Credit Ratings vs. CDS Spreads, and Which Measure is More Responsive

During the past decade, the United States suffered the worst financial crisis and the most severe recession since the Great Depression.  In response to this dire situation, the federal government took action in October 2008 to inject capital into some of the biggest financial institutions in the country.  Some individuals believe that credit rating agencies failed to adequately assess the creditworthiness of many of these institutions in a timely manner.  In short, the contention is that ratings were kept too high for too long.  As a result, investors may have relied too heavily on the ratings, and thereby suffered losses before the large institutions were downgraded.

To assess this belief, I look at the credit ratings that Fitch assigned to eight of our largest financial institutions prior to the government bailout in October 2008.  Specifically, I compare the credit ratings assigned to these institutions in 2004, 2005, and 2007, a period before the full emergence of the financial crisis and before the Great Recession.  This will enable us to determine the extent to which the each of the institutions was downgraded, depending upon the degree to which each was leveraged (i.e., the total assets per each dollar of equity capital).  Clearly, the more leveraged an institution, the greater the likelihood an institution will become insolvent for any given amount of losses.  One would therefore expect the credit ratings to decline with substantial increases in leverage.

Chart 1 shows the relationship between credit ratings and leverage for our sample of eight institutions.  Over the period examined, only two institutions were downgraded, Citigroup and Merrill Lynch, three institutions received the same rating, Bear Stearns, Goldman Sachs, and Morgan Stanley, and three institutions were upgraded, Bank of America, JPMorgan Chase, and Lehman Brothers.  In the case of the two institutions that were downgraded, Citigroup was downgraded from AA+ to AA and Merrill Lynch from AA to A+, which still were investment grade ratings.  And the other cases, all the ratings were A+ or higher.  As we eventually learned, however, Lehman Brothers failed despite its upgrade in rating after 2005, and Bear Stearns with its investment grade rating was acquired by JPMorgan Chase.

Chart 1

Source: Bloomberg.

In contrast to credit ratings, there is other information about the financial condition of big financial institutions.  In particular, credit default swap premiums (i.e., the price one pays to essentially insure against losses on investments) provide indications of the financial condition of institutions.  The higher the credit default swap premium, the greater the cost of protecting one’s investment against losses.  Chart 2 shows the average credit default swap premiums along with the leverage ratios for the same eight large financial isntitutions shown in Chart 1.  In contrast to the lack of any significant relationship between credit ratings and leverage, there is a significant positive relationship between CDS premiums and leverage.  Specifically, the CDS premiums increased to a high of nearly 80 (indicating investors would have had to pay, on average, $80,000 a year to insure $10 million against losses) from a low of just under 20 basis points (indicating investors would have had to pay, on average, $20,000 a year to insure $10 million against losses), a roughly four fold increase over the period.  Notice that the CDS premiums for both Bear Stearns and Lehman Brothers increased the most, and they were among the most highly leveraged institutions, and, as already noted, one of which failed and the other acquired by another large institution.

Chart 2

Source: Bloomberg.


The bottom line is that the CDS premiums were a much better indicator of the financial condition of big financial institutions insofar as there is a significant positive relationship between the premiums and the degree of leverage.  And it was the highly leveraged institutions that suffered the most as a result of the recent financial crisis and severe recession, with most bailed out by the government and only one institution allowed to fail.  To this extent, credit default premiums, if not a replacement for ratings, should surely be used in addition to such ratings when assessing the financial condition of large financial institutions.  The benefit of also using publicly available CDS premiums is that they are market-based measures, unlike publicly available, but yet based upon proprietary information, credit ratings.  

Collateral is the Linchpin of Modern Finance, Part I: The Shift from Retail Banking to Wholesale Banking

Over the last forty years, the banking industry has dramatically changed the way it funds itself.  At one time, banks relied almost entirely upon retail deposit funding. Under this traditional funding model, banks offer deposits to customers in exchange for interest rate payments. Banks then turn around and use the deposits to extend loans to businesses and consumers, earning profits by charging them higher interest rates than what they pay depositors.

However, this model’s weakness was its susceptibility to “bank runs” on deposits.  Whenever depositors believed that banks were in deep trouble, they would panic and “run” to the banks to withdraw their deposits.  The runs would often even affect healthy institutions, resulting in cascades of insolvencies, as banks sold assets at “fire sale” prices to meet the deposit withdrawals.  This problem was largely resolved by the establishment of the Federal Deposit Insurance Company (FDIC) in 1933.  Should banks fail, depositors are now insured against losses by the FDIC up to $250,000 per account.

Beginning in the 1970s, banks began to modify their traditional funding model by expanding their funding sources to include the wholesale markets, as shown in Figure 1.  More specifically, banks began relying more heavily on issuing short and long-term debt to other financial institutions.  This enabled banks to grow larger without relying as heavily on retail deposits. Furthermore, it enabled banks to leverage to a greater degree, and thereby potentially increase their return on equity.

Wholesale funding instruments, also known as non-core or non-deposit liabilities, include repurchase agreements, foreign currency debt, commercial paper, large-denomination certificates of deposits (CDs), federal funds, and brokered deposits.  The purchasers of such instruments are large institutions such as hedge funds, private equity firms, insurance companies, ultra-high net worth individuals, and corporations.

Figure 1 & 2

Source: Federal Deposit Insurance Corporation. 

Since wholesale funds in the form of debt are generally not insured like retail deposits, large institutions in the wholesale market attempt to achieve a comparable degree of security and safety by putting their money into high-quality collateral, such as mortgage-backed securities and government treasuries.

A problem that arises with this newer funding model is that to the extent a bank cannot roll over its short-term debt, it may have to sell off assets if it cannot obtain additional deposits or issue additional equity.  In short, if purchasers of short-term debt believe that banks are in deep trouble or collateral is impaired, they may decide to “run” away from such debt, which creates a problem somewhat similar to that which existed before the establishment of the FDIC’s deposit insurance scheme.

Ironically, this means that the modern banking system still faces runs, but no longer on just retail deposits.  Instead, as shown in the financial crisis that fully emerged in September 2008, banks are now vulnerable to runs by participants in the wholesale funding market.  In 2008, the world watched as the wholesale market seized up, and banks could not rely upon this market funding.  Banks’ ability to roll over their debt and uninsured liabilities disappeared overnight along with their ability to use repurchase agreements. As a result, the government created the Troubled Asset Relief Program (TARP) to provide funding to banks, and the Federal Reserve engaged in three quantitative easing programs.

In the course of the evolution of the banking system, the government solved one problem early on, but a new one arose in its place.  Since the modern banking model is now more dependent upon wholesale funding, high-quality collateral will likely be instrumental to finding a solution that both emulates the earlier solution provided by a federal deposit insurance system, and helps prevent runs on the wholesale market. Whatever steps regulators take next will have landmark consequences for preventing or reducing the severity of future financial crises, just as the FDIC’s introduction of retail deposit insurance did.