The credit ratings industry played an important role in bringing the world economy to its knees in 2008. Seven years later, after damning reports and record settlements, their biggest problem may be regaining their customers’ trust.
The United States Justice Department announced in February that ratings agency Standard & Poor’s (S&P) would pay it a record US$1.37 billion in a settlement. The agency paid the money to avoid court action over its behaviour before the 2008 global financial crisis.
The settlement meant S&P was never charged with wrongdoing. But it did have to agree to a published statement of facts suggesting, in essence, that it had underplayed or ignored advice about the riskiness of residential mortgage-backed securities before the 2008 crisis.
Problems with these securities helped to trigger the 2008 crisis, whose effects linger today in many advanced economies.
“S&P claimed its ratings reports were mere marketing ‘puffery’. ”
On the surface, the agency’s admissions have not yet affected much more than its bank balance. As FBR Capital Markets’ William Bird put it to The Wall Street Journal: “S&P’s reputation was dented but not permanently impaired.”
The agencies have survived other problems. The US Financial Inquiry Commission reported in January 2011 that “the failures of credit rating agencies were essential cogs in the wheel of financial destruction”. In 2012, the Federal Court of Australia found S&P misled investors by assigning its top rating to financial products that blew up in a matter of months.
In its defence during the Justice Department investigation, S&P claimed its ratings reports were mere marketing “puffery” that no investor should take seriously.
At S&P’s biggest rival, Moody’s, executives were still being interrogated recently by the US Justice Department for allegedly compromising standards to win business. But no lawsuit has yet been issued against Moody’s.
Moody’s, S&P and Fitch Ratings are the three largest assessors of debt risk. They issue about 95 per cent of credit ratings globally, a figure unchanged from the pre-crisis days, and no credible rivals have emerged.
Many issuers still stand by the agencies’ ratings. So could S&P’s hefty payout, and the years of widespread criticism of the agencies’ conduct, finally bring change to the industry?
The crisis revealed that the main ratings problem has been the “issuer pays” model the agencies use. They earn revenue when a bond’s issuer pays them for the initial rating of a security, or for a continuing rating. This means, potentially, an agency has a short-term incentive to rank an issuer’s paper generously.
The evidence suggests this may have happened in the mid-2000s. S&P admitted in its statement that decisions about its rating models were affected by business concerns. A US Senate subcommittee chaired by Carl Levin issued a report decrying a “race to the bottom” where “rating standards weakened as each credit rating agency competed to provide the most favourable rating to win business and greater market share”.
The agencies defend themselves by sayingg they were not the only ones to misread the debt problem. In court filings before the 2015 settlement, S&P said the then chairman of the US Federal Reserve, Ben Bernanke, and then US treasury secretary, Henry Paulson, also did not anticipate the depth of the crisis before it hit.
As S&P told the court: “When Mr Bernanke stated in March 2007 that ‘the central scenario that housing will stabilise some time during the middle of the year remains intact’, his views (and those of other governors) were similar to those of S&P Ratings.”
An S&P spokesman told INTHEBLACK of improvements to the “methodologies, procedures and rigour” of its ratings. The company had invested more than US$400 million in governance, systems, analytics and methodologies and had increased the transparency of its processes.
S&P also says it now rotates analysts assigned to particular issuers and has improved analyst training. It has banned its analysts from fee negotiations and separated analysts’ pay from the volume of securities they rate and the types of ratings they assign.
On top of new regulatory oversight worldwide, S&P says it is “improving market confidence in the quality and transparency of ratings”.
“There are few means to solve the conflicts of interest inherent in the agency monopoly.”
Moody’s head of Asia-Pacific communications, Tim Osborne, says his company has also made significant changes since the financial crisis, including refining its methodologies, increasing the transparency of its analysis and “adopting new measures to reinforce processes and policies that address potential conflicts of interest”.
Some of the sharpest criticism of the agencies has come from European governments. They have accused the agencies of worsening Europe’s sovereign debt crisis after a number of eurozone nations had their debt savagely downgraded by all three in 2010. These negative ratings were followed by a flight of capital, which exacerbated Europe’s recession and ushered in a period of social hardship. The criticism has given rise to calls for alternatives.
Are these complaints valid? Did Europe’s politicians believe a flawed methodology was behind the agencies’ decisions, or did they censure the agencies because they didn’t like the ratings their respective nations received?
In April 2010, when S&P downgraded Greece’s debt to junk status, it weakened already fragile investor confidence, blew out interest rates and in the month following the downgrade, an international rescue package was put together. But subsequent events have shown that whether Europe liked it or not, downgrading Greece was a fair and well-judged move by S&P.
When sovereign debt ratings are high, nations are keen to bask in the glory – witness Australian treasurer Joe Hockey’s ebullience when all three issuers maintained AAA ratings on Commonwealth debt, in effect “gold-plating” his recent budget. Governments enjoy the status when they are highly rated, and complain when they are not.
Politics is never far away from sovereign debt assignment. Sebastian Mallaby, from the US-based Council on Foreign Relations, says the more governments meddle with agencies, “the more the rating agencies will be browbeaten into giving a generous rating to the sovereign”. When the US Justice Department put its case against S&P, the agency counterclaimed that it was being prosecuted in retaliation for its downgrade of US sovereign debt (from AAA to AA+) in 2011.
Chinese agencies also face scepticism about their ratings quality. When Anhui province issued debt worth 25.8 billion yuan (US$4.2 billion) in April, Golden Credit Rating International in Beijing rated the debt for just 50,000 yuan (US$8000), provoking a flurry of scepticism.
Despite new oversight powers gained in the US in the Dodd-Frank legislation of 2010 and the establishment in 2011 of the European Securities and Markets Authority, governments don’t seem ready to dramatically change the game for the rating of private companies.
Ignoring the ratings
The financial markets have responded to the agencies’ conflict-of-interest problem in their own way: they have become less interested in the agencies’ opinions.
A survey by Bloomberg in 2012 found that after Moody’s debt rating announcements, credit spreads moved in the opposite direction 56 per cent of the time. It was similar for S&P. In other words, a credit rating has a more than 50 per cent probability of being ignored.
Pundits say the ratings assigned are often backward-looking and tend to lag behind forward-looking fundamentals.
Paul Dales, chief Australia and New Zealand economist at Capital Economics in London, says the markets give scant regard to sovereign debt gradings. “Even if Australia were stripped of its AAA rating, all the evidence suggests that this would hardly affect the economy or the financial markets,” Dales says.
The Australian dollar, Dales argues, would be unaffected by a ratings downgrade. “The currency was broadly stable in the years after Australia lost its AAA rating in 1986 and bond yields fell steadily throughout the AA years.”
Sonia Baillie, AMP Capital’s head of credit research, says that since the agencies ceased rating retail securities such as the hybrid bonds issued by big banks, their relevance has shrunk.
“We’ve always assigned our own credit assessments to every bond and security that we hold in our portfolios. Our approach is more proactive and forward-looking. We’re looking to identify mispriced bond securities ahead of the market. It’s how we add value to the credit portfolio,” Baillie says.
She says the big three agencies influence the bonds rated in benchmarks, but beyond that their influence is peripheral. “We’ve always done our own shadow ratings and never relied on them.”
Gus Medeiros, head of credit analysis at Deutsche Bank in Australia, says many of the issues the agencies faced related to specific sectors, notably the structured credit products before the financial crisis. “The track record in traditional areas such as corporate and sovereign ratings has been acceptable and agencies have managed to maintain their reputation accordingly,” he says.
Each to their own (rating)
There has been plenty of talk about how the three main agencies’ dominance could be disrupted or even replaced, but for now the biggest change may be the new awareness among investors that they need to do their own homework rather than just trusting the agencies.
After the Anhui rating, Bloomberg quoted Jeffrey Qi, a money manager at E Fund in Hong Kong, saying his firm trusted its internal ratings more. “We are not sure if outside ratings companies are doing enough due diligence,” Qi reportedly said.
Mallaby at the Council of Foreign Relations says there are few means to solve the conflicts of interest inherent in the agency monopoly, particularly in relation to sovereign debt. “The reason the subprime bubble could happen, or the reason the European sovereign debt crisis can happen, is largely that very blind investors bought bonds relying on ratings, and [didn’t do] their own homework. The real credit risk was in the bonds themselves,” Mallaby says.
If the power of the agencies is a problem, there’s only one solution, he says. “Just stop giving their ratings so much weight.”
Adding an agency
Across the world, nations and groups have been toying with ideas to disrupt the three-agency structure. In Europe, ideas have been put forward for a ratings agency owned by high-income investors who would implement their internal compensation structures, rewarding accuracy and transparency over revenue production.
Salary increases for agency staff would reflect analysis, not sales, and staff would be paid as much for challenging ratings methodologies as those who assigned them.
Last year the Bertelsmann Foundation in Germany advanced the notion of an international non-profit credit rating agency known as Incra, to be funded as a sustainable endowment. It would have a large range of donors, including governments, the World Bank and the International Monetary Fund. Incra would ring-fence the analytical function from the funders with a stakeholder committee.
The BRICS economies (Brazil, Russia, India, China and South Africa) have also discussed the creation of an independent agency to counter what is perceived as a culture of geopolitically biased economic assessment by Western agencies. The Universal Credit Rating Group (UCRG) was created in 2013 as a partnership between the Chinese Dagong, Russia’s RusRating and the American Egan-Jones ratings agencies.
UCRG is set to produce its first ratings this year, but some are sceptical that a BRICS-style agency will gain traction. Even the World Bank’s adviser on BRICS, Otaviano Canuto, has played down the idea, saying a ratings entity with government backing “would never be free of government influence”.
Medeiros at Deutsche Bank believes new agencies could emerge but this would require coverage scale, robust fundamentals and methodologies and some kind of record.
He also says existing agencies are improving their credibility because of new regulatory requirements, for example, the training of analysts. “The methodology transparency has improved. Ratings may be replaced by a superior system but the existing system is working well. Above all, ratings are opinions and should be used as one of many inputs in investors’ broader investment assessment.”
“The main ratings problem has been the ‘issuer pays’ model the agencies use.”
Behind the ratings
"We rate every deal. It could be structured by cows and we would rate it.”
Internal instant message by an S&P employee, April 2007
“Let’s hope we are all wealthy and retired by the time this house of cards falters.”
Internal email by an S&P employee, December 2006
“The failures of credit rating agencies were essential cogs in the wheel of financial destruction.”
US Financial Crisis Inquiry Commission, January 2011
“Financial markets ... have become less interested in the agencies’ opinions.”
Who is the best performer?
Banking market research and analysis firm East & Partners recently reviewed the performance of agencies in Australasian markets, seeking responses from credit issuers and investors. In all, 198 corporate and institutional issuers of debt were interviewed as well as the top 100 investors in specified rated debt.
Martin Smith, head of markets analysis at East, says investors and borrowers saw notable differences between different agencies’ work. S&P ranked clearly ahead of Moody’s, although the latter recorded strong improvements in rated performance with issuers and investors.
Smith says investors were harsher than issuers in their assessments. Relative reliance by investors on Moody’s and Fitch Ratings had nearly doubled since the previous review. Fitch also registered a clear increase in its “footprint”, especially in the structured finance and bank sectors.
This article is from the August issue of INTHEBLACK