More Than You May Want to Know About Credit Rating Agencies
By Cydney Posner
With the U.S. (not to mention Italy and Spain) facing the possibility of a sovereign debt ratings downgrade, the credit rating agencies are once again taking center stage. You'll recall that the last time they were the focus of attention, it was because they gave high ratings to junk mortgage-backed derivatives and failed to downgrade any of the banks before they almost collapsed. They don't seem to be quite so reluctant when it comes to sovereign debt. Following is a link to an interesting article from Reuters regarding the power of credit ratings agencies.
The article contends that reports from one or more of the credit rating agencies have been behind many of the recent market moves in government debt. Yet the irony in their current prominence is that these "are the same firms that many blame as prime instigators of the 2007-2008 credit crisis for freely giving out top ratings to ultimately worthless structured mortgage products, allowing the credit bubble to form. Now they sit in judgment of the countries that had to ruin their public balance sheets to prevent financial collapse by saving the banks shattered by those bad instruments once blessed by the agencies."
The agencies have already downgraded three European countries and now "they have Washington in their thrall. S&P and Moody's both have threatened to cut the top-notch credit rating of the United States' sovereign debt for the first time in its history, a move that could have deep ramifications for financial markets, pushing up the cost of credit world wide for many years."
The major agencies charge private issuers for a rating, which, critics claim, creates "perverse incentives such that at the height of the credit boom in 2005 to 2007, the agencies recklessly awarded Triple A ratings to complex exotic structured instruments that they scarcely understood." They also charge that the agencies weakened their standards in a race to achieve market share. While the agencies have "profited handsomely" from this practice, there "is no such incentive for sovereign ratings, which are provided free of charge to the country. But this creates potential for a different type of conflict or at best a lively political tension where raters judge those who regulate them.
" ‘Four years ago, the rating agencies were rating everyone AAA. They had a clear conflict of interest and they missed the crisis,' said [a former aide to House of Representatives Speaker John Boehner and now a lobbyist].
" ‘Now they're seeing the world with clearer vision. The irony isn't lost on anyone in either party,' said [the lobbyist].
"To be sure, there is nothing to suggest they have abused their power to determine the financial fate of nations. And during the intensive lobbying in Washington when armies of trade groups descended on the city in the spring and summer of 2010 to influence debate on new financial rules that eventually were enshrined in the Dodd-Frank financial reform bill after the credit crisis, ratings agencies were scarcely to be found.
"At the time, a financial lobbyist said privately he did not want their business. An official at one of the big three agencies complained that ‘no one was on their side.' "
The credit score for the U.S. has outsized importance because it could affect interest rates worldwide: "The ripple effects could be dramatic, from lower corporate profits to weakened consumer spending, as everything from mortgage rates, credit cards and car loans are costlier. At worst it could be enough to tip a shaky U.S. recovery back into recession and seriously dent world growth."
The power of the credit ratings agencies also stems their central role in the world financial system role through the regulatory structures that dictate operations of banks and many pension and mutual funds. As NRSROs, they are qualified to rate companies and their various financial obligations, and many governments and financial institutions require those ratings for securities before they will buy them.
In 2004, the "Basel II rules put credit ratings at the heart of evaluating how much capital a bank must set aside in reserves against potential losses -- but with a twist. Sovereign debt was considered risk free under Basel II, a decision coming back to haunt bank regulators. As sovereign nations face downgrade and even default, it further weakens banks whose capital reserves are filled with once risk-free sovereign debt."
Apparently, there are actually 10 rating agencies, but only Moody's, S&P and Fitch carry much weight. However, the weight the three do carry is enormous: "The responsibility they bear is so huge that even people who wield it think it is too much. They say it distorts the financial system by encouraging bondholders to substitute the judgment of a handful of ratings agencies for their own in-depth credit analysis. It stacks the deck when a handful do the homework for hundreds of thousands of private investors, banks and funds." Under Dodd-Frank, rating agencies are now subject to liability for reckless behavior and regulators are required to reduce reliance on ratings in the rules, thus no longer requiring in the rules that credit ratings be obtained.
Over the past 18 months, Western governments have absorbed the attention of the rating agencies: "In Ireland, beset by huge bank bailouts, its government liabilities have risen to 70 percent of GDP this year from 1.5 percent in 2006, according to the OECD. In the United States, the level is 74.8 percent of GDP, against 41.7 percent five years ago.
"Right now, Washington is the bull's-eye. The changed status of ratings agencies from accused to accuser in less than three years is remarkable.
" ‘It flabbergasts me that we are all on 'pins and needles' as to the verdict of the rating agencies as if the rating agencies themselves have any credibility after completely missing the crisis of '08 and '09,' said [a senior executive at a large investment bank].
The agencies have long been subject to criticism, having failed to detect "unsustainable capital inflows that led to currency collapses across Eastern Asia and deep recessions" during the 1997-98 Asian currency crisis and failing in 2001 to timely lower Enron's credit rating: "The harshest public criticism of late comes from European governments, where the agencies have become a pariah for their sovereign downgrades. They are accused of untimely actions that immensely complicated the cost and the structure of international rescue packages."
(This article published yesterday describes the seizure by Italian prosecutors of documents at the offices of Moody's and S&P in a probe over suspected "anomalous" fluctuations in Italian share prices. Of course, cynics might be a bit suspicious about that. http://www.reuters.com/article/2011/08/04/uk-italy-ratingagencies-prosecutors-repe-idUKTRE7735A620110804?type=companyNews)
The article then describes the history of the Big Two rating agencies:
"The two companies have in many ways the same story, which has a lot to do with trains.
"At the turn of the 20th Century, John Moody revolutionized markets with his Moody's Manual of information on stocks and bonds. His business failed with the 1907 market collapse, but he went back to the well in 1909 with a system of analyzing and rating railroad stocks and bonds.
"Within 15 years the company was rating virtually everything in the bond market. In the 1970s, the business made a shift in its fee structure, one that would become a central point of criticism during the recession -- it started charging issuers for ratings as well as charging subscribers for its reports.
"Critics say that makes Moody's (MCO.N) beholden to issuers, on whose fee revenue it relies; the company, in its corporate history, says ‘the rationale for this change was, and is, that issuers should pay for the substantial value objective ratings provide in terms of market access.'
"By age, though, Standard & Poor's takes pride of place. The company dates to Henry Varnum Poor's 1860 ‘History of the Railroads and Canals of the United States,' an attempt to consolidate the financial details on the railroads.
"Around 1906, aspiring actor Luther Blake formed the Standard Statistics Bureau, publishing cards with news on industrial companies outside of the railroads. He had taken a job at an investment bank to pay the bills while trying to make it on Broadway, a not-unfamiliar path even today.
"In the 1920s, Standard Statistics and the company that had evolved into Poor's Publishing started rating bonds. In 1941 the two merged, ultimately going public in 1962. [Some might suggest that that move was the fatal error.] The publishers McGraw-Hill (MHP.N) acquired the company in 1962 and remain the owners today -- though just this week, activist investors started a push to break the company up and sell S&P."
According to the article, the ratings process is intensive: "A lead analyst on a country, usually a Ph.D. with language skills, becomes something of a private investigator writ large, talking to figures from government, the media, academia, the banking sector and strategic industry to piece together economic trends and evaluate credit risks. The point, veterans of the process say, is to develop a report the ratings committee can use to help guide its decision." After reviewing a written report by the analyst containing a core recommendation, the committee of up to 20 members engages in intensive debate: " ‘The sovereign committees are much more heated' than for corporate or other credit products, said [a former chair of Moody's fundamental credit policy committee]. There's more divergent opinion expressed. In many cases there was just a bare majority voting for a rating outcome whereas in other areas, structured or corporate, you were more likely to see unanimous ratings decisions.' " To avoid undue pressure, the names of committee members are kept confidential, but those subject to ratings can be frustrated by the lack of information. The decision is by majority vote, with the possibility of appealing a downgrade.
Sovereign ratings can obviously have a substantial impact. Because the horizon for a country rating decision is "medium-term, looking out five to 10 years at the trajectory of fiscal and macroeconomic policies. This often clashes with the short-term objectives of politicians and some investors, causing increasing political tension." Western governments are not accustomed to "seeing their sovereign credit under the microscope. For decades, their ratings were stable, and downgrades were the provenance of ill-run emerging economies such as Argentina, Russia or Brazil. Now the tables are turned." U.S.Treasury debt plays a benchmark role in pricing credit instruments worldwide. The U.S. securities industry trade group "last week estimated a downgrade to double A would push up Treasury yields by 0.6 to 0.7 percentage points…. S&P and Moody's both have said they need to see a burying of political differences so that Congress can agree on a credible, medium-term plan for cutting the U.S. budget deficit."
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