Why we should be wary of ratings agencies

Demonstrators in front of Standard & Poor’s credit rating agency offices in Paris 15 January 2012. AAP

For decades, credit ratings agencies were largely ignored by the masses, but in recent months they have continued to hit the headlines again and again. The big three (Standard & Poor’s, Moody’s and Fitch) have relentlessly embarked on an orgy of downgrading sovereign debt, despite calls for them to reign in their negative ratings.

In August, S&P downgraded the US credit rating, despite a last-minute Congressional agreement on raising the federal debt ceiling to avoid default. In January, they downgraded the credit ratings of nine European countries, stripping France and Austria of the top triple-A rating. The move put Italy at BBB+ level, the same as Kazakhstan, and pushed Portugal into junk status.

While the credit ratings agencies have come under fire from all sides in recent years, the effect of their downgrades is still under debate, more so since it has become common knowledge that the downgrading happens retrospectively. When the U.S. credit rating was downgraded to AA+, there were no adverse effects on the ability of the U.S. Treasury to borrow at low rates. In Europe, many countries have been severely punished by financial markets by having to pay more for borrowing, but this isn’t necessarily directly linked to downgrades by the ratings agencies. High borrowing costs have been par for the course for European countries for some time.

Therefore, the question is: why it is still “business as usual” for the rating agencies? They’re providing us with retrospective information that is useless at best - and destructive at worst.

Through a combination of the agencies’ recklessness in the run-up to the global financial crisis and their saturation of the market with excessive downgrades since the crisis began, we have come to the point whereby the ratings they spew out can largely be ignored. Yet they are still treated with a respect that many feel they do not deserve. We only need to look at the Basel III provisions, which still require the calculation of regulatory capital on the basis of the ratings provided by the rating agencies.

Barack Obama signing the financial reform bill into law. AAP

In the US, the Dodd-Frank Act, signed into law in July 2010, prohibits the use of ratings agencies when calculating capital charges. The decision of US regulators to disregard the views of the rating agencies is due to the belief that they contributed to the advent of the global financial crisis by rating junk debt instruments (CDOs) as AAA securities.

In its report on the global financial crisis, the U.S. Financial Crisis Inquiry Commission concluded that “the failures of the credit rating agencies were essential cogs in the wheel of financial destruction”, that “the three credit rating agencies were enablers of the financial meltdown”, and that “this crisis could not have happened without the rating agencies”. The report states that “from 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A” and that “in 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every day”.

It’s only fair to say that the role played by the rating agencies in the materialisation of the global financial crisis would not have been possible without the Basel II requirement that regulatory capital be calculated on the basis of risk-weighted assets, where the weights are determined by the ratings agencies. Since financial institutions wanted to minimise the regulatory capital as required by Basel II, they rushed to accumulate triple A securities, including the bonds issued by Greece (at one time rated AAA by the rating agencies), thus making it easy for Greece to borrow excessively. Hence the rating agencies, in collaboration with the Basel Committee, have not only contributed to the advent of the global crisis but also to the current European credit crisis.

Reliance on the rating agencies to determine the riskiness of assets sounds ludicrous at this stage. One has to remember why the likes of Citigroup and Bank of America were brought to their knees: it was exposure to the triple-A securitised debt, an allegedly risk-free asset manufactured, with the help of the rating agencies, from risky loans. The agencies granted these high ratings either because they were incompetent or corrupt.

Standard & Poor’s offices in New York. AAP

It has been well established that it is questionable whether or not the rating agencies meet the credibility, independence, objectivity and transparency criteria demanded by Basel II and Basel III. It is ironic then, that the Basel rules still take into account the views of the rating agencies.

Two economists at the Bank for International Settlements, where the Basel Committee resides, argued against the use of the ratings of these agencies back in 2000. The economists suggested that “many would be wary of putting too much emphasis on the assessment of credit-rating agencies”.

To support their argument, the economists referred to the performance of the rating agencies during the Asian crisis. The big three refrained from downgrading most Asian countries before the crisis, when imbalances were developing, but continued to downgrade in the midst of the crisis, exacerbating the situation. The findings concluded that “rating agencies were backward-looking rather than forward-looking in their assessments”.

The credit rating agencies’ response to the outcry was to state that their advice constitutes “an opinion” that is only valid for a “point in time”. They argue that they never promise or guarantee a certain rating to a security, and that any change in circumstance regarding the risk factors of a particular security will invalidate their analysis and result in a different credit rating. So, what’s the point?

The offices of Fitch Ratings in New York. AAP

Apart from the destruction they inflicted on humanity by contributing to two major crises that have hit since 2007, the list of accusations against the rating agencies is long. They don’t downgrade companies and countries promptly enough (Enron’s rating remained at investment grade four days before the company went bankrupt). This, coupled with the fact that they have been accused of manipulating business executives and are known to have engaged in heavy-handed blackmail tactics in order to solicit business from new clients (pay or run the risk of being downgraded), illustrates the point.

The gang of three represent an oligopoly that is kept intact by barriers to market entry. It has also been suggested that a conflict of interest is involved in assigning sovereign credit ratings, as the agencies have a political incentive to show that they do not need stricter regulation by being overly critical in their assessment of governments intending to regulate them.

In the big picture, a financial world without the rating agencies would not be in a worse shape than it is now. The market itself could do a better job revealing deteriorating creditworthiness than any of the big three.