Junk ratings May 11, 2013 at 4:47 pm

Bloomberg reproduces the following chart of Moody’s ratings of major banks with and without government support.

Bank ratings

You could read this at face value: the claim would then be that an unsupported BofA and Citi are junk. But really, is this credible? The BB+ one year default rate averages, depending on period, somewhere around 1 – 1.5%. A fair credit spread, without liquidity premiums or other compensation, and assuming a Lehman-type 25% recovery would therefore be at least 1%, with the actual credit spread being bigger than that.

This does not seem credible to me. The PDs are high; the spreads are high; perhaps it is the stand alone ratings that don’t make sense?

2 Responses to “Junk ratings”

  1. Not to quible, but why would the fair spread be at least 1%? I’m pretty sure the approximation is default rate * (1-recovery); therefore the fair spread with a 1-1.5% prob of default and a 25% recovery should be 0.75-1.125%, no?

  2. PD x R + (1 – PD) x (1 + s) = 1, without rates, roughly, so 1 + s = (1 – PD x R) / (1 – PD). At 1% PD, the spread is (1 – 0.0025) / .99 = 0.7575% over. At 1.5% its (1 – 0.00375) / .985 = 1.142%. But yes, you’re right, my bad.