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The New Normal in Sovereign Debt Ratings


Now, not only do the feelings of traders and bond investors matter to Moody's, but the attitudes of protesters and voters as well.

If you haven't seen his work, Carl Richards over at has a wonderful way of taking complex issues in the financial services space and translating them into incredibly simple "Sharpie" drawings. And among my favorites is his simple sketch "Markets = Feelings."

Two weeks ago, I relied heavily on this phrase in talking to a group of eighth grades about the Roaring '20s and the Great Depression. And it is amazing when you ask kids "So how did the people in '20s feel?" how quickly they can then tell you in which direction the market went.

Of late, though, I have begun to wonder whether the rating agencies have been checking out Mr. Richard's website, as increasing "Sovereign Debt Ratings = Feelings" as well.

I first began to notice this in December when Moody's put Spain's sovereign debt rating on watch, citing "the country's vulnerability to funding stresses, weak market confidence and the possibility of greater public debt should the banks need further capitalization." And more generally, Moody's made it clear that going forward, sovereign borrowing costs and market receptivity would matter more in the determination of sovereign debt ratings than they did in the past. And judging by the timing of Moody's announcement, it sure felt like the rating agency was watching CDS spreads very closely.

But the result, to put Moody's ratings watch into simple mathematical terms, is now clearly:

Market Confidence = Spain's Ratings

And by applying the transitive property in math to the sovereign debt market more broadly, I'd offer:

Feelings = Markets = Ratings

And this doesn't just apply to sovereign ratings in Europe's periphery either. Two and a half weeks ago, Fitch put Egypt on watch noting "The outlook revision reflects the recent upsurge in political protests and the uncertainty this adds to the political and economic outlook…"

And Moody's, which didn't hesitate with its downgrade, went even further saying that "Egypt suffers from deep-seated political and socio-economic challenges, including a chronic high rate of unemployment, elevated inflation and widespread poverty. These, together with a desire for political change, have fueled popular frustrations…There is a strong possibility that fiscal policy will be loosened as part of the government's efforts to contain discontent."

So not only do the feelings of traders and bond investors matter to Moody's, but so too do the attitudes of the people protesting in the street.

But there is even more. What really got my attention with the regards to the whole "Feelings = Ratings" issue was Friday's news that Moody's was downgrading (with potential for even further downgrade) to junk status the senior debt of Bank of Ireland, Allied Irish (AIB), Anglo Irish and three other Irish lenders on concerns that senior bondholders may now be asked to share the cost of saving the country's financial system following the country's February 25 elections. As Moody's wrote, "While some of [the] statements [from opposition party candidates] may reflect the current pre-election debate, Moody's is increasingly concerned that they represent a growing underlying threat for senior creditors."

So we can add voters to the list.

"Feelings of Traders, Protesters and Voters = Sovereign Debt Ratings."

While I don't disagree with Moody's conclusion, I'd offer that for most sovereign debtholders (and dare I add municipal bondholders) this is not what they thought they were buying into. Most, I suspect thought that their bonds' ratings were determined through a clinical, emotion-free evaluation process, not a popularity contest -- especially one in which the ultimate winner is determined by an unruly mob of bond traders, voters and/or protesters.

But that looks to me to be the "new normal" in sovereign debt ratings. Like it or not, bondholders are now married to the mob.

But I'd add that there is another new dimension to all of this as well, and that is timing. Heretofore rating agencies like Moody's waited -- some would argue woefully too long -- to downgrade securities; but judging by the actions in Egypt and Ireland, Moody's is now anticipating outcomes and acting on a preemptive basis.

In Egypt, Moody's didn't even wait to see what the crowd of protesters would do before it downgraded that country; and in Ireland the rating agency just looked at the mood of voters and the rhetoric of political candidates and, with none of the precincts even reporting, concluded that bondholders were clearly in trouble.

The concern that I have today is that we now have a sovereign ratings world in which cause and effect are increasingly indistinguishable. And thanks to the CDS market, it is all on public display 24/7. And the potential for death spiral is staggering given the now hardwired ability of market volatility to trigger downgrades leading to further market volatility triggering further downgrades…

Chicken and egg have been scrambled to the point that it is now impossible to tell which came first.

For policymakers seeking to buy time, Moody's recent change in behavior presents a daunting new challenge. And how long regulators and politicians tolerate these mood-driven ratings scud attacks remains to be seen.

But I am also afraid that the tolerance of sovereign debtholders will be tested as well. Investors who sought out government debt as a safe harbor from the 2008 stock market crash didn't sign up for volatility, and after what they've already been through, I am not sure it would take much right now for these investors to just throw their hands up and say "I'm done".

And judging by this comment from Morgan Stanley offered at the end of 2010, I'd offer that Elvis may be headed out the door already:

"The bonds of several peripheral countries, while still being government bonds in name, no longer offer the advantages of a government bond -- safety, liquidity, low volatility and a negative correlation with risky assets…Hence, investors running a traditional government portfolio are exiting those markets. In short, peripheral government bonds have become an asset class in search of a new investor base."

"Ratings = Feelings," and today, faster than ever.

I'd plan accordingly.
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Position in SPY, SH and JPM.
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