Gap between implied and real ratings still evident

Credit default swap spreads for many banks continue to imply default risk greater than that shown by credit ratings, according to a senior analyst at Moody’s Analytics.

“My personal view is the market is still trading many banks cheaply,” says the divisional managing director of Moody’s Analytics capital market research group, David Munves.

He cited Citigroup as an example of a firm whose current CDS spreads do not reflect the true risk of default. During October, Citigroup’s average CDS price was 209 basis points, a level indicative of a Ba1 rating. “That’s probably too low an implied rating in my opinion,” says Munves.

Moody’s rates Citigroup A3, four notches higher than the CDS-implied rating. The bank has received extensive US government support as a result of heavy losses during the financial crisis.

The agency rates UBS and Deutsche Bank five notches higher than the CDS market implies. In October, the average CDS spread for UBS (rated Aa2) was 93bp, while for Deutsche Bank (rated Aa1) it was 77bp.

The Royal Bank of Scotland and Goldman Sachs are currently rated A1 by Moody’s, four notches higher than their implied ratings.

Munves attributed the differences to the agency's focus on individual risk factors affecting the banks, in contrast with the markets, which tend to reflect overall sector risk. “Moody’s ratings are entity specific. There is obviously a sector component to the ratings, but a rating reflects Moody’s view of credit risk at the entity level. In the case of financials, the market did a very good job of identifying risk on a systemic basis, but has a much harder time picking out individual companies that might, and in some cases did, go bust,” he says.

By way of illustration, Lehman Brothers’ CDS-implied rating fell only one notch from Ba1 to Ba2 between August 2007 and September 2008, when the Wall Street giant filed for bankruptcy.

The analyst said it was too simplistic to describe either Moody’s ratings or CDS-implied ratings as right or wrong: “All risk systems make some trade-off between accuracy and stability. Market-based signals as credit risk indicators are very strong over a short time horizons, while Moody’s ratings rise in accuracy over longer horizons.”

Despite the current differential between Moody’s ratings and market implied ratings, Munves says: “If underlying prices on bank assets such as commercial real estate and consumer loans stop falling, then that should provide a basis to close the gap between their CDS trading levels and their Moody’s ratings. My estimation is this is probably another year or so off.”

The credit rating agencies have come in for heavy criticism during the crisis, with many investors claiming their ratings did not truly represent the risks involved, particularly with structured finance assets.

However, Munves insists Moody’s ratings were designed to give a relative rather than an absolute indication of risk: “A given rating category is not tied to a fixed default rate. Ratings aim to provide relative rankings of default risk over time. For example, the average default rate on B rated issuers should remain higher, on average, than that for Ba rated entities. If you’ve achieved that you’ve done your job properly.”

Munves says this is well understood by bond investors: “Anybody who knows the topic shouldn’t be confused.”