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Rating the raters:Who pulls the strings?
The ratings agencies are bouncing back, reports KEITH AITKEN. Castigated by regulators for their pre-crisis role as ‘banking’s puppets’, the benchmarkers of sovereign debt continue to exert a formidable influence.
“Always keep a hold of nurse,” counselled Hilaire Belloc, “for fear of finding something worse.” Such seems to be the emerging attitude of the financial world towards the international credit rating agencies, as the dust continues to settle on a banking crisis in which their role was widely deplored as culpable.
The big three agencies – Moody’s, Standard & Poor’s (S&P), and Fitch – were universally lambasted for failing to warn investors about the spiralling instability of structured securities and of the ensuing liabilities for some national economies.
Worse, they were blamed for giving dodgy investment packages pristine ratings to please their paymasters in the banks. As recently as April 2011, a US Senate report, following a year-long inquiry, accused Moody’s and S&P of helping trigger the crisis by caving to pressure from a battery of US banks to upgrade questionable securities.
“The ratings agencies weakened their standards as each competed to provide the most favourable rating to win business and greater market share,” the Senate Permanent Subcommittee on Investigations concluded. “The result was a race to the bottom.”
Post-apocalypse, regulators on both sides of the Atlantic and in the Far East have been pointedly looking for ways to reduce the weight placed on ratings in the legitimisation and registration of investment vehicles, and various reforms are in the pipeline.
Yet, while the formal role may be downgraded, the attention paid in the markets to ratings as a benchmark assurance against default remains strong and, as the recent economic ructions in countries like Greece, Ireland and Portugal have demonstrated, ratings of sovereign debt continue to exert a formidable influence.
A profoundly flawed business model?
“It is one thing to identify the shortcomings of ratings,” The Economist remarked recently, “quite another to find alternative standards that are clearly better.” In other words, the ratings agencies are bouncing back.
It is a revival signalled not just in a landmark US court case – which confirmed their ratings as legally immune free speech – but also in rising profits, as the need to level mountains of corporate and civic debt churns a growing volume of new bond issues.
Moody’s revenues in 2010 rose 13 per cent on 2009 to $2.032bn. Fitch Ratings similarly posted revenues up 7.8 per cent to $657.2m.
The case against their performance during the banking crisis is forcibly made by former Observer editor Will Hutton in his book Them and Us. As leverage (borrowings to capital) ratios soared as high as 50:1, he writes, the banks diversified risk by bundling high- and low-risk ventures together in highly complex packages.
“In effect, they thought they had created a new alchemy – the lead of poorly rated bonds and assets was turned [by the agencies] into the gold of triple-A ratings.”
What Hutton calls a “suspicious” unanimity of agency view was, he argues, sustained by two factors: a “profoundly flawed” business model that saw them paid by the sellers – the banks – rather than the buyers of investment vehicles; and US security laws that prevent them from being sued for rotten advice.
As a result, he argues, 60 per cent of the banks’ structured investment vehicles were accorded AAA ratings, against just 1 per cent of corporate bonds.
This sour view of the agencies is shared by one senior investment analyst, who tells Chartered Banker: “They did get humiliated, and they should have been humiliated more, for putting triple-As on vehicles that had quality investments on the top and a load of junk underneath.
“People just didn’t know what they were holding. The whole problem of unwinding it and working out what was good or bad was impossible,” he adds. “The real problem was that the agencies were giving out views that their paymasters were determining.”
Yet, with more resignation than enthusiasm, the same source attests to the resilience of the agencies, especially in calibrating sovereign debt: “Their reputation has suffered hugely from getting it so wrong with the banking crisis, but at the end of the day there isn’t really any alternative. You still need someone to assess whether a country is going to go phutt.”
Europe’s recent economic basket-cases, he says, show how immensely powerful that role actually is. “Defaults by countries are much more common than people think,” he says. “But the agencies don’t just determine the availability of sovereign debt. They also determine the cost of it, and then you can get a downward spiral.”
Their purpose is also often misunderstood. What they rate is not the likely level of return from an investment proposition, but the risk of default. Indeed, a major plank of the agencies’ defence against the litany of criticisms they have faced since the banking crash has been that too many investors were using their ratings in a way that was never intended – as a benchmark of investment risk, rather than default risk.
Fund managers who rely solely or even predominantly on ratings when assessing a proposition, so this argument runs, deserve all that they and their benighted clients get.
The grading systems
The big three can all summon up the mystique of long history. Moody’s began in 1900, when a business reformer called John Moody published an instantly successful investor manual of stocks and bonds. The agency now has offices in 26 countries, and tracks investments in more than 110.
S&P – based, like Moody’s, in New York – is even older, having begun in 1860 when Henry Varnum Poor published a definitive guide to the performance of US railroad companies. It has offices in 23 countries, with over $3.5tn of investments benchmarked against its prestigious S&P 500 Index of large-cap US stock.
Fitch, now dual-headquartered in London and New York and a subsidiary of a group headquartered in Paris, began in New York in 1913 as a publisher of financial statistics. It has 50 offices worldwide, and tracks markets in 150 countries.
Though they compete for business, the agencies deploy strikingly similar styles. The ratings they affix are all but identical, especially at the high end of the chart, which runs from the top ranking of AAA (Moody’s prefers lower-case: Aaa), through AA to A. Below that, as the rating deteriorates to what is known officially as ‘speculative’ (and unofficially as ‘junk’) grades, Moody’s again uses a slightly different format: Baa to its competitors’ BBB, Ba instead of BB and Caa instead of CCC.
But the message is the same and, in the case of sovereign debt, all but definitive. When the agencies downgraded Greece’s debt last year to junk grade, it left Greek bonds ineligible as collateral under European Central Bank rules, just as the EU was assembling a rescue package. And that prompted the authorities – including the Bank of England – to talk loudly of looking for alternative benchmarks to agency ratings.
Yet the authority of the agencies’ pronouncements has not been acquired by accident. S&P figures, published in the March issue of The Economist, showed that no country rated AAA, AA or A had defaulted over the subsequent 15 years and nearly 98 per cent of countries rated AAA were still AAA or AA 15 years later. An earlier Fitch study, published in 2004, found that none of its AAA-rated corporate bonds had defaulted within five years, whereas a third of CCC-rated bonds had.
Such figures may not in themselves repair the reputational damage done by the banking crisis, but they do stand as a reminder that the agencies, appraisal of default risk is more scientific than a wet finger in the wind. Besides, if not nurse, then who?
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