Doom-loops: The Role of Rating Agencies in the Euro Financial Crisis

During the euro-area financial crisis, interactions between sovereign spreads and credit ratings appeared to have led to self-generating feedback loops. To examine the interaction between spreads and ratings, we estimate a simultaneous two-equation model in which spreads and ratings are endogenous. Using a panel of 5 euro-area countries, we construct time series comprising the ratings of its sovereigns determined by the three major rating agencies. We find that, controlling for the economic and political fundamentals, spreads and ratings strongly interacted with each other during the crisis, producing effects well-beyond those of the fundamentals, and with the interactions demonstrating high persistence.