Are sovereign ratings measuring default risk?

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Moody’s attempt to improve the transparency and predictability of its credit ratings should be welcomed. But is it high time the agency dropped the pretence of default-signalling when, like its rivals, the ratings have sometimes been more about measuring loss risk than an accurate gauge of credit default?

Do sovereign ratings provide a reliable indication of prospective sovereign default risk or merely a measure of the expected loss involved? It’s a moot point, but an important one, particularly as agency-bashing has proven to be a competitive sport in recent years.

Moody’s, one of three main agencies alongside Fitch and Standard and Poor’s (S&P), initiated a review of its ratings methodology in December. This is something it has previously carried out occasionally to enhance the quality of its sovereign risk signalling, and is a natural process of the learning and refining that takes place in the field, which is embraced, too, by the other agencies.

In Moody’s case it has, first, involved proposing suitable changes, second, soliciting feedback from users and, third, publishing the results before establishing the new method. The current revamp is only partially complete.

So long as the ratings do not alter constantly as a result of the changes, creating too much uncertainty, the majority of those involved – the users especially – would herald it as a useful exercise in improving transparency and predictability.

Moody’s notes that its sovereign credit risk assessments are based “on the interplay of four key factors: economic strength, institutional strength, fiscal strength and susceptibility to event risk”.

It is proposing to add new sub-factors and change the way factors are combined, using a scorecard approach familiar to Euromoney’s own country risk survey users – an alternative sovereign risk evaluation guide – in this case to provide a ratings range.

Fitch and S&P unsurprisingly differ little in their approaches – all of the agencies make an attempt to factor in the influential factors affecting risk, measuring the ability and the willingness to honour obligations.

Subtle differences in model construction and interpretative judgements account for their ratings differentials. Fitch notes it tries to fully distinguish between cyclical (“temporary”) and structural (“permanent”) trends, giving greater weight to cyclically adjusted budget balances where possible.

However, transparency is no guarantor of accuracy. As with the underlying economic analysis, the ratings are produced from a combination of science and non-science – an attempt to combine raw numbers with the judgements of analysts and the intangible components of risk that make more advanced industrialized economies able to manage larger debt burdens.

All of these strategic, model-based processes employ a combination of the quantitative and qualitative. Relying on the maths alone could prove fatal. Risk-based models are only valuable up to a point – an element of good judgement must be incorporated. The ratings have always been largely driven by the views of experts with a panoply of data to hand.

Moody’s does not expect its enhanced approach to alter any of its ratings, which perhaps begs the question as to why it feels necessary to embark on the process at all. The agency would probably counter that by arguing it provides suitable justification for its actions – evidence that they accurately represent all the risk-components involved.

The new approach is merely quantifying in greater detail the sub-factors that were implicitly incorporated through valued judgement.

So, what are the ratings actions supposed to be signalling? Moody’s makes this abundantly clear – its ratings measure one-year default risk; in other words a specific judgement on dishonoured obligations.

However, this is probably a pedantic interpretation. All of the agencies focus either explicitly or implicitly on loss-risk as a process rather than just default. It is the changing nature of creditworthiness that provides important signals to investors, not necessarily the discrete and sudden switch from solvency to insolvency.

Fitch and S&P make this clear, indicating that their sovereign ratings distinguish credit quality.

That path might be self-fulfilling, of course. Downgrades to eurozone sovereigns might push up the cost of borrowing, thus creating the very predicament the rating is signalling.

Moody’s might be simply trying to get a march on its rivals, which seemingly can’t always agree on sovereign risk assessments. Cyprus, rated Caa3 by Moody’s, CCC+ by S&P and B by Fitch, is on review for a downgrade by all three and its ratings are now so low that investors are hardly ill-advised.

Moody’s indicates that as of end-2012, all defaulters “had ratings of Ba2 or lower within one year of default”.

The UK is a separate case. Investors might suffer a loss through devaluation but not through default. The Bank of England could simply print the money to avoid it.

In the words of Julian DA Wiseman, a macro analyst: “The downgrade of the Bank of England has been caused by a methodological error of Moody’s. Moody’s methodology takes no account of the degree and quality of the issuer’s control over the numéraire of the debt.

“Instead, sovereigns are treated as large railroads, with tax income, debts and various other outgoings.”

There seems little reason to expect Moody’s will respond to this when it releases the results of these latest changes to its rating method. Indeed, there is nothing in this latest review that would make such a distinction. Either it needs to introduce a central bank bailout-ability factor, thus preserving the UK’s cherished triple-A, or it needs to make more explicit what its ratings are supposed to measure.

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