Leading up to the systemic meltdown of 2008, the big-name credit rating agencies seemed to take their eyes off the ball. Most observers agree that Standard & PooraEUR(TM)s, MoodyaEUR(TM)s and Fitch failed to adequately assess the creditworthiness of key financial institutions. As a result, many investors who relied on their judgment suffered sizable losses before the banks were appropriately downgraded. Surprisingly perhaps, the premiums assigned to credit default swaps were a far better indicator of those companiesaEUR(TM) condition, signaling the severe deterioration in credit quality much earlier.
Delving into this history, we first examined the credit ratings Fitch assigned to eight of the largest U.S. financial institutions in 2004, 2005, and 2007, prior to the government bailout in October 2008. This offered a view into whether each institution was sufficiently downgraded prior to the full emergence of the crisis and recession.
We also compared the credit ratings to each institutionaEUR(TM)s leverage ratio (i.e., total assets per each dollar of equity capital). Clearly, the more leveraged an institution, the greater its risk of insolvency when faced with losses. One would therefore expect rating markdowns as leverage increased when losses started to accumulate due to the deterioration of the housing sector in 2006.
Figure 1 shows the relationship between credit ratings and leverage for our sample of eight institutions. In the period we examined, only two institutions were downgraded: Citigroup and Merrill Lynch. For Bear Stearns, Goldman Sachs, and Morgan Stanley, the ratings did not change. In fact, three institutions were upgraded: Bank of America, JPMorgan Chase, and Lehman Brothers. In the cases of the two that were downgraded, Citigroup dropped from AA+ to AA and Merrill went from AA to A+. Still investment grade. For the others, all ratings were A+ or higher. ItaEUR(TM)s well known that Lehman failed despite its upgrade to AA- after 2005, as did Bear Stearns with its consistent A+ rating. Eventually, Lehman suffered a chaotic bankruptcy and the remnants of both were acquired by other banks.
Like credit ratings, credit default swap premiums (i.e., the price to essentially insure against losses on corporate bonds) gauge the financial health of companies. Unlike credit ratings, those premiums are determined by the market, and the higher they are, the greater the cost of protection. Figure 2 shows the average CDS premiums along with the leverage ratios for the same eight large institutions.
In contrast to the absence of an apparent link between credit ratings and debt, we see a significant positive relationship between CDS premiums and leverage. Those premiums increased roughly fourfold from 2004 to 2007, from a low just under 20 basis points (meaning investors would have had to pay, on average, $20,000 a year to insure $10 million against losses) to a high of nearly 80 basis points (investors would have had to pay an average of $80,000 a year for the same insurance). CDS premiums for highly rated Bear Stearns and Lehman Brothers increased the most, consistent with their positions among the most leveraged institutions.
Looking back, itaEUR(TM)s clear that CDS premiums outperformed credit ratings as indicators of the financial condition of some of the nationaEUR(TM)s most systemically important institutions. In our view, they deserve more frequent use alongside conventional ratings by those making such assessments.