- The financial strains of the 2007-2008 global financial crisis and the COVID-19 recession provided important real-world stress tests of the performance of credit rating agencies.
- However, comparing the financial and public health crises reveals how very different the circumstances are for governments, the economy and the rating agencies themselves.
- During the pandemic, credit rating agencies added valuable stabilizing force to markets, provided price-sensitive information to investors in a timely manner, and accurately predicted which companies were most at risk of failure.
Credit rating agencies perform a vital function in the modern economy by rating the likelihood of default of debt securities and debt issuers, including corporations and sovereign nations. The need for some form of credit rating has not immunized rating agencies from criticism, however, and the industry has come under congressional scrutiny for decades. Much of this criticism stems from the key role credit ratings played in the global financial crisis of 2007-2008; highly complex toxic mortgages that were eventually downgraded to ‘junk’ status, resulting in half a trillion dollar losses, were wrongly rated as safe investments by the ‘big three’ credit rating agencies – Moody’s, Standard & Poor’s and Fitch Ratings. The main criticisms of credit rating agencies in times of crisis generally relate to inappropriate asset valuation, response time and inconsistent and opaque methodology.
The unique economic challenges posed by the COVID-19 pandemic and the ensuing recession therefore represent the most significant challenge and opportunity for credit rating agencies. The context, of course, is not identical. The global financial crisis and the COVID-19 recession had different economic implications over different time periods, and credit rating agencies themselves saw subsequent legislative reform and invested billions in their management and risk management. Yet the performance of credit rating agencies remains more important than ever, with access to federal emergency loan facilities tied directly to an applicant’s credit score.
Understanding these differences and the continued vital role of credit rating agencies, how do we assess the performance of credit rating agencies during the COVID-19 pandemic?
Rating agencies and sovereign ratings
Credit rating agencies issue credit ratings, not only for individual companies, but also for countries in what are called sovereign credit ratings. Governments raise capital by issuing government bonds and selling them to private investors, and a sovereign credit rating represents a rating agency’s assessment of the likelihood that a country is able or willing to meet to its future debt obligations. Sovereign credit ratings represent the best indicator of sovereign default risk, despite criticism that credit rating agencies have received for their perceived inability to react quickly enough to crises, including the European debt crisis and the default of the subsequent Greek debt.
Source: S&P Global
A perceived lack of timeliness is the main criticism of credit rating agencies in a pivotal Cambridge University paper assessing sovereign credit ratings during the COVID-19 pandemic. This document revealed that between January 2020 and March 2021, the three major credit rating agencies issued 99 sovereign rating downgrades across 48 countries. Among these, the document compares S&P Global’s sovereign rating downgrades in the six months beginning in February 2020 (19) and six months after the collapse of Lehman Brothers in September 2008 (31). The authors of the article use this comparison of governments at wildly different stages of economic health, in entirely different global economic contexts, and in response to different economic crises to suggest that by having downgraded fewer sovereign governments, rating agencies business-as-usual mode.
While the pandemic represented a sudden and unforeseen economic shock, it is not immediately apparent that credit rating agencies should have operated differently from the status quo or deviated from their sovereign review schedule as required by the regulations. In addition to offering investors the highest degree of investment comfort available on the market, rating agencies play a valuable role in stabilizing the markets. Planning for an off-season review, as the Cambridge paper suggests, may instead have exacerbated the negative financial impacts of the pandemic, and in particular, any perceived financial instability, including the stock market crash of 2020.
The fact that credit rating agencies have operated under their usual procedures at an unusual time indicates that the flexibility built into their process in the wake of post-Dodd-Frank industry and regulatory reform may be working. The Cambridge paper also noted that, despite its criticism of the industry, sovereign rating information from Moody’s and S&P Global conveys price-relevant information to bond markets, the most valuable information available. for investors.
Credit rating agencies and companies
Businesses, fortunately, collapse much more easily than governments; the COVID-19 recession was expected to trigger an increase in the global level of business failures.
Source: S&P Global
While increased financial distress in the form of business failures was expected once the economic shock of the COVID-19 recession was identified, the rate of business failures is considerably lower than that recorded following the global financial crisis, and not much higher than the rate in 2015.
Based on credit ratings, corporate defaults are expected to focus on lower-rated financial instruments. Although credit rating agencies differ in their credit rating methodologies and the credit rating ratings they assign, ratings can be broadly summarized in the Big Three as “investment grade” (the term used to imply a low risk of default, and an umbrella term for the highest ratings offered by credit rating agencies) or “speculative grade” (higher risk of default, and the lowest ratings offered by credit rating agencies). credit).
Source: S&P Global
In 2020, 85% of all corporate defaults were speculative grade. While investment grade remained close to its historical default average, speculative-grade bonds defaulted at a level well above historical projections.
Source: S&P Global
This default was concentrated on issuers that S&P Global said were most likely to default indicates that ratings agencies are playing their role as quantifiers of creditworthiness and providing the best possible information to investors. Although much has been said about the different rating approaches of the Big Three, what is more important than the inherent factual basis or methodology of any individual rating is the ability to compare ratings to other potential investments. A Fitch rating, for example, has less or no value in isolation compared to all other Fitch ratings which are compiled using the same methodology. It is indicative of the success of this methodology that the vast majority of business failures found by S&P have had the lowest rating assigned by S&P.
It should also be noted that 2020 saw the default of zero investment grade rated companies (the remaining 15% of defaults were for unrated entities). 2008 saw the default of 11 companies rated as investment grade; this seems to suggest that credit rating methodologies are only improving and that comparisons between the economic circumstances of the global financial crisis and the COVID-19 recession that do not account for these differences will fail. One of those key differences, of course, is the billions of dollars in business support issued under the Federal Reserve’s emergency lending facilities and other sources of pandemic stimulus. While there is no indication that credit rating agencies are not presenting an accurate picture of the health of the overall economy, that health itself is somewhat artificial given the nature of the economic support provided by the Fed.
The global financial crisis represented a failure of both the instrument and the issuer. The inappropriate pricing of highly complex securitized mortgages has in turn caused the collapse of Investment Grade issuers. None of these sources of global systemic economic stress are apparent in the COVID-19 recession and its aftermath. It remains to be seen whether the rating agencies could face a similar set of circumstances, although regulation and better risk management within credit rating agencies themselves suggest that they are considerably better equipped to do so. Under these entirely different circumstances, however, credit rating agencies stabilized the markets, provided investors with timely price-sensitive information, and accurately predicted which instruments and issuers were most likely to fail.