After every market crisis, when blame starts to be handed out, the chances are that a fair chunk of it will land on the rating agencies doorsteps. Issuers will claim their debt was downgraded too soon, investors will say it was downgraded too late, and accusations of collusion and incompetence will start to fill the air like confetti. Rarely, if ever, will a rating agency be congratulated on its timeliness and perspicuity.
In this respect, the European sovereign debt crisis has adhered scrupulously to the prototype. No sooner had Standard & Poors demoted Greek debt to junk status in April than Europes policymakers began the long-established ritual of shooting the messenger. In a joint letter to European Council president Herman van Rompuy, French president Nicolas Sarkozy and German chancellor Angela Merkel wrote: "The decision by a ratings agency to downgrade the rating of Greece even before the programme of the authorities and the amount of the support plan was known prompts us to consider the role of the ratings agencies in the spreading of crises."
S&P attracted similar brickbats in August when it downgraded Irelands debt to AA-, this time from the head of the Irish National Treasury Management Agency (Nama), John Corrigan, who called the agencys analysis "flawed" because of its negative assessment of Irish bank liabilities.
Three months later, when the extent of the crisis in Irelands financial sector was becoming clear, it was Moodys turn to take the flak. As the last of the big three to cut Irish debt to single-A levels, it became the subject of lively market speculation that the agency had succumbed to political pressure, neatly illustrating the "damned if they do, damned if they dont" ratings conundrum.
So far, so normal. The agencies have long since resigned themselves to the fact that their actions only make headlines when markets are already destabilised, investors are running scared and politicians are looking for scapegoats. "People who criticise our timing always do so during bearish phases of the market they ignore the contrarian positions that weve staked out during periods of market optimism," says David Beers, head of sovereign ratings at S&P in London.
As he points out, for the first 10 years of the eurozones existence, when the market was pricing debt from every country in the region at or near triple-A levels, S&P and its fellow agencies were rating southern members of the single currency as low as single-A. "We started downgrading sovereigns like Greece back in 2004," he adds. "We didnt suddenly wake up, like many in the marketplace did, to underlying fiscal pressures or the financial contingent liabilities that contribute to them for many of these sovereigns back in 2009 or this year. Likewise with our downgrades five or six years ago people simply ignored them because the markets didnt react to them."
A very different crisis
Yet despite the many similarities with previous sovereign crises, there are signs that things may be different this time around and that Europes troubles could finally precipitate a fundamental shift in attitudes to ratings. If so, the agencies will, to some extent, only have themselves to blame thanks to their dubious role in the subprime fiasco, their credibility was at an all-time low before the latest crisis even began. One bank ratings advisor comments: "Its like the emperors new clothes in the world of structured finance the ratings were clearly utterly wrong and unfortunately once that kind of facade starts to crumble then fingers are pointed rightly and sometimes wrongly at all other ratings."
As a result, pressure to increase the restrictions around ratings had been building on both sides of the Atlantic for nearly 18 months before Greece imploded. On September 7, rating agencies in Europe came under regulatory control for the first time as a result of a ruling in April 2009 by the European Commission, with national regulators taking the reins ahead of the establishment in January 2010 of the European Security Markets Authority (ESMA). The initial scope of the regulations was limited to such relatively minor issues as analyst rotation, business separation and independent directors, but there are already abundant signs that policymakers view these as the start of a lengthy process of adjustment.
In November, the EC launched a second consultation on the rating industry to address "the risk of overreliance on credit ratings by financial markets participants, the high degree of consultation in the credit rating sector, the civil liability of credit rating agencies [CRAs] and the remuneration models used by CRAs". Proposals included extending the already controversial 12 hour notice period for rating actions to three days for sovereign issuers, prohibiting EU states from paying for ratings, and requiring agencies to provide their sovereign rating research free of charge.While smacking slightly more of self-interest, the tone of the ECs consultation document echoes that of an October update from the Financial Stability Board (FSB). Subsequently endorsed by policymakers at the G20 summit in Seoul, the report entitled Principles for reducing reliance on credit rating agencies recommended structural reforms to curtail the use of ratings by both regulators and market participants. "The use of CRA ratings in regulatory rules has contributed to an undesirable reduction in banks, institutional investors and other market participants own capacity for credit risk assessment and due diligence," said an FSB spokesperson.
As if that werent enough, ratings have also taken a renewed battering from the buy-side. Fund management heavyweights such as Blackrock and Pimco have traditionally done their own credit work but dealers report that even smaller investors have become disillusioned with sovereign ratings.
Contingent liability hole
One frequent criticism concerns the agencies failure to allow for hefty contingent liabilities in the banking sector that caused much of the pain in economies such as Iceland and Ireland. "If you look at the Moodys methodology, the word bank hardly ever appears, and its really only from the point of view of the banking system providing liquidity to stimulate economic growth," says Raymond Travis, managing director financial solutions ratings advisory at Barclays Capital in London.
Similarly, the continuing dichotomy between emerging market and eurozone periphery ratings has prompted widespread concern that the agencies are no longer reflecting economic realities. "Ratings have lost their shine as a decisive factor for investors to come in or not, because youve seen so many emerging market sovereigns who are triple-B or even lower having a good run in terms of their issuance and duration," says Kiso Kentaro, head of public sector group at Barclays. "And its not only about the spread level thats compressing, its also about the volatility level theyre seeing, its very low."
Yet despite coming under heavy attack from both sides of the market, the agencies themselves are remarkably phlegmatic indeed, Beers at S&P insists that further legislation might even be welcome if it would put an end to the "unintended consequences" of regulators use of ratings. "We dont advocate the use of ratings for regulatory purposes and to the extent that the regulators are now moving in some jurisdictions to remove the mandatory use of ratings thats something were quite relaxed about," he says.
Whether the agencies would be quite as sanguine about interference in the private sector is another matter. Nevertheless, their apparent unconcern may have less to do with the possession of an admirable set of stiff upper lips and more with the realisation that, so deeply embedded are ratings in the workings of the market, rooting them out would be a near-impossible task.As Gary Jenkins, head of fixed income at Evolution Securities, points out, the instinctive reaction of European policymakers in the wake of the Greek downgrade was not to call for the abolition of ratings per se, but for the creation of the EUs own rating agency. "There is clearly some kind of desire or need for ratings," he says. "Maybe theyre just ingrained in our psyche because theyve been around for so long, but we do need that collection of letters. Its our little comfort blanket without it life becomes a lot more complicated and difficult."
Certainly the popular theory that the eurozone turmoil has prompted more investors to do their own analysis rather than relying on that of the agencies prompts a wryly amused response from S&Ps Beers. "After every market confidence crisis you hear one refrain, that people are doing more credit work that was true after the Mexican financial crisis, it was true after the Asian, Russian, LTCM and virtually ever other crisis," he says. "Thats the one bromide that you can count on people saying."
His argues that, while bank credit analysts may come and go according to the economic cycle, rating agencies are the only ones in a position to provide consistent, objective analysis. He is, naturally, talking his own book but even the agencies market critics have to admit that its hard to come up with a better model. "If we were starting with a blank piece of paper we might set the rating agencies up very differently, but they are what they are and for all the outcry about the dreadful acts that theyve committed over the last few years the fact is that theyre there," says Jenkins. "If the rating agencies didnt exist then wed have to invent them."Certainly the agencies have proved remarkably resilient so far policymakers bent on eliminating them may yet find that they have bitten off more than they can chew.