 0.17 1.67

1.29 4.50 2.38 2.33 3.00 20.00 17.00 0.89 0.65 1.67

S&P Ratio UP/DN 0.94 1.14 1.75 2.90 3.43 3.00 5.00 0.38 0.12 1.47 5

Comparing the Performances of the Three CRAs, 1 January 2001 – 1 January 2011  One of the contributions of A Century of Sovereign Ratings (2011).

 Examination of a unique sample composed of 747 annual observations for 84 sovereign issuers rated simultaneously

by Fitch, Moody’s, and S&P from 1 January 2001 to 1 January 2011.  Comparing the quality and the accuracy of ratings assigned by the different credit raters.

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Fitch average cumulative default rates, 1 January 2001 – 1 January 2011 In % AAA AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B+ B B– CCC+ CCC CCC– CC C Source: Gaillard (2011).

Year 1 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.78 0.00 4.00 3.23 4.17 33.33 66.67 N.R. N.R. N.R.

Year 2 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.50 0.00 2.78 0.00 4.00 10.39 17.23 33.33 66. 67 N.R. N.R. N.R.

Year 3 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 5.65 0.00 2.78 0.00 8.80 14.29 21.37 33.33 66.67 N.R. N.R. N.R.

Year 4 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 5.65 0.00 2.78 4.17 13.87 14.29 25.74 33.33 66.67 N.R. N.R. N.R.

Year 5 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 5.65 0.00 2.78 9.21 13.87 14.29 25.74 55.56 66.67 N.R. N.R. N.R. 7

Moody’s average cumulative default rates, 1 January 2001 – 1 January 2011 In % Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Source: Gaillard (2011).

Year 1 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.00 3.57 11.11 12.50 33.33 0.00

Year 2 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.08 0.00 0.00 0.00 4.08 7.76 14.53 37.50 33.33 0.00

Year 3 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 4.36 0.00 0.00 0.00 6.48 7.76 18.25 46.43 33.33 0.00

Year 4 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 4.36 0.00 0.00 0.00 9.32 12.62 18.25 54.08 33.33 0.00

Year 5 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 4.36 0.00 0.00 0.00 9.32 17.47 18.25 54.08 66.67 0.00 8

S&P average cumulative default rates, 1 January 2001 – 1 January 2011 In % AAA AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B+ B B– CCC+ CCC CCC– CC Source: Gaillard (2011).

Year 1 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.63 0.00 3.57 7.41 0.00 66.67 N.R. 100.00

Year 2 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.94 0.00 0.00 2.63 0.00 7.28 14.81 14.29 83.33 N.R. 100.00

Year 3 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 6.41 0.00 0.00 2.63 0.00 11.31 14.81 38.78 83.33 N.R. 100.00

Year 4 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 6.41 0.00 0.00 2.63 0.00 19.76 14.81 47.52 83.33 N.R. 100.00

Year 5 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 6.41 0.00 0.00 2.63 0.00 24.48 14.81 56.27 83.33 N.R. 100.00 9

One-year cumulative accuracy profiles, 1 January 2001 – 1 January 2011

Source: Gaillard (2011).

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Sources: Author’s computations.

Accuracy ratios 1 January 2001 – 1 January 2011 One-year accuracy ratio 0.890

Three-year accuracy ratio 0.819

Five-year accuracy ratio 0.817

Moody’s

0.915

0.835

0.852

S&P

0.914

0.847

0.852

One-year accuracy ratio

Three-year accuracy ratio

Five-year accuracy ratio

Moody’s

0.935

0.840

0.787

S&P

0.950

0.823

0.761

Fitch

Source: Gaillard (2011).

1 January 1987 – 1 January 2011

Source: Gaillard (2011).

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Sources: Author’s computations.

We Have to Mitigate These Results

1/ There have been few sovereign defaults since the 1990s, 2/ Sovereign Ratings turn out to be less pro-cyclical than market-based indicators.

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Sovereign ratings vs. CDS-IRs, 1 January 2009

DEU FRA FIN BEL NLD PRT ESP SVN AUT ITA SVK IRL GRC

10-year CDS (in bps) 50.2 59.0 65.5 83.9 93.5 100.4 104.6 117.2 135.0 161.1 165.0 185.0 239.5

Fitch actual rating AAA AAA AAA AA+ AAA AA AAA AA AAA AA– A+ AAA A

CDS– Fitch IR AAA AAA AAA AAA AA AA AA AA AA AA– AA– A+ A–

Moody’s actual rating Aaa Aaa Aaa Aa1 Aaa Aa2 Aaa Aa2 Aaa Aa2 A1 Aaa A1

CDS– Moody’s IR Aaa Aaa Aaa Aaa Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 A1 A1

S&P actual rating AAA AAA AAA AA+ AAA AA– AAA AA AAA A+ A+ AAA A

CDS– S&P IR AAA AAA AAA AA+ AA AA AA AA AA– AA– AA– A A–

Source: Norbert GAILLARD, A Century of Sovereign Ratings, Springer, New York, October 2011.

Note: CDS-IRs (CDS-Implied Ratings) result from the transformation of CDSs into credit ratings.

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Sovereign ratings vs. CDS-IRs, 1 January 2010

DEU FIN NLD FRA BEL SVN AUT SVK PRT ITA ESP IRL GRC

10-year CDS (in bps) 31.1 34.5 38.9 39.9 60.8 80.8 88.6 89.0 98.5 115.8 119.6 160.4 279.4

Fitch actual rating AAA AAA AAA AAA AA+ AA AAA A+ AA AA– AAA AA– BBB+

CDS– Fitch IR AAA AAA AAA AAA AA+ AA AA AA AA A A BBB+ SG

Moody’s actual rating Aaa Aaa Aaa Aaa Aa1 Aa2 Aaa A1 Aa2 Aa2 Aaa Aa1 A2

CDS– Moody’s IR Aaa Aaa Aaa Aaa Aaa Aa1 Aa1 Aa1 Aa1 A1 A1 A3 SG

S&P actual rating AAA AAA AAA AAA AA+ AA AAA A+ A+ A+ AA+ AA BBB+

CDS– S&P IR AAA AAA AAA AAA AA+ AA AA AA AA A A BBB+ SG

Source: Norbert GAILLARD, A Century of Sovereign Ratings, Springer, New York, October 2011.

Note: SG denotes “Speculative Grade”.

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Sovereign ratings vs. CDS-IRs, 17 May 2010 10-year CDS (in bps) FIN 35.12 NLD 51.22 DEU 52.96 AUT 70.64 FRA 79.34 SVN 82.04 SVK 93.17 BEL 104.63 ITA 136.28 ESP 180.74 IRL 195.05 PRT 246.10 GRC 544.89

Fitch actual rating AAA AAA AAA AAA AAA AA A+ AA+ AA– AAA AA– AA– BBB–

CDS– Fitch IR AAA AAA AAA AA+ AA+ AA+ AA AA A– BBB BBB– SG SG

Moody’s actual rating Aaa Aaa Aaa Aaa Aaa Aa2 A1 Aa1 Aa2 Aaa Aa1 Aa2 A3

CDS– Moody’s IR Aaa Aaa Aaa Aaa Aaa Aa1 Aa2 Aa2 A1 A3 Baa2 SG SG

S&P actual rating AAA AAA AAA AAA AAA AA A+ AA+ A+ AA AA A– BB+

CDS– S&P IR AAA AAA AAA AA+ AA+ AA+ AA+ AA– A– BBB+ BBB SG SG

Source: Norbert GAILLARD, A Century of Sovereign Ratings, Springer, New York, October 2011.

Note: SG denotes “Speculative Grade”.

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Are the Traditional Determinants of Sovereign Ratings Still Relevant?

Five traditional determinants (Cantor & Packer 1996):    



GDP per capita, CPI, FC debt/revenues, Development indicator, Default history.

These determinants have been the same since the 1920s (Gaillard 2011).

Two more determinants for emerging and developing countries:  

Foreign exchange reserves (Afonso, Gomes and Rother 2011), Workers’ remittances (Avendano, Gaillard and Nieto 2011).

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Conclusions  Greater transparency of sovereign rating methodologies since 2008 but paradox: the default of Greece is about to lead to the biggest “misrating” since the mid-1980s…  WHY?     

Belief in the “euro umbrella”, GDP per capita and income levels have been overestimated, Debt sustainability has been overestimated (Greece and Italy), Insufficient focus on tax systems (Greece), Lack of analysis in terms of competitiveness (Greece, Portugal, and Spain).

→ “Welfare states” are not sustainable in Southern European countries.

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