Tuesday, November 22, 2011

European credit ratings: a case of self-fulfilling expectations

Europe is a mess, and one has to wonder why. First, there is no reason that the credit difficulties of Greece should have any consequences on the Euro. I doubt the US Federal Reserve would feel compelled to do anything if a state were to default on its debt, and nobody would claim it should. Why should it be different in Europe? Because politics want it.

To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.

4 comments:

Vilfredo said...

Credit rating agencies are useful for obscure securities for which information is costly to obtain. This is where they failed in a major way with the US securitized mortgages.

They are not useful for well known assets, like government bonds. The only role here is for the rating to be used in rules-tied investing, like some mutual funds that require securities with some specific ratings. So I suppose the impact the rating downgrades have is to remove some demand from the market, making the price of these bonds plunge. But I agree, these in itself does not mean those bonds got worse.

Kansan said...

Wait a moment here. If market valuation reacts to a rating downgrade, it means that the rating change provided information that the market did not have, and that this information is believable.

Vilfredo said...

Kansas, there is no way you can distinguish the impact of new information from the automatic change in demand stemming from a change in rating. You cannot say that then market necessarily reacted to new information (implicitly about the risk of the bonds).

Wikirating said...

Well, the downgrade of France is less a question of information (reliable of not) than a political issue I believe. With the election in 5 months, the credit agencies knows the impact a credit rating downgrade could have on the french election. Otherwise, France would have lost its triple A for a while...

Wikirating