Tuesday, June 7, 2011

Ratings History and Credit Risk for Southern EU Sovereign Debt

Contagion in 2008 was driven by credit losses, and so it follows that the main risk for a new round of contagion is also credit risk. This is to say that the EU banks potentially could lose a lot on the default/restructuring of Greek and/or Irish debt, and/or other Southern EU debt.

Credit losses depends in part on the previous ratings of, in particular, Greek and Irish debt -- anything above A would mean that the European banks could hold the government debt without much in the way of reserves. (I believe under Basel, a bank can buy with AAA rated debt with no reserves, AA with 10% or so and A with 20% or so -- need to check this)

This is what got the banking system into such a tangle with the subprime mortgages -- they were rated AAA, and so the banks bought them without almost any reserves. The losses flowed down straight into equity.

So rating history of Greece: (Moody's)
currently as of 6/11 Caa
A1 --> A2 12/09
A2 --> A1 11/02
Baa3 (oldest I can find) 1996

So Greece has never been above A2, which means the European banks likely have some reserves for this debt. (this is to say, the writedowns won't be the same as write downs on AAA debt)

Raing History of Ireland (Moody's):
Baa1 --> Baa3 4/11
Aa2 --> Baa3 12/10 (ouch!)
Aaa --> Aa2 7/10 (Ireland was rated triple A??)

Note that from 2000 to 2007 Irish debt/gdp was below 38%, reason for the AAA rating, now it's at 93.6%. However, the main problem in Ireland is the banking system not necessarily the governmental debt. If the governmental debt became an issue, this could be a problem (only slightly mitigated by the fact that overall Irish governmental debt is not overwhelmingly large at around $US165Bn approximately -- in so far that the EU banks tend to be highly levered and any losses will put capital ratios at risk).

Other countries:
Aa1 --> Aa2 3/11
Aaa -> Aa1 10/10 (Spain was also triple A!)

Note however Spain has debt to GDP of 63% so isn't a huge default risk currently.

Aa2 (current)
Aa2 (2007)
Aa2 (2004)
Aa3 --> Aa2 5/2002

Appears Italy has been rated Aa2 for a long time, before in 2002 it was Aa3 (thank goodness it hasn't been AAA).

Overall, the main risk again appears to be Italy -- due to its relatively high rating and above 100% debt, so far the market isn't worried about Italy, rather Greece, which was never rated higher than A2 -- EU banks likely have reserved (in part) for holdling Greek debt.

Still there is risk due to the fact that the European banks tend to be more levered than American banks. I´ll research to see if the major EU banks publicly disclose their EU sovereign debt holdings.