Explainer: the role of credit ratings agencies

Standard & Poor’s could still downgrade the US credit rating, despite the debt ceiling deal. AAP

Washington lawmakers in the US House of Representatives have passed an agreement hammered out between Republican and Democrat leaders designed to avert a US debt default.

The move is a further step towards raising the US debt ceiling, but despite this, the United States’ coveted AAA rating may still be downgraded.

University of Melbourne Professor of finance and research director of the Australian Centre for Financial Studies Kevin Davis explains the role of ratings agencies.

How do rating agencies make their decisions?

They look at the probability of default of the country. They look at various indicators like the size of its debt compared with GDP, its ability to cover interest payments on time and so on. What they’re measuring is essentially the probability from an investor’s perspective that there may be some delay in receiving interest or principal repayments and the possibility of loss.

Why do they do this?

In general investors struggle to assess the likelihood of default or the risk of a particular issuer of debt and also it’s become commonplace for a lot of investors such as fund managers and institutional investors to have requirements that they are only allowed to invest in certain types of securities that meet various standards - which have been created by the ratings agencies.

For example, ratings of BBB+ have become regarded as investment grade and institutions like superannuation funds or various university endowments may have restrictions on investing only in investment-grade bonds.

Do the ratings vary much between agencies?

Not a lot, no. They have different symbols, one of them will use AAA, one might have Aaa, but you can relate them fairly closely and its not often that you get what is referred to as split ratings, which is where they have a difference in the rating. Typically if they have a split rating, the difference is only fairly minor.

If there was a downgrade of the US AAA rating, what would happen first?

One consequence is that the US government would be very angry! In general the effects are probably not going to be too dramatic, but it’s very hard to tell.

This may be a case where the ratings agencies’ opinions are not going to be regarded as highly as they might otherwise be.

People in general would perceive the US as unlikely to actually default on its debt; it may be that there could be some delay of interest payments, but I understand they are reaching an agreement on expanding the debt ceiling, so there is no current issue if that’s the case.

Could a downgrade happen anyway?

Yes, because of what might happen in the future, because we’re talking about debt securities which in the US case stretch out to 30 years maturity.

What would be the impact on Australia?

If there was a ratings downgrade you would probably expect to see some decline in the price of US government bonds so to the extent that Australian superannuation funds are holding those they will probably suffer a decline in the market value of those assets. Realistically, in terms of the long run stream of interest and principal repayments, it wouldn’t have that much effect.

However, if investors worldwide decide to divest their holdings of government securities around the world, then Australian government bonds start to look attractive. The only problem there is not very many of them to go round.

(Because Australian bonds can only be purchased in Australian dollars, this increases demand and pushes the Australian dollar higher.)

The influence of ratings agencies has been highly debated, haven’t they?

Yes, the ratings agencies got a lot of stick during the global financial crisis because they were rating a whole lot of very complex securities and had conflicts of interests in terms of the ratings, because they were also providing information to the issuers of the products about what characteristics those products had to have in order to get a AAA rating.

As hindsight shows very clearly, lots of things that were rated AAA were a long way from AAA. That reflected the fact that in general people didn’t understand the risks associated with lots of those securities.

It’s interesting how the ratings agencies have managed to bounce back very strongly from all of the bad press they get during the global financial crisis and seem to have moved back into a very strong position in terms of their role in financial markets.

Is that warranted? Have they addressed these faulty practices?

In general ratings agencies have tried to put in place much better governance arrangements, but I think there is still potential for international regulators to demand more of them.

Certainly there were a number of multinational agencies which had various proposals for ratings agencies, but I think in general the governance has improved, although it’s early days to make a firm judgement on that.

Those proposals didn’t get very far.

No. The ratings agencies have managed to escape fairly well from all of this. One of the issues that will have to occur in the next few years is the extent to which the legal privilege of ratings agencies decline in the US and also the extent to which there will be the growth of new competitors for them. Effectively there has only been the three major agencies operating – Standard & Poors, Moody’s and Fitch.

One of the things they have going for them is that even though they are in a position of significant influence, because of the way in which they are legislated in the US they are effectively regarded as giving their opinion and not subject to legal liability on people acting on their ratings.

This is not the case in Australia, where in the last couple of years, if retail investors were utilising any ratings information, ASIC has required agencies to hold an Australian financial services licence and be members of an external dispute resolution scheme.

One of the consequences of that is the ratings agencies simply now preclude retail investors from accessing their websites here.