What are ratings, contagion and sovereign debt

Do ratings matter?

Ratings agencies, which assess the state of a country’s finances, assigned a AAA rating to many of the assets that turned out to be toxic in 2008.

They are private agencies that label assets so that financial actors can measure their risks.

So investors wanting to compare different types of investments—US treasury bonds to mortgage backed assets or student loan backed assets—can compare their credit rating.

There are three big ones—Standard and Poor (S&P) which has downgraded the US debt, Moody’s and Fitch. Their ratings affect the return attached to various assets.

What is contagion?

Contagion refers to the idea that financial crises may spread from one institution to another.

So, a bank run could spread from a few banks to many or from one country to another, as when currency crises, or stock market crashes, spread across countries.

What is a sovereign debt crisis?

Governments, just like people, have to borrow money if their expenditure (public sector spending) is higher than their income (mainly from tax receipts).

And, just like people, the rate of interest depends on their perceived ability to pay that money back.

If you have a decent income, low debts and a good credit history, you can borrow from your bank. If you’re not in such good standing you might have to use a credit card. If you’re in a really bad way, you have to get a payday loan at a colossal rate of interest.

The only difference is that states issue bonds, which traders can buy. In the US they are called treasury bonds. In Britain they are sometimes called gilts.

Greece reached the point where it had more debt than it could roll over, and at far higher interest rates than it could afford. It faced default.