Credit rating agencies wield considerable power in the global financial system. With one of the big three agencies, Standard & Poor’s, being sued for $5 billion by the US department of justice, we look at what credit ratings do and why they are all over the news.
“Investor fears over Greek government liquidity misplaced”,
Moody’s, six months before Athens received a $147bn rescue package.
WHAT IS A CREDIT RATING AGENCY?
Credit rating agencies, evaluate the creditworthiness of organisations that issue debt in public markets,’ says the Financial Times Lexicon. That means credit agencies judge the likelihood of corporations, non-profit organisations and governments who get a loan (buy debt) being able to pay it back, in full and on time.
Rating agencies give each organisation a grading that tells investors and others how likely they believe the debt will be paid as promised.
Ratings are made on a descending scale: AAA is the highest, then AA, A, BBB, BB, B, etc.
The big three credit rating agencies, Standard & Poor’s, Moody’s and Fitch Ratings dominate the global market, grading the creditworthiness of governments and businesses internationally.
It’s a lucrative business. In 2012, Moody’s reported profits of $1,077 million, and 2013 is expected to produce record profits as investors seek shelter from growing financial uncertainty.
WHY ARE THEY IN THE NEWS?
Since the global financial crisis, a number of private cases have been brought against the rating agencies, in the US and elsewhere.
A notable case settled in Australia was a class action led by Bathurst Regional Council against Standard & Poor’s and their partners ABN Amro and Local Government Financial Services. The decision found that S&P had “engaged in misleading and deceptive conduct” and had made “unjustifiably and unreasonably optimistic assumptions” when modelling for risk. The councils involved in the class action lost an estimated $16 million dollars during the global financial crisis.
In February, the US Department of Justice sued Standard and Poor’s for $5 billion for similarly issuing “inflated ratings that misrepresented the securities’ true credit risk”. The outcome of this case is yet to be determined.
WHO PAYS THE RATING AGENCIES?
The banks that issue debt pay to have their debt rated if they use one of the big three agencies. This is called issuer-pays. If you are a bank issuing debt, you are the organisation who pays the agency to signal to global investors whether or not your debt is considered a safe investment.
WHO REGULATES THE RATING AGENCIES?
Governments have worked to introduce tighter regulation after the Enron collapse in 2001, a case of massive fraud that the rating agencies did not signal. (It is arguable whether the agencies can be held responsible when information is misrepresented to them.)
Governments themselves are affected by the ratings they receive from the agencies they regulate. Some suggest this opens up the opportunity for a conflict of interest.
The frameworks for bank ratings have become more transparent. When rating government finances, the agencies argue that they are balanced and impartial. Downgrading a country’s rating inevitably puts an agency in the firing line, but this doesn’t mean they are necessarily wrong to do so.
SHOULD WE EXPECT CREDIT RATINGS TO GET IT RIGHT ALL THE TIME?
No one can predict the future. Credit ratings are assessed by modelling risk of default, not by predicting the unforeseeable. Experience, combined with rigorous procedures, can finely tune risk modelling and increase its reliability, but, ultimately, investors act at their own risk and according to their own judgment.
However, credit ratings have the potential for significant social, economic and political fall out. Governments are shaken if their ratings drop. The cost of borrowing rises, interest rates may be affected, and it has an impact on the value of a nation’s currency. Many are asking for more transparency in how the agencies evaluate banks and whether this high impact public service should remain in the hands of private operators.
WHAT THE RATING AGENCIES MISSED
The US subprime housing collapse
The collapse of Enron
The fall of AIG
The Asian financial crisis
The collapse of the Greek economy
Lehman Brothers
WHAT NOW FOR THE RATING AGENCIES?
Credit ratings are important for borrowings on any scale. The key is regulation, transparency, independence and impartiality.
Also, the meaning of the ratings need to be understood by those who use them: they are opinions, not guarantees, and they have to be understood in context. Fallibility is inevitable. Where the agencies have made a mistake is in losing their impartiality.