Rating agencies' infallibility is dangerously over-rated

ECONOMICS:A downgrade by one of the three main credit rating agencies can tip a company or even a country into bankruptcy, writes PAT McARDLE

THE RECENT controversy over credit rating agencies arose when Greek government bonds were downgraded to junk status just as the EU was about to finalise the rescue package. The rating agencies became part of the problem and were roundly criticised by the European Central Bank and the EU, which has promised, yet again, to look at what can be done about them.

Rating agencies are little known here because few Irish companies, apart from the banks and, of course, the Government, are big enough to be rated.

The three main credit rating agencies are Moody’s, Standard Poor’s and Fitch. Moody’s and SP control 80 per cent of the market, while Fitch has another 15 per cent. This concentration means they wield great power, and a downgrade can tip a company or even a country into bankruptcy.

Rating agencies have been dogged by controversy, because they have failed to spot virtually every major problem in the past 40 years. Examples include several Latin American failures, including the 2001 collapse of Argentina, as well as Enron, WorldCom and Parmalat, not to mention the recent crisis.

The problem is compounded by the fact that markets ascribe a much greater importance to agency ratings than they should. A rating is merely an opinion on the creditworthiness of a particular debt issue or borrower.

In the US, the agencies have successfully asserted that these opinions have the same status as those of financial journalists and are therefore protected by the constitutional guarantee of freedom of the press. In Europe, rating agency contracts generally include a clause stating their opinions are not financial advice, shielding them from litigation.

Banks and other treasurers who bought AAA-rated mortgage-backed subprime US securities felt aggrieved when their assets turned out to be worthless. But they were living in a fool’s paradise if they relied on the ratings instead of doing their own research.

Investors were not the only ones to over- rely on rating agencies. Financial regulators, under the Basel II agreement and some EU directives, give ratings an important role in the determination of bank regulatory capital. By incorporating ratings into their requirements, regulators effectively outsourced functions to rating agencies and made it essential for borrowers to have their bond issues rated. A rating became a precondition for an offering on a debt market in contrast to an equity market, where large sums of money are raised without any ratings.

The quality of staff is a long-standing issue. Rating agencies are in regular contact with the major investment houses, which have tended to cherry-pick their good people. The resultant high turnover often saw the promotion of relatively junior, inexperienced staff into positions of responsibility.

The banks, in turn, got knowledge of the agencies’ working methods and became adept at playing them off against each other. New bank recruits were frequently tasked with picking holes in the models they had created in their old jobs. These models were flawed anyway because they assumed that recent history would continue and that, in general, house prices would not fall. Tellingly, hedge funds seldom used them, preferring to rely on their own calculations.

The situation was exacerbated by the fact that the entity being rated paid the fees. This gave rise to an unhealthy conflict of interest.

Credit rating agencies played a pivotal role in fuelling the unsustainable growth of the asset-backed structured finance debt market – a major catalyst for the global financial crisis.

Many people wrongly believed that ratings were interchangeable, ie that a AAA-rated country was the same as a AAA-rated mortgage-backed security. They bought ever-more innovative and complex securities believing they knew what they were doing. Agencies churned out ratings, not really knowing what they were doing either.

This allowed the market for these new- fangled products to explode, generating huge profits for the banks that originated the securities and the agencies that rated them. Agencies did this without checking the accuracy of the information they were given – they were under no obligation to do so. Nor did they look at the original loans underlying the securities. They took a statistical, probability approach to default ratios, and did not pretend to have lending expertise.

Banks no longer had to wait 20 years for borrowers to repay. They bundled the mortgages, got the package rated and sold it on, recycling the cash into fresh loans. Irish banks had little exposure to US subprime debt but did raise almost €40 billion from such securitisations. But for this, mortgage credit outstanding would now be €110 billion instead of €150 billion. Who knows how the housing market would have developed had this extra funding not been available.

Fees for the more complex structured products were three times the standard rate. Moody’s had the highest profit margin of any SP 500 company five years in a row. Its share price peaked in 2006 at almost six times its 2000 level. This outpaced even Anglo Irish Bank, which rose 5.3-fold in the same period.

It all ended in disaster, typified, perhaps, by the fact that Lehman Brothers had an investment-grade rating right up until it filed for bankruptcy. Credit Suisse had $340 million (€270 million) of AAA-rated collateralised debt obligations – 37 per cent of them defaulted.

Once the tide turned, agencies indulged in an orgy of downgrading, which continues with the recent moves on Greece and Spain that so irritated the EU.

When he was European internal market commissioner, Charlie McCreevy promised to reform rating agencies, but quietly dropped the idea. The US is into a new round of congressional public hearings on the subject. Already these have found that the big two were unduly influenced, and wilfully ignored signs of fraud.

In 2007, an internal Moody’s e-mail described some of the structured products it rated as “weapons of mass destruction”.

The US has introduced modest changes. The EU has again promised action. So far, there has been little of that on either side of the Atlantic.