Waking up to risk

This article from the Economist continues its renewed "emperor has no clothes" focus. I am pleased this publication has returned to this format and hope it continues. The Economist was going the way of Businessweek in the sense that some of its articles seemed a bit "manipulated" by PR divisions of large multi-nationals.

Several years of calm should send warning signals to analysts, and considering the interconnectedness of the global economy, a daisy-chain scenario like the world is currently experiencing should have been factored in when analyzing sovereign risk.

WHEN the subprime crisis broke in 2007, credit-rating agencies were among the first groups to take the blame. Critics argued that investors had drawn false comfort from the AAA ratings that the agencies handed out on complex packages of mortgage-related debt. Furthermore, the raters were hamstrung by the conflicts of interest inherent in being paid by issuers to assess their bonds. Never again, it was solemnly proclaimed, should the markets rely on the word of the agencies.

Now that investor attention has shifted to sovereign risk, the three big agencies (Fitch, Moody’s and Standard & Poor’s) once more find themselves at the centre of the action. Upgrades of sovereign debt exceeded downgrades in every year between 1999 and 2007. That has changed as a result of the financial crisis (see chart).

The rules of the financial system make ratings impossible to ignore. If Moody’s joins its peers and downgrades Greece below A-, the country’s bonds risk becoming ineligible for use as collateral by the European Central Bank when the ECB tightens its rules at the end of this year. Politicians fetishise ratings, too. Tim Geithner, the treasury secretary, claims that America will “never” lose its AAA mark. Britain’s opposition Conservatives have promised to defend its AAA rating.

Over the long term the ratings of most developed nations have been remarkably stable. No country rated AAA, AA or A by S&P has gone on to default within a subsequent 15-year period. Indeed, nearly 98% of countries ranked AAA were either at that rating, or the AA level, 15 years later. (Ratings are based on the probability of default so they are absolute, not relative; in theory, all countries could default on their debts.)

That stable record may not persist. Investors have been buying government debt for years in the belief it is “risk-free”, almost regardless of the economic fundamentals. But if they lose faith in a government’s policies, the situation can change very quickly. “Countries can go bust in a matter of weeks if the markets close to them,” says one rating-agency executive.