Business Ethics
Sovereign Debt Crisis and Rating Agencies

Background

Many parties are responsible for the creation of financial crises around the world in 2007, which in turn causing sovereign debt crisis in Euro zone. For example, prior to the financial crises, regulators in US are actively encouraging financial innovations, such as interest-only mortgages, negative amortization loans, option adjustable mortgages to the derivatives derived from these complex assets that are the main actors in the crises. Then, investors are largely greedy and complacent. There are also many structural and incentives issues in the banking industry, leading to serious moral hazard attitudes an irresponsible decision making process by the financial institutions. Last but not least, there are also credit rating agencies, such as Fitch, Moody and Standard and Poor, which made hefty income from the securitization process and are happy to turn the toxic subprime loans into ‘high-quality’ securities to be marketed to other part of the world (Roubini, 2010; Cuockley & Barnes, 2008).

In this paper, the role of credit rating agencies in creation of sovereign debt crisis in Euro region in 2010 and 2011 today are discussed. It is discussed that rating agencies had been playing significant and active roles in formation of sovereign crisis – although they are not the only culprits to be blamed. Lastly, several investment strategies in sovereign bonds market will also be presented, based on the findings and discussions presented in this paper.

Credit Rating Agencies and the Sovereign Debt Crisis

The various rating agencies have been playing significant role is leading and affecting the sovereign debt crisis in Euro region today. As argued by many researchers, the impacts of irresponsible or delayed actions from rating agencies are among the main culprits leading to the formation of sovereign debt crisis. The story started as early as the irresponsible act of rating agencies to rate toxic assets as high as the golden standards, so these assets are sold to the public and investors around the world. Credit rating agencies, such as Fitch, Moody and Standard and Poor, made hefty income from the securitization process (of those subprime loans from US) and are happy to turn those toxic loans into ‘high-quality’ securities. By giving high rating to the securities or entities under reviewed, the rating agencies not only able to earn hefty fees from the entities they are rating, but also are being promised of future businesses (Roubini, 2010; Cuockley & Barnes, 2008).

Nonetheless, from another perspective, it is also reasonable to expect that rating agencies may have real difficulties in evaluating these esoteric securities as well. Some researchers are arguing that it is truly hard for the rating agencies to come out with fair and accurate assessment on these complicated securities. The probabilities of default of these securities are hard to analyzed, as there is no historical data for such innovations. Not only that, these securities get even more complicated as time pass by, such as the emergence of collateralized mortgage obligations (CMOs), collateralized debt obligations, to those CDOs of CDOs (i.e., CDOs2) or even CDOs of CDOs of CDOs (i.e., CDOs3) (Roubini, 2010).

Anyway, the roles of rating agencies in causing the financial crisis in 2008/ 2009 that eventually leading to sovereign debt crisis in 2010 are widely acknowledged. For example, Stiglitz (2010) argued that the delegation of regulatory duties to the rating agencies is one of the root causes leading the entire world to the current mess. There was also US congressman arguing that rating agencies serve as the triggermen of the crisis in 2008. One of the US congressional committee even pointed out that these rating agencies already knew that their risk models were flawed in 2006, but they were stuck in inaction until 2007. That view is shared by shared by Dr. Doom, namely Roubini (2010) in his latest book titled Crisis Economics.

As a matter of fact, the well-packaged toxic securities remain toxic and dangerous. Eventually, the growing defaults by borrowers were causing many of the mortgage lenders to fall. Subsequently, many of the investors invested in those subprime mortgage-backed securities suffer losses. Many of the highly leveraged hedge fund specializing in this sector eventually went bankrupt as well (Chitakornkijsil, 2010).

At last, it is noted that credit rating agencies eventually downgraded the ratings for investment banking entities and banks holding these toxic assets. However, the act is too slow, and damages had been done. In fact, the downgrades of credit rating hasten the downfall of the banks, and drive the economy into deeper recession by creating panic among public, which eventually resulted in credit crunch and the Great Recession (i.e., now the rating agencies become the triggerman of the crisis, besides being a significant contributor to the formation of the subprime crisis earlier) (Barro et. al., 2010; Roubini, 2010).

Soon, the financial crises spread to Europe. At that point of time, many of the banks in Euro region were loaded with the toxic assets rated as the investment grades by rating agencies. They are greatly exposed to unrecoverable loses due to default of subprime borrowers, or simply suffer huge financial losses from investing in these toxic securities. Besides, as the recession spread to the region, many of the countries found themselves suffering from a deteriorating economic outlook (Batchelor, 2010; Hill & Haff, 2010). All of these issues invoke the formation of another crisis in 2010 – namely the sovereign debt crisis.

Sovereign debt crises in Euro-area are largely caused by the consequences of subprime financial crises in 2008 (Herman, 2009). For discussion purposes, Greek will be used as an example to illustrate the formation of sovereign debt crisis in the nation. Due to the proliferation of subprime financial crisis to other countries, the government of Greece has been using debt to stimulate the nation’s economy to get out from recession. However, the dependency on debt is excessive, as since 2000, the government had been relying largely on debt to pay for social welfare program, to roll over old debt, and to fulfill other fiscal obligation. On the other hand, the country is already being troubled with stagnant economy, structural problems in the economic system, dysfunctional tax system, high deficit to GDP and worst, had been misrepresenting the public finances data related to the country in order to stay within the monetary boundary set by Maastricht Treaty (Abboushi, 2010).

Before the misrepresentation issues by the Greece government is found, the market is already sensing the riskiness of the sovereign debt of Greece, and had raised the yield on the new Greek government bonds that the government can hardly afford. However, once the misrepresentation issues are announced, rating agencies such as Fitch, Moody and Standard and Poor immediately downgraded the creditworthiness of Greece sovereign debt significantly, based on the opinion that Greece was not trustworthy and the newly disclosed unfavorable statistics (of high deficit to GDP). Such a move significantly increased the yield of Greece sovereign bonds (to as high as 15.3%). As a result, Greece found itself harder to raise new debt from the public to roll over its existing debt, and is forced to seek bailout from EU and IMF (Manasse et. al., 2009; Simos, 2010; Abboushi, 2010).

Once the downgrade of Greece sovereign debt is announced, the market was suddenly leaded to investigate the situations in other countries in the Euro region, and get suspicious if other countries (that facing similar economic dilemmas as Greece) are able to honor their sovereign debt obligation. As such, the sovereign debt crisis is invoked. Confidence levels dropped. The bond yields spread of several countries, such as those PIIGS (Portugal, Ireland, Italy, Greece, and Spain) widened while the costs of risk insurance increased tremendously. Not only that, market is soon to discovered that many of the big banks from France and Germany are holding sovereign debt from these countries, and get suspicious if these banks are still financially strong. As consequences, the stock prices of the banks plummeted, and they found that they are now hard to borrow from others. Such a situation is similar to the banking crises happening in 2008/ 2009, where by the inability of the banks to borrow create credit shortages in Euro region (Simos, 2010; Abboushi, 2010).

Again, rating agencies are blamed as the triggermen for the sovereign debt crisis, as the downgrade of sovereign debt rating for PIIGS essentially triggered market panic that lead to a crisis of public confidence against sovereign debt and banks (Attinasi et. al., 2010). Not only that, as many of the governments around the world prohibit institutional investors from investing in lowly rated bonds, those PIIGS found themselves in a even harder position to get funding from the public (Barley, 2010). European Commissions believe that the act of downgrading sovereign debts made the situation worst, as that would deprive those nations requiring help to become harder in getting helps (i.e., funding) from the public. The downgrades essentially lead to a spike in borrowing costs for those PIIGS countries (Evans, 2010).

From another point of view, it is reasonable to argue that the rating agencies were again slow to take action with regards to the sovereign debt issues in Euro region. According to Neumann (2010), countries such as Portugal, Italy, Spain and Greece had already insolvent by 2009, as the internal economies policies are largely unsustainable, coupled with the ever increasing current account deficit in these countries. For example, rating agencies again fail to sense and signal the degradation of the economic position of the Greece timely. If they had done so, it is likely the crisis may not be as severe as it is today. Secondly, as what they had done in the financial crisis in 2008/ 2009, the announcement of downgrades of rating for PIIGS hasten the process of the sovereign debt crisis in Euro region (Herman, 2009). (In contrast to the popular opinion that rating agencies should delay its announcement to downgrade the rating of these countries, it is of the author opinion that they are indeed too late to downgrade it, as early detection of problems or earlier downgrade can present the countries from falling into such a deep trouble as they are in today.)

Implications to Investment Strategies

As shown in discussion above, it is obvious that rating agencies tend to be slow in highlighting red flag on the riskiness of certain investments. For example, they are slow to downgrade the toxic subprime-based assets in 2006 as well as the already problematic sovereign debts of PIIGS prior to 2010. Essentially, they tend to lag the market. A research by Minescu (2010) on the subject of failures of credit rating agencies reaffirmed such viewpoint. Thus, a prudent investment strategy should not trust advices or recommendations from rating agencies blindly. Investor should exercise care and diligence in assessing the risk factors pertaining to a particular investment before any investment decisions.

Secondly, it is found that rating agencies often acted as the triggermen of financial crisis. As such, the downgrade impacts of rating agencies should not be taken for granted by investors. Investors should watch possible downgrade from rating agencies, and liquidate the respective positions to avoid huge losses, as it is witnessed that downgrade tend to hasten the speed of a crisis, if not to make the crisis worsen. From another view, the public finances and total debt to GDP for countries such as Japan, UK and US are problematic as well. Market already senses such issues (Dawsonm, 2011; Gray & Jobst, 2010). Thus, investors may short the sovereign bonds of these countries if rating agencies downgraded the rating of these debts.

Currently, the yield form sovereign debt in those PIIGS and other countries in the Euro region are relatively high. This apparently promises huge return to the investors, but investors should be aware that the expected returns come with an abnormally high risk. It is reasonable that the expected returns may not materialize, or if the situations in Euro region worsen, the yield on the sovereign debt may spike again, causing great losses to those investors. The problematic economic structure and public finances policies in those PIIGS countries are real, and many researchers argued that it is reasonable to expect that Greece may default on its debt, even with the assistance of bailout options from EU (Yue, 2010).

Overall, high return comes with high risk. Investors should take a diversified approach in investing in these risky assets. In fact, taking an active trading approach, with close monitoring on the economic situations in Europe is indeed critical to successful investment at such point of time. A tight cut loss policy will definitely be helpful. Due to the current economic outlook, investors may well shift their funds to equity to hunt for undervalued but promising companies, in the emerging markets, instead of concentrating in sovereign debt market in Europe.

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