Who rates the rating agencies?
France last week had its credit rating knocked down a tick from AA+ to AA by one of the ‘big three’ rating agencies. Standard & Poor’s blamed the French economy’s sluggish recovery, high unemployment and a high debt-GDP ratio. Credit ratings, whose rationale is to make risk assessments for investors, matter for governments and other bond issuers, since lower ratings mean higher borrowing costs, and downgraded bonds can tailspin as increased repayments up the likelihood of issuers’ defaulting. For governments, that means higher budget deficits, and calls for austerity to balance the books.
So credit ratings are big bananas. But what are credit rating agencies? The US Securities and Exchange Commission also recognises seven smaller CRAs, but the big daddies are S&P, Moody’s and Fitch. These ‘Nationally Recognised Statistical Rating Organisations’ have the power to kite-mark bonds for issuance firms. They act as gatekeepers, regulating the flow of market-sensitive information.
As usual with government-sanctioned market activity, the questions are who regulates, in whose name, and who holds the regulator itself to account. The big CRAs, whose grades the mainstream news greet as if awed at the latest papal encyclical, are themselves raptor-capitalist businesses. As the crash showed, the fact that the firms work in an oligopolistic market is not conducive to feeding through accurate information about risk. Dodgier still is the fact that issuers, who pay the CRAs' wages, want investors to take their bonds, so the agencies have an incentive to sign off junk as a sure thing. As the US Financial Crisis Inquiry Commission reported,
Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings.
In the run-up to the crash, banks would shop around the agencies to get the best rating for investment vehicles: as if used-car dealerships were to pay garages to get their cars through their MOT.
Though they’re big firms, the agencies operate on a shoestring: credit decisions at S&P are made by a coterie of five to eight people. According to S&P, the indicators might include ‘economic, regulatory and geopolitical influences, management and corporate governance attributes, and competitive position’ – in other words, a whole load of anything. Staff are poorly remunerated, at least compared with Wall St bond traders, and often jump ship, taking market-sensitive information with them. So the idea that a Chinese wall separates CRAs and clients is a bit of a joke.
The 2008 crash might have been thought to have dented the agencies’ credibility. Enron products were still getting investment-grade ratings four days before it went bust. Freddie Mac preferred stock was top-rated by Moody’s till mid-2008. Shortly before its bail-out by the Fed, the insurance giant AIG had entered into credit default swaps to insure $441 billion of AAA-rated securities on the London market. In the FCIC’s words, ‘the three credit rating agencies were key enablers of the financial meltdown’. Moody’s comes in for particular flak. In 2000-7, it rated nearly 45,000 securities as AAA. Eighty-three per cent of the securities given that rating in 2006 were ultimately downgraded. Catastrophe resulted from ‘the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight’.
The overall effect is like an inverted morality tale. Agencies conceived to temper risk and boost confidence take punts on products they nod through because their hard-pressed staff lack the resources to vet them properly and are actors in the markets they purport neutrally to observe. A hands-off oversight body, the SEC, does little to address failures of corporate governance. When the mismatch between real and CRA-rated risk becomes disastrously clear, governments nationalise the losses while those in the know, as at Countrywide, get out on a sauve qui peut basis.
And the big three grind on, oblivious to failure. Earlier this year EU passed reg-lite legislation to curb them. But sovereign governments remain in their thrall, though there are suggestions of replacing the CRAs’ ad hoc ratings by marking credit according to bond yield spreads, rather than the converse. Meanwhile, at the sharp end, where austeritarian government bites, are the poor, the old, the underfed, the cold.