Rating agencies - prophets or cause of the crisis?

We hear it again and again, "Greece", with the next crucial vote ahead of us. And ever since the Greek crisis, many regard the rating agencies as the cause, or at least accomplices in the crisis, some even see an Anglo-American conspiracy against Europe behind, an increasing number of EU leaders agree to this choir. This turmoil is nothing new, just think of some doubtful role of these agencies in the past 20 years, as the 1997 Asian crisis or Enron and Co. or the asset-backed securities, or...  As a fact rating agencies tend to be behind the curve.

Rating Agencies: partially responsible for the Euro-debt crisis?

By December 2009, the rating agency Moody's called raising concerns over liquidity problems of Greece excessive. Less than six months later, the country had to be bailed out from bankruptcy with more than 100 billion €. The likely reluctance of rating agencies is largely due to their influence on investor's decisions leading to a sort of self-fulfilling prophecies. A downgrade usually also threatens a debtor to difficulties in raising capital and solvency, which in turn again, deteriorates the credit rating, etc. The accumulated mountain of debt, under which the euro zone is to collapse is not generated by the rating agencies, but by politicians, gladly financed by banks and insurance companies. Is there is a complicity of the rating agencies in that they mislead investors with positive credit ratings and over-optimistic assumptions, so that investors may be encouraged to take higher risks?

Rating agencies, however, rely mostly on publicly available information and incorporate them with different methods in the models they constructed. This gives way for a lot of potential errors. Rating agencies are at the mercy of reliable data like any other market participant, think of data manipulated at the source e.g. budget figures in Greece or the balance sheets of spectacular bankruptcy cases! Second source of error are the models used. In a world of data overflow beyond calculation plenty of uncertainties remain that cannot be squeezed into a model.

A credit rating of any state or company for the next 10 or 20 years offers the same value as weather prophecy for the winter after next. And finally there are tangible conflicts of interest, because the ratings are usually paid for by those whose credit quality is assessed, government bonds, however, are treated differently. Rating agencies have therefore a very lively self-interest in rapid growth of credit and bond markets - obvious during the U.S. mortgage boom, as lots of top ratings awarded for hundreds of billions of highly questionable loans. And ultimately, it is providential that they did not have to bear the consequences of their misjudgement. A brilliant business model, at least so far.

Where does the great influence of the rating agencies come from?

Rating agencies meet the needs of investors and creditors for an independent assessment of borrowers by a qualified third party. Since 1975, companies must show ratings of at least two of the three major rating agencies (Moody's, S & P's, Fitch) before they are approved for the U.S. capital market. Since then, the power of rating agencies has increased dramatically worldwide, almost all banks, insurance or investment companies and pension funds have investment guidelines, which specify certain minimum ratings for their capital investments. Consequently supervisory and regulatory authorities of banks and insurance companies postulate certain capital requirements depending on rating levels.

Governments, regulators and financial industry have collectively worked in this way into a dead end, difficult to get out in time. The basic problem here is the world's way too high debt levels and increasingly complex financial products. In the last 30 years the creation of a gigantic global credit bubble that would be unthinkable without the rating agencies and the few globally dominant rating agencies at the same time ensures a tremendous position of power.

It was created in the last 30 years a gigantic global credit house of cards that would not rating agencies and their market position hardly conceivable. While a bank for private clients or small businesses in the next town does not need a rating agency at all that case looks quite different for cross-border lending and bond purchases – even more so in the increasingly complex financial products. For the latter often not even its creators know all of which is inside and what the risks really are. This also applies to the rating agencies, however, it is modelled and estimated, the results are all known.

How to solve this dilemma?

The fundamental problem is not the existence of rating agencies and even the country in which they are established, it is rather the oligopolistic structures and their de facto disclaimer. Add to that the exaggerated regulatory significance. Many investors who have relied too long too heavily on these ratings would have to stand much more on their own assessments. Judgments of rating agencies continue to have a certain role – but only as one opinion among many. If still in doubt, why not just put hands off specific, highly complex instruments or intransparent issuers– anything to argue against it?

Who wants to be no longer dependent on judgments of rating agencies, will, on one hand, have to gradually trim back the global financial system. On the other hand, it is on people and politics, to finally turn state finances while it is still possible. That may be painful for all concerned with tangible way cuts. But certainly better than waking up one day and find yourself going bust in Greek rating status. And again the "bad" debt rating agencies are to blame...


Author:
Klaus Glaser
Head of  Product Management
Raiffeisen Capital Management 
3 June 2012