LAST AUGUST ONE of the three main credit rating agencies, Standard and Poor’s, did what many thought was unthinkable and downgraded the United States’ AAA credit rating.
The effect on the global economy was seismic as stocks fell and the markets remained volatile in the days that followed. Similarly the same agency, known simply as S&P, caused an upset in the markets when it decided to downgrade France’s AAA rating earlier this year.
When the US was downgraded, president Barack Obama hit back furiously while more recently the French downgrade and that of other European countries drew an angry response from the European Economic Commissioner Olli Rehn who slammed S&P and the inconsistencies of credit ratings.
Where it all began
How did we get here? How did we come to a point where the decision of one organisation could have such far-reaching and potentially devastating financial consequences for companies, banks, and entire countries as well as generate such anger amongst prominent world leaders?
Last year, we explored the reasons behind credit rating agencies’ (CRAs) dominant status in the financial world.
Briefly, the foundation of such agencies came at the time of the construction of the Transcontinental Railroad in the US where investors on one side of the country wanted to gauge just how reliable those constructing projects on the other side of the country were. So was born the book of financial details about rail operators which assessed their creditworthiness. First Henry Poor’s version, later John Moody and then John Fitch.
The kind of power, influence and authority which the three main agencies – Standard and Poor’s, Moody’s and Fitch – hold now was derived primarily from the stock market crash of 1929 and subsequent Great Depression which prompted the US government to monitor the quality of bonds that banks invested in.
They did this through effectively outsourcing the assessment of creditworthiness to the rating agencies and as the years progressed the three big players took on a more and more important role.
In 1996, the highly-regarded American journalist and author Thomas Friedman noted:
There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.
In the 2000s, particularly in the US, the number of bonds and financial products that received a AAA rating multiplied massively. Of particular note was the numerous mortgage-backed securities that received a top rating from one of the three main agencies. A US congressional committee later found that Moody’s and S&P inflated the credit ratings of such products prior to the financial crisis.
Why such ratings were given to products that later transpired to be less than creditworthy is the subject of much controversy. Broadly, the agencies say they would have acted in “good faith” based on information given to them by the issuers they were rating.
But the Oscar-winning documentary Inside Job also noted the extent to which the agencies were seen to be in the pockets of those whom they were supposed to be independently rating:
This was starkly highlighted by the disclosures of a former Moody’s senior analyst, William Harrington, last August when he told the Securities and Exchange Commission (SEC) in the US that the agency was being paid by the same banks and companies whose securities it was supposed to objectively rate.
This sort of funding model and the extent to which the agencies essentially got it wrong prior to the sub-prime mortgage crisis and subsequent global financial meltdown makes it all the more puzzling to many as to why these same credit rating agencies continue to retain such trust.
Speaking to TheJournal.ie Independent TD Shane Ross noted:
A lot of their funding comes from the banks and that is the fundamental flaw with them. They are hugely influential despite that which is a bit of a puzzle.
He added: “[In Ireland] they were behind the curve by a long way. Quite often you see situations where markets are well ahead of the ratings agencies and that was certainly the case with the Irish banks. The markets were selling a lot of the bank shares before the ratings agencies had downgraded them.”
Last year, a survey of chartered financial analysts in Canada found that 71 per cent of them believed that CRAs had played a key role in the financial crisis while 85.
In the aftermath of the financial crisis, rating agencies promised reforms and carried out some but maintained their view that their rating was always an opinion. In a document outlining the benefits of its work, S&P states several times that its view is “independent” and cautions that “investors do not, and should not, base investment decisions solely on ratings”.
But in many cases investors did. Why? The economist Ha-Joon Chang notes that in the case of Europe, eurozone countries installed financial regulatory structures that are heavily dependent on the verdict of credit rating agencies. Writing for the Guardian earlier this year he outlined the issue:
We measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential.
The EU’s Internal Market Commissioner Michel Barnier is even more outspoken. His spokesperson, Chantal Hughes, told TheJournal.ie: “We have in our legislation at European and at national level, and even at global level given a de-facto institutional role to credit rating agencies.”
And yet agencies like S&P sounds a cautionary note in its briefing document, stating that its ratings “are not investment advice and only cover one aspect of investment risk – the risk of default.”
We know a little bit about defaults. Some in Ireland argue it is what we should do in order to free ourselves from austerity. While Greece technically already has defaulted on its debt obligations. Indeed, in February S&P cut Greece’s rating to ‘selective default’ after Athens imposed losses of as much as 70 per cent on some of its bondholders.
‘Ahead of the crowd’
S&P’s rating could be considered to be fairly reflective of the current situation in Greece. It’s not just Greece, Italy’s debt mountain and the political turmoil in the final days of Silvio Berlusconi’s regime led to it being downgraded.
While it could be argued that with the US’s failure to deal with its colossal debt it was inevitable that S&P took the drastic step that it did in downgrading it even in the face of huge criticism from the Obama administration and others.
The anonymous author of the respected NAMA Wine Lake blog believes that credit rating agencies have done a good job in the area of sovereign ratings in recent months:
[They] have displayed courage in ignoring the criticism of EU governments. The Greek situation has been particularly telling with the agencies turning out to be spot on despite severe criticism from the EU and Greece. In general they are inches ahead of the crowd but sometimes, that’s enough.
It will come as little surprise that Moody’s views its sovereign ratings as vital.
In a brief statement to TheJournal.ie it said: “For markets to function efficiently there needs to be a free flow of information, including views on credit risk, from CRAs and others.”
But it is Commissioner Barnier’s belief that the credit rating agencies have made mistakes in the past and that the framework in which they operate has not been “sufficiently clear or tough”, according to his spokesperson.
“The biggest objective in all those proposals is to reduce the reliance on CRAs,” Chantal Hughes told TheJournal.ie. She added: “[There] needs to be more transparency and rigorousness. That’s why we have made the proposals.”
The proposals, which the Commission hopes are in place by some time next year, are broadly aimed at doing four things:
- Ensuring that financial institutions do not “blindly rely” on credit ratings when determining where they invest.
- That agencies are more transparent about their reasons for a particular sovereign rating and that they rate every six months, as opposed to every 12.
- That companies issuing financial products rotate every three years between the agencies that rate then to eliminate any conflicts of interest and encourage competition.
- That CRAs are more accountable for the ratings they provide and that in cases where investors bring claims before the courts, the burden of proof is on the CRA.
Unsurprisingly this has not gone down well with the credit rating agencies who vary in the degree to which they are unhappy with the proposals. TheJournal.ie approached all three of the main agencies to discuss the proposed reforms but all declined to be interviewed.
In its statement Moody’s said of the proposed reforms, known as CRA3, that:
As currently drafted, CRA3 will not improve ratings quality but it will damage credit access for European companies and will negatively impact economic growth and job creation. Moody’s believes constructive alternatives exist, including reducing regulatory reliance on ratings and encouraging further debate on sovereign credit risk.
For all three one of the main sticking points is the idea that financial institutions and others reliant on agencies rotate which one they use to rate their products. This “would undermine the stability and continuity of ratings and disrupt European companies’ access to global capital markets,” according to S&P.
Fitch group managing director, Paul Taylor was quoted as saying in the Financial Times that CRA3 “has a handful of proposals that are very damaging” including the rotation idea.
Nonetheless, at a summit of EU finance ministers in Denmark last month, leaders agreed to the idea that companies rotate rating agencies to prevent conflicts of interest and encourage competition in the sector. An actual law is some way off, but that was a sign of considerable progress.
What hope for the reforms?
But what hope have such reforms got of making any difference? Shane Ross is sceptical: “The motivation behind the EU doing it is purely and utterly selfish. They are trying to get a tamer agency which produces the kind of results they want.”
Ross believes that the current trio of ratings agencies are so utterly flawed in their funding and their history that there is little point to having them any more: ”I think they are a bad brand, but the markets look to them still. That is the kind of conundrum there. They are a discredited brand because they got it wrong for so long but the markets are still influenced by what they say,” he said.
The European Commission’s aim is to solve that condundrum by reducing the markets’ reliance on the CRAs’ verdict. Chantal Hughes said:
We’ve given the credit rating agencies an enormously important role in our legislation and what we want to ensure is that they can do their job properly but that their opinion becomes one opinion amongst many others. Not the be all and end all.
Ross believes that the current crop of rating agencies have become so “irreparably damaged” that there is room yet for an “objective credit rating agency to emerge.”
But there are no indications that anything of the sort is in the offing. Meaning the reliance on Moody’s, Fitch, and Standard and Poor’s will continue for the foreseeable future.