The difference between S&P and Moody’s

By Felix Salmon
August 9, 2011
not Moody's, which downgraded the US. I

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Amidst all the downgrade talk, one crucial point has been largely missing: there’s a very good reason why it was S&P, and not Moody’s, which downgraded the US. It’s this: the two companies don’t measure the same thing with their credit ratings.

An S&P ratings seeks to measure only the probability of default. Nothing else matters — not the time that the issuer is likely to remain in default, not the expected way in which the default will be resolved. Most importantly, S&P simply doesn’t care what the recovery value is — the amount of money that investors end up with after the issuer has defaulted.

Moody’s, by contrast, is interested not in default probability per se, but rather expected losses. Default probability is part of the total expected loss — but then you have to also take into account what’s likely to happen if and when a default occurs.

The difference, as it applies to the US sovereign credit rating, is enormous. No one doubts America’s ability to pay its debts, and if the US should ever find itself in a position where it’s forced by law to default on a bond payment, that default is certain to be only temporary. Bondholders would get all of their money, in full, within a couple of weeks, and probably within a few days.

Contrast that with, say, some incomprehensibly complex constant proportion debt obligation, which makes all of its payments by dint of clever leverage games, and which, if it ever does default, does so with utter finality, and will never pay out a single cent again.

Let’s say, then, that Tim bought Treasuries in 2006, with their triple-A rating, while Chris bought triple-A CPDOs. They both had the same rating, but Treasuries were safer, and therefore had a lower yield. Tim was paying a premium for the liquidity associated with Treasuries: he knew that there would always be a willing buyer for them, even in the event of a default. And it’s conceivable that there was a tiny premium too for the fact that the recovery value on Treasury bonds is likely to be very close to 100%: if there ever is a default, investors will ultimately get back everything they’re owed. Chris, by contrast, knew that in the event that his CPDO defaulted, he’d get no money back at all.

All of those are very good reasons for Tim to pay more for his bonds than Chris paid for his. But all of them are explicitly ignored by S&P. S&P doesn’t put itself forward as some kind of investment-advice company: it takes no position on which bonds are good buys and which ones should be sold. All it does is try to rate credits on the basis of how likely they are to default.

Moody’s, by contrast, appreciates that bonds are investment instruments, and tries to build into its ratings the likelihood that investors will end up getting all their money back at the end of the day, rather than simply measuring how likely it is that there might be a default.

Here’s David Levey, for instance, the former managing director of sovereign ratings at Moody’s:

US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a “safe haven”, due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking “risk-free” reserve assets that they reallocate their portfolios toward these relatively illiquid markets.

This is a very Moody’s thing to say, and is quite different from how the people at S&P think. S&P bends over backwards to try to say that it is not sending a market signal, and that a downgrade is not the same as a “sell” rating. Moody’s, by contrast, is a bit more realistic and appreciates that people use its ratings in the context of deciding which bonds to buy and which bonds to sell.

If Moody’s were to downgrade the US, then, that would indeed be an implicit suggestion that investors rotate out of Treasury bonds and into safer credits like, um, France and the UK. Which is a pretty silly idea. But S&P isn’t Moody’s, and so I think that Levey is wrong to say that S&P is making that suggestion.

Similarly, Nate Silver has a long post on “why S&P’s ratings are substandard and porous” which starts with the point of view of “an investor looking for guidance on which country’s debt was the safest to invest in.” That’s something you (purportedly) get from Moody’s; it’s not what you’re getting from S&P.

Silver also has a big problem with the fact that S&P ratings are more correlated with the Corruption Perceptions Index than they are with things like GDP growth or inflation, or debt. That fact, he says, “suggests that S&P is making a lot of judgment calls about countries.” Which, well, yes. Sovereign defaults are always political, rather than economic: if you looked only at macroeconomic ratios, then Ecuador should be investment grade, as would just about any other country which has recently defaulted and wiped out most of its debt. A sovereign credit rating is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay.

Silver goes on to complain that credit ratings are a lagging indicator: upgrades and downgrades tend to lag the market, rather than anticipate it. Again, this is a complaint only if you think of the ratings agencies as being some kind of guide to help people beat the market. But they’re not. Sovereign upgrades and downgrades are big, important things, and the ratings agencies take their time over them — they’d much rather err on the side of caution and act too late than jump onto some wave of excitement and then regret doing so a few weeks later. That kind of activity they’re happy to leave to markets.

This is also the reason why S&P doesn’t much go in for multi-notch downgrades. Silver is right when he says this means that a country which has been downgraded to AA is a worse bet than a country that has been upgraded to AA: the former is much more likely to get another downgrade than it is an upgrade, while the latter is on an upgrade path and is more likely to get another upgrade than a downgrade. So they’re not exactly the same.

But the ratings agencies are very good at emphasizing that two countries with the same credit rating are far from identical in other respects. Again, S&P — and even Moody’s — would never say that investors should be agnostic when it comes to choosing between countries with the same credit rating. They’re just being cautious when it comes to their ratings moves, going slowly rather than quickly because that way they won’t make major multi-notch mistakes and they’re giving countries the opportunity to stop the deterioration in their ratings. The markets love to give an immediate verdict on creditworthiness: if you want that kind of thing, just look at bond prices or CDS spreads. Credit ratings are something different, which is a good thing.

Silver’s main thesis seems to be that the markets are a better guide to the markets than the credit rating agencies are. Which is true as far as it goes, but misses what it is that the ratings agencies in general, and S&P in particular, actually do. They’re a datapoint, not a financial advisor: ratings are more of a constant, in contrast to bond prices, which are highly variable. If you want a guide to bond prices, look at bond prices. If you want a guide to default probabilities, however, then the ratings agencies are still a good place to start.

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