Saturday, November 23, 2013

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.  

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