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Why Credit Ratings Matter

Why Credit Ratings Matter

Photograph by Bloomberg

This week, the ratings firm Moody’s (MCO) said it is reviewing 17 banks and securities firms for possible downgrades. Morgan Stanley (MS), UBS (UBS), and Credit Suisse (CS) could fall three notches, it said, and Goldman Sachs (GS), Deutsche Bank (DB), JPMorgan Chase, (JPM) and Citigroup (C) could be cut by two levels. After ratings firms were criticized for giving top grades to investments backed by subprime mortgages before the housing bust—and investors shrugged off Standard & Poor’s downgrade of the U.S. government debt over the summer—a natural question is: Do ratings matter any more?

John Kiff, a senior financial sector expert at the International Monetary Fund, was part of a team that published a study in January asking just that question. The short answer is, yes, a lot. The study looked just at sovereign debt, but Kiff says the findings likely apply to corporate debt too. (He says he can’t say for sure without further research).

The researchers found that while investors don’t react to most changes in ratings, certain downgrades tend to have a big impact. The most damaging is a move from investment grade to junk. Many institutional investors, such as pension funds, are often barred from owned non-investment grade bonds. Kiff says there’s one other big pivot point, although it wasn’t covered in the study: the drop from what he calls “super investment grade” down to middle investment grade, where many large, more conservative investors draw the line. Facing a smaller pool of potential investors, companies and countries may have to offer higher interest rates to sell their bonds.

Even minor downgrades—ones that don’t put the company into a different category—can raise borrowing costs because investors will demand compensation for taking additional risk. Generally, the lower the credit rating, the greater the impact of even a one-step demotion, says Larry White, an economics professor at NYU’s Stern School of Business. The increases in borrowing costs “are bigger at the lower notches,” he says. “The difference between AAA and AA+ is comparatively small, but B and B- would be bigger.” Downgrades are particularly costly for banks, White says, because they borrow much more frequently than non-financial corporations. “The higher costs will impact a bank sooner than a steel company that may not have to issue bonds for several years,” he says. On the other hand, non-bank companies may feel the impact in other ways. Suppliers, for example, may demand quicker payment from a lower-rated company, he says.


Weise is a reporter for Bloomberg Businessweek in Seattle. Follow her on Twitter @kyweise.

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