2.6.2011
By Simon Miller
The financial crisis and sovereign debt issue has thrown credit rating agencies (CRAs) into the spotlight as politicians, commentators and businessmen line up to criticise their role in events.
In 2008, following investigations into the roles of CRAs, chairman of the House Oversight and Government Reform Committee in the US, Henry Waxman, commented that rating agencies “broke the bond of trust” and added that “the story of the credit rating agencies is a story of colossal failure”.
But is this a fair reflection of the role CRAs bring to the industry? Have they become the scapegoats for poor investment decisions and a cover for poor regulatory decision making? Or is it the case that the balance between the piper and the payer has become confused?
Frank Raiter, former executive, Standard & Poor’s, says that while CRAs were necessary players in the exploding market, the agencies were not the drivers of the train.
Giving evidence to Waxman’s committee, Raiter continued: “The engine was powered by the low interest rates that prevailed after the turn of the century. The conductors were the lenders and the investment bankers who made the loans and packaged them into securities, and the rating agencies were the oilers who kept the wheels greased. And I might add, the passengers on the train were the investors, and it was standing room only. There is a lot of blame to go around.”
A brief history
Credit agencies are not new. The first formalised agency was set up in the silk industry 170 years ago to solve a fundamental issue of how a lender knew that the borrower was creditworthy. By the 1920s the main players in the industry, Standard, Poor’s, Moody’s and Fitch had begun rating schemes.
But it was after the 1929 crash that, ironically, the seeds for the current discontent were sown when US bank regulators began using ratings to monitor banks’ securities portfolios. This role was formalised in the 1970s by US regulators when the Securities and Exchange Commission established a recognition regime for CRAs and began using ratings in making its regulatory determinations.
According to Professor Frank Partnoy of the School of Law at the University of San Diego, CRA’s had become woven into federal and state laws, regulations and private contracts.
In his paper, Rethinking regulation of credit rating agencies, Partnoy comments: “The rating agencies have evolved from information providers to purveyors of ‘regulatory licences’. A regulatory licence is a key that unlocks the financial markets. CRAs profit from providing ratings that unlock access to the market regardless of the accuracy of their ratings.”
Although CRAs can operate on a national basis, the industry is highly concentrated with the top three global CRAs – Standard & Poor’s, Moody’s and Fitch – accounting for more than 90% of total revenues according to a study from the Financial Services Authority (FSA). According to estimates, the combined revenue of S&P, Moody’s and Fitch in 2010 stood at $8.9 billion (£5.5 billion)with a combined gross profit of $5.5 billion.
The FSA Stability paper, Wither the credit ratings industry, pointed out that the concentration partly reflected considerable advantages to scale. It said: “A global CRA with a widely recognised brand and an established reputation is more likely to be appointed by issuers and references in financial contracts.”
A rating with power?
As pseudo-regulatory bodies, CRAs sit in a unique place where their pronouncements can shift value in a matter of seconds. One criticism levelled at this power is that as a result, investors fail to initiate their own due diligence and rely on the word of the ratings. Although this is obviously the fault of the institutional investor, it is an example of the power that agencies have.
Mike Tierney, spokesman at S&P, says: “Ratings are not investment recommendations. They do not address investment risks such as liquidity and volatility, and they are not a substitute for independent investment analysis. They are one of many inputs that investors can consider in their decision making process.”
Indeed, as one banker who wished to remain anonymous comments, it is all too easy for investors to blame the agencies. “I am sure that there are sufficient checks in the CRAs ratings but it is only part of the system. Banks must do their own diligence and investigations before making a decision.”
Conflict of interest
One area that CRAs are coming under increasing criticism is a perceived conflict of interest. The majority of agencies operate on a fee –basis paid for by issuers, that is those that the CRAs rate.
Unfortunately, this model creates inherent tensions and risk for CRAs.
Since rating agencies are dependent on raising fees from issuers, there is a concern that CRAs will spend greater time chasing custom rather than improving methodology. In addition, there is a fear that CRAs may inflate ratings upwards to meet an issuer’s expectations.
In his statement to the Committee on Oversight and Government Reform in 2008, Sean Egan, managing director of Egan Jones Ratings, said that this business model was explicitly a conflict of interest: “Investors want credible ratings. Issuers on the other hand want the highest rating possible, since that reduces funding costs. Under the issuer-pay business model, a rating agency which does not come in with a highest rating will before long be an unemployed rating firm. It’s that simple. And all the explanations and excuses cannot refute this elementary truth.”
This view is shared by Moody’s former managing director, credit policy Jerome Fons who thought that a large part of the blame could be placed on “the inherent conflicts of interest found in the issuer-pays business model and on rating shopping by issuers of structured securities”.
He told the Congressional Hearing: “A drive to maintain or expand market share made the rating agencies willing participants in this shopping spree.”
Rating shopping is where issuers seek indications from several CRAs and then choose the agency that is likely to deliver the most favourable rating. It is this combination of pressures that has been blamed for the likes of Lehman’s getting top-notch ratings days before it crashed.”
Indeed, it was the Congressional Hearing that revealed the extent that even CRAs were aware that their conflicts of interest were giving unduly high scores to risky assets.
The hearing released an internal presentation to Moody’s company directors in 2007 that noted that the entrance of Fitch had created competitive pressures that put downwards pressure on ratings quality.
The presentation from Moody’s CEO Raymond McDaniel notes: “The real problem is not that the market does underweight ratings quality but rather that, in some sectors, it actually penalises quality by awarding rating mandates based on the lowest credit enhancement needed for the highest ratings. Unchecked, competition on this basis can place the entire financial system at risk.”
He adds: “Moody’s for years has struggled with this dilemma.”
The company had various mechanisms in place to prevent such conflicts of interest, including assigning ratings by committees and preventing anyone with “market share objectives” from chairing such a committee.
“This does not solve the problem, though,” McDaniel writes. “Ratings in the securities that have helped cause the financial crisis are simply the latest instance of trying to hit perfect rating pitch in a noisy market place of competing interests.”
“If the industry adopted an alternative business model in which investors rather than issuers pay for ratings, this would not relieve the perceived conflict – it would only shift it,” he comments. “An ‘investor-pays’ model would give preferential information for bigger and wealthier investors.”
Addressing the Practising Law Institute in 2009, the Securities Exchange Commission’s Chairman Mary Schapiro acknowledged that “improving the quality of credit ratings by addressing the inherent conflict of interest credit ratings agencies face as a result of their compensation models was a priority for the commission”.
Tierney agrees there is an issue but points out that “as almost every recent independent review of this issue has concluded, no business model is immune from the potential for conflicts of interest” and that the key issues are how these potential conflicts are managed and overseen, and what systems work best for investors.
“We believe that the issuer-pays model – with conflicts properly managed – is the best available model because it enables the provision of ratings simultaneously to all investors free of charge and maximises public scrutiny of ratings,” he adds.
Getting it wrong
Another major issue is what the penalty is if the CRAs get it wrong. Egan-Jones pointed out that, if Moody’s, S&P and Fitch’s ratings prove to be drastically wrong, since there are few alternatives, the major rating firms face few penalties.
He added: “Over the past three years there have been numerous
examples of investment grade firms filing for bankruptcy protection on
short notices. Enron was rate investment grade four days before its filing.
National Century was rated Aaa two months before its filing. WorldCom was rated at Baa/BBB level three months before filing and the California Utilities were rated at the A level 16 days before defaulting. Despite these failures, the major rating firms have regularly grown their revenues because of the restrictions on competition.”
Partnoy notes that CRAs pose a systemic risk as they are financial gatekeepers with little incentives to get it right.
“Creating a rating agency oversight board and strengthening the accountability of rating agencies is thus consistent with the broader push by US policymakers for greater systemic risk oversight. The accountability has deteriorated so much that institutional investors now are vulnerable if they rely on credit ratings in making investment decisions,” he writes.
Liability?
Agencies have traditionally viewed their ratings as free speech, that is to say an opinion that investors are free to make a decision on after considering that view. As a result, CRAs do not see how they can be made liable for the actions of investors as they provide information not give guidance.
In addition, CRAs are legally accountable in much the same way as market participants. Any business that intentionally misleads or defrauds investors can be held liable under securities fraud laws, and ratings firms are not an exception.
“CRAs should not be subject to discriminatory or higher standards of liability relative to other market participants. Otherwise, new ratings providers may be discouraged from entering the market and ratings may be restricted for riskier credits,” says Tierney.
Moody’s spokesman, Francesco Meucii, adds: “In addition, in Europe for example recent regulation has established high regulatory standards granting regulators extensive sanctioning powers.”
Partnoy argues that making CRAs liable would assist them in upping their game. “A credible threat of civil liability would force credit rating agencies to be more vigilant in guarding against belligerent, reckless and fraudulent practices,” he comments.
However, for a system of penalties to operate, regulators need to distinguish between bad luck, bad judgement or rating agency bias.
According to the FSA paper the “inability to draw such distinctions accurately could simply serve to make CRAs excessively conservative or restrict their operations with potentially adverse implications for investment and growth”.
The report also notes that by granting CRA ratings the same status as other expert reports – such as medial or legal experts – it could have the “unintended and undesirable effect of generating even greater reliance on ratings”.
Learning the lessons
So have CRAs learnt from the past? S&P believes that although the recent performance of ratings of certain US residential mortgage-related securities does not reflect a wider trend it had “studied the lessons of the recent financial crisis and taken major steps to further strengthen ratings”.
According to Tierney, the criteria for rating banks was being revised with greater insight into how S&P rate banks and enhance the comparability of Standard & Poor’s ratings. “They build on our existing analytical framework and incorporate what we have learned during the recent financial crisis. We also propose to place greater emphasis on economic risk and industry risk, and on capital retention,” he says.
Indeed CRA’s are all examining their criteria for rating banks. One insider admitted the agencies could have been more robust: “We realise that although the systems are there, they can be built on to reflect that we didn’t act quick enough or robustly challenged our own findings to test their adequacy.”
“For example we have incorporated stress tests into our assessment of banks’ potential future losses. We have re-assessed the level of systemic support that could be available for different classes of debt holders in times of stress,” says Meucci.
Tierney concludes: “We believe these changes can lead to better and more rational use of ratings, as one of many inputs in investment decisions.”
Sovereign Issues
Eurozone politicians are furious with the ratings agencies, an anger that finally boiled over with continued downgrades to Eurozone countries.
The EU had already viewed the ratings agencies with suspicion with many blaming the groups for failing to predict the financial crisis and indeed valuing stricken banks favourable just days before they collapsed.
Brussels is aiming to introduce tough rules against the agencies, possibly opting to make them liable for damages against incorrect ratings.
In March, rating agency Moody’s downgraded Greece a further notch to Ba1 taking it further into junk bond status. Moody’s contends that the fiscal measures already taken by the Greek government to stabilise the country’s debt metrics remains “very ambitious and are subject to significant
implementation risks.” In addition, the agency criticised the prevalent tax evasion in Greece and added that there was a risks that conditions attached to continuing support from official sources after 2013 “will reflect solvency criteria that the country may not satisfy, ands result in a restructuring of existing debt”.
However there was further bad news and breeding of discontent when S&P downgraded Greece’s credit rating further into junk territory to B in May, just one notch above Pakistan.
At the time of writing Moody’s Investor Service was threatening to downgrade Greece by several notches, placing Athens’ B1 sovereign rating on review due to increased worries that it might seek to impose losses on private bondholders while Fitch Ratings said it still rated Greece at BB+ with a negative outlook.
Moody’s has also gained the displeasure of Spain by downgrading Spain to Aa2 saying that Madrid’s estimates of €20bn of fresh capital needed to rebuild the banks and Cajas was too low with the overall costs likely to be nearer €40bn to €50bn – possibly rising to as much as €120bn in a stressed situation.
However, the latest downgrades led the Greek finance minister Giorgos Papaconto write to the EC, and the European Central Bank accusing Moody’s of only seeing negatives in Greece. He argued that this made it difficult to access international markets and borrow at reasonable rates, thereby risking the creation of “self-fulfilling prophecies”.
He added: “Ultimately, Moody’s downgrading of Greece’s debts reveals
more about the misaligned incentives and the lack of accountability of credit rating agencies than the genuine state or prospects of the Greek economy.
“Having completely missed the build-up of risk that led to the global financial crisis in 2008, the rating agencies are now competing with each other to be the first to identify risks that will lead to the next crisis.”
At the meeting of Euro finance ministers on 11 March, Luxembourg Prime Minister Jean Claude Juncker told reporters: “There should be a better regulation for credit rating agencies because we think this is particularly urgent.”
He also put the blame for the recent tensions on the sovereign debt market
concerning the Eurozone firmly on the decrease in the Spanish and Greek credit rating and added that many Euro-ministers “were surprised with the timetable for adjustments and the analysis made”.
