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They are just doing their job
What do the rating agencies do? They rate the debt issued by a company or a government. After analysts’ recommendations, a committee of senior staff formally decides a rating (Moody’s and Standard & Poor’s have recently downgraded the rating of France by one notch). Every prime minister or CEO who wants to borrow money from the market needs to show a rating to investors, who hope to be repaid in the future. For example, if UK treasuries (gilts) were degraded by one notch from AAA to AA, it would raise the cost of official borrowing up by 0.5 percentage point. Who would pay for that? The taxpayers. When George Osborne, the Chancellor of the Exchequer, said: “Judge us … on whether we are able to protect our credit rating,” justifying government spending cuts, he implicitly underlined the essential power of the agencies.
“We need credit rating agencies,” says Philip Wood, special global counsel at Allen & Overy, to Ibanet.org, the website of IBA, a task force on the financial crisis. “They obviously got it wrong on home loans, but only on home loans, and they were far from being the only people to do so. The IMF did too. Even the mighty Greenspan and Bernanke could not tell there was a bubble. They are just doing their job”.
It is actually a job that has been poorly undertaken too often in recent years , raising doubts on the activities of the Big Three agencies (Moody’s, Standard & Poor’s and Fitch). In December 2009 Moody’s published a report called “Investor fears over Greek government liquidity misplaced”. In the analysis the agency argued that there was “an extremely low probability that the government’s liquidity will pressured.” After six months the IMF and the EU agreed on a first bailout package of $147bn. When the global financial bubble burst in September 2008, Lehman Brothers and AIG were still rated AAA and AA before their collapse. Moreover, according to the statistics from Sukhdev Johal at Royal Holloway University of London, of the corporate debt rated AAA by Standard & Poor’s, 32 per cent has been downgraded in three years, 57 per cent in seven years. Examples of recent misjudgments are countless.
The short-circuit is evident, and started years before the financial meltdown. In the 1990s rating agencies were earning three times as much as usual because they were evaluating complex financial products instead of traditional bonds. The subprime mortgages given to homeowners with bad incomes and poor creditworthiness were bundled in securities that received a high rating and then were sold to global investors. Without those AAA ratings, the demand for securities would have been considerably less. “The three credit rating agencies were key enablers of the financial meltdown,” reported the US Financial Crisis Enquiry Commission in 2011. “The real problem” says Philip Booth, professor of finance at Cass Business School in London “is that regulators have become involved in this whole process. Banks were able to reduce their regulatory capital by holding highly-rated securities. The regulatory capital requirements depended on the rating of the securities: better rating implied lower risk and therefore lower capital. A high rating became more important than an accurate rating. This upset the delicate balance and created big conflicts of interest”.
Cannot live without them
The only thing in common among European countries is the currency. Currently an EU rating agency sounds utopian. The European Securities and Markets Authority (ESMA), however, has the power to approve ratings and ban them in “exceptional circumstances”, for example for countries undergoing a bailout. Nevertheless the ESMA cannot do the most important thing: to prevent agencies from outside the EU rating European countries.
Is any structural reform, somewhere and somehow, therefore possible? One solution would be to take all the agencies into public hands, one run by the United Nations and funded by both lenders and borrowers: a not-for-profit utility able to access data from countries and corporations.
Another possibility is to have investors paying for ratings, or the SEC deciding the rating assignments. Or again make sure that investors have the same information as rating agencies. Some experts, however, assert that the same regulators have caused the huge conflict of interest between banks, agencies and institutions: “Ratings agencies” says professor Philip Booth “provide an opinion on the creditworthiness of debt instruments and there should be no statutory controls on their activities. Their activities should be a matter of indifference to regulators. The more the industry is regulated, the more uniform and systemically dangerous it will become.”
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