Last week Friday, S&P announced a credit-rating downgrade of many many Eurozone countries. Although, judging from the BBC news items, you would think that only France was affected. Also – and perhaps more concerning – one of the BBC articles had the following phrase at its tail-end, clearly a tentative bone thrown to the financially confused: “Credit ratings are used by banks and investors to decide how much money to lend to particular borrowers”.
And I had a little “not quite” moment to myself.
So, I came up with a list of definitions that need to be mentioned:
- Debt (or Sovereign Debt) – is how a government or a large corporation borrows money. You and I would go to the bank and get a loan. Actually, I’d go to my rich uncle and beg. But these guys need a fair amount more than any bank can give, or would be willing to give (after all – given the size of the loans we’re talking about – the bank would be effectively throwing all their chickens, and livestock, and their mother, into one giant basket – which sounds a little risky). But when we talk about bond issues, or treasury bills, or commercial paper (CP) – these are basically all different forms of borrowing (as a general rule of thumb – the different names usually denote the time period of the loan: bonds are longer, treasury bills and CP are very short-term). And instead of one large lender, the debt gets parcelled into smaller bonds, or notes, and sold to multiple investors. And when we say “sold”, we mean that the investors are buying the rights to receive the future cash-flows of the bond. It’s the same as the bank “selling” me a loan – it’s “buying” the right to my future repayments.
- Ratings Agencies – we have more than one of them. Three main ones, in fact: Standard & Poors (or S&P, as I affectionately refer to it on twitter), Moody’s, and Fitch. There are others – but those are the three big boys that cause the big uproar when they change anything. Ratings Agencies are meant to be independent third parties that go and do all the background credit checks on the borrower on behalf of the investors. And because borrowers know that investors like knowing that a credit check has been done: they will pay the Ratings Agency to come in and do them, in order to make their bond issuances (loan applications) more appealing to the investing public. This does create a problem with independence, however – who is paying for the rating, and who wants a better rating?
- A Credit Rating – is the Ratings Agency’s opinion of how likely the borrower is to pay back the debt on time. It is affected by two things in general: the terms of the debt issue (how big is the issue, when are the payments due, etc), and the financial status of the borrower (affected by both their internal capabilities and their external environment). The credit rating, from what I understand, reflects how things stand at the date of the rating. Unlike a Credit Outlook:
- A Credit Outlook – is the Ratings Agency’s feeling on what will happen at the next rating review. A negative rating would suggest that the Agency realistically expects to downgrade the rating at the next review.
- Credit risk – this is the likelihood that the borrower will default on the debt.
- Default – this does NOT mean that the borrower goes bankrupt (although it can mean that). Generally speaking, default refers to missing a debt repayment. So if Greece is a day late in paying its next installment, it will be in default. Even though it may pay the very next day.
- A credit rating generally affects the interest rate that the borrower will have to pay. The better the rating, the lower the interest rate. And practically, this means that if I look at two different bonds that I’m going to buy – and one is rated AAA (the least likely to default) and the other is rated AA+ (highly unlikely to default, but more likely than AAA) – and they both offer 3% interest – well then I’m going to buy the AAA! It makes no sense to take on more risk for the same interest rate. So the borrower will have to offer slightly higher interest rates in order to get me to buy the AA+ bond.
- But more importantly: the biggest investors in bonds are large institutional investors, like pension funds. These large institutional investors are usually required to keep a large percentage of their investments in AAA bonds. And this is for good reason. Most of us invest some of our salaries in pension/provident/retirement funds every month – and those funds have to do something with the money to make it meet our requirements when we eventually retire. Pension and Provident and Retirement funds – they are the giant money-players. And because of this, they’re highly-regulated by their national governments. Many of those regulations place restrictions and limits on where they can put their money – precisely because there is such high political risk at play (can you imagine how UNHAPPY a voting public would be if a pension fund crashed? It doesn’t bear thinking about). So, as it turns out, the biggest investors are hyper-conservative.
- Most borrowers are not intending to pay back their full debt any time soon. The debt “rolls” – so each time a repayment is due, more money is borrowed to pay it back. Theoretically, it’s very possible for a borrower to operate at a consistent level of debt. But when credit-rating downgrades occur, it becomes more expensive and more challenging to re-finance the debt.
And in answer to the BBC – I see what you’re saying. But I think that credit-ratings are more about the interest rate the borrower has to pay, and whether an investor is legally permitted it in his portfolio, rather than the investor decision about whether he wants to lend or not.
Comments
Gareth Crosland January 25, 2012 at 20:09
Good job Jayson – understandable and enlightening!
ReplyJayson Coomer January 25, 2012 at 22:15
I'm glad you liked it!
Reply