Rating agencies behind the curve

American International Group (AIG) fell by more than 30% Thursday as concerns about Lehman Brothers and the credit crunch deepened. This is in spite of many experts claiming (yet again) that with the Fannie and Freddie bailout the end of the credit crunch was in sight.

Standard and Poor’s response:

On Friday, credit-ratings firm Standard & Poor’s threatened to downgrade American International Group Inc., citing the significant decline in the company’s share price and the increase in credit spreads on the company’s debt.

Increasing spreads and decreasing equity value are both good indicators of a deterioration in credit quality. Moody’s KMV model is based on the “Merton Model” approach to estimating probabilities of default by explicitly considering the market value of assets (typically derived through the market value of equity and debt) and the market implied volatility of assets (also derived through the market implied volatility of equity and the level of gearing).

  • If AIG becomes insolvent, shareholders are unlikely to get anything out of the company. As probability of ruin (insolvency) increases, the value to shareholders decreases.
  • Increases in volatility of assets increases the probability of default.
  • The VIX (Volatility Index) has a strong record of negative correlation with overall market performance, reinforcing the rationale for high volatility being bad for share prices.
  • Decreased equity implies higher gearing. This is often put forward as a possible reason for the equity volatility skew (or “sneer” as some describe the not-quite-smile). Higher gearing implies higher risk of financial distress.
  • As the value of underlying assets decreases, not only the probability of default increases, but the Loss Given Default also increases since there will be less to return to bondholders in the event of default.

Higher yields on corporate bonds imply higher credit spreads. Unless there is reason to believe that liquidity in AIG’s share has dried up (which would increase the spread but not necessarily indicate a deterioration in default probabilities), this implies the market views the bonds as more risky.

So, S&P’s rerating consideration is sensible to the extent that there is clear evidence of credit deterioration.

But if S&P waits for the market to assess these risks then follows several weeks later with a change in rating, what is the point of the rating agencies in the first place?