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Credit ratings in the Euro crisis
By: Milken Institute
June 01, 2012

During the 2012 Global Conference, much of the discussion focused on the ongoing crisis in Europe and the Euro. The video, above, from our panel on Europe at a Crossroads, offers one perspective on the role of credit ratings in the continuing crisis. The blog below, on credit ratings, comes from one of our researchers and offers a different perspective. Who do you agree with? Share your thoughts in the comment section below the article.

Do credit ratings matter? Should they?

By Jacob Thomas

Moody's, the credit rating agency, recently downgraded one Norwegian and three Swedish banks, citing their exposure to the eurozone and its potential effect on confidence in these institutions. Whose confidence, however, remains a mystery. Shares and bond prices of the three institutions climbed immediately after Moody's announcement. Bloomberg concluded the confidence problem may actually lie with the credit raters themselves, rather than with the subjects of their assessments.

While the notion of credit rating agenciesaEUR(TM) irrelevance isnaEUR(TM)t new, sovereign downgrades nonetheless make for a ruckus among experts and policymakers. With Spain now the media's focal point, it is worth examining if, and how, the bond market reacts to credit rating announcements. The figure below graphs the yield for 10-year Spanish government bonds, with Moody's rating announcements highlighted in gray.

What we see is a diagram of inconsistencies. When Moody's placed Spain's AAA status under review at the end of June 2010, bond yields merely fluctuated by about 20 basis points for three weeks. Then a dramatic change occurred: Yields decreased from 4.5 percent to close to 4 percent by the end of August! When Spain ultimately lost its prized credit status to Aa1 on Sept. 30, 2010, and after the downgrade to A1 on Oct. 18, 2011, the bond yield began to surge a month later. Moreover, when Spain's Aa1 status was placed under review (Dec. 15, 2010) and later lowered to Aa2 (March 10, 2011), the market barely reacted with mild and mostly downward fluctuations. Similarly, the most recent downgrade to A3 (Feb. 13, 2012) resulted in a decline of 35 basis points.

Most strikingly, the yield on Spanish 10-year bonds experienced an utter landslide after the downgrade to A1 on July 29, 2011, declining from 6.1 to 5 percent within days. If it were true that investors are startled by credit rating announcements, we would expect, at least, somewhat consistent yield changes in the right direction. However, as far as Spanish government bonds are concerned, this has not been the case over the past two years.

This might surprise some, but not those who have paid close attention to the three major credit rating agencies' exploits over the past decade. In their most recent book, "Guardians of Finance: Making Regulators Work for Us," authors James R. Barth, Gerard Caprio and Ross Levine describe in vivid detail how flawed employee compensation schemes, regulatory indolence and a defective business model led credit agencies to tender AAA ratings for sale. These past malfeasances serve as an explanation for today's trigger-happy approach to rating European sovereign states. The agencies, the argument goes, are overcompensating with strictness in order to restore their credibility.

However, another explanation is perhaps more pertinent. As the book illustrates, it took a decade of racketeering to deteriorate the very culture of credit rating to a point where AAA subprime mortgage-backed securities were acceptable. It is illusory to think this deterioration could have been undone and turned around in a matter of months. Never mind lessons from the U.S. mortgage market collapse and congressional hearings and investigations. It is time to ask whether "The Big Three" at this point are even capable of producing impartial and prudent credit analysis.