“The best books… are those that tell you what you know already,” wrote George Orwell. Apparently policymakers have forgotten this mantra when it comes to rating agencies. Over the past year, each time one of the big agencies has reminded a large western nation of painfully obvious truths about the state of its finances, the agency has faced a torrent of criticism.
On a recent Friday, when Standard & Poors (S&P) cut the ratings of nine European countries, politicians again took to the microphones to lambast the agencies for exacerbating the eurozone crisis and to reassure investors they had a plan. The financial media again speculated about a run on European banks and the collapse of the euro. But this time, the market barely reacted. France lost its top-ranked AAA rating, but European stocks barely moved. Spain, which saw a two-notch downgrade, auctioned off bonds on Tuesday at significantly lower interest rate than it had the previous year. Fitch followed suit this past Friday, downgrading several countries including Italy and Spain. Italian Prime Minister Mario Monti reportedly said he reacted to the downgrade with “detached serenity.”
The role of rating agencies has been hotly debated since the financial crisis. The three industry leaders — S&P, Moody’s, and Fitch — had bestowed their highest praise on the toxic mortgage-backed securities that inflated the U.S. housing bubble. These agencies have wielded tremendous power since the 1970s when the SEC gave them the official title of “Nationally Recognized Statistic Rating Organizations” and made it nearly impossible to buy or sell a financial product without a stamp from one of the three big firms.
And yet, the past few years have exposed a substantial flaw in the agencies’ business models — namely, that they make their money from the very institutions whose products they judge. So, in the early 2000s, when they were signing off on worthless mortgage-backed securities, they were profiting handsomely.
This flaw was much discussed after the financial crisis. Yet now another seems to be coming to the fore — the ability of rating agencies to put a meaningful stamp on sovereign debt. Ostensibly, rating the debt of countries should be less fraught than rating the debt of banks. After all, governments don’t pay these agencies to rate their bonds. Indeed, through much of their histories, the agencies have gotten it right when it comes to sovereign-default risk. The countries that defaulted since the mid-1970s all had their debt cut to “junk” status at least a year beforehand, according to a report by the IMF published in 2010.
Alas, recent history has proven that sovereign ratings may not be as bias-free as previously thought — and they may no longer be a reliable arbiter of government bonds. Over the last two years, many eurozone countries, like Ireland and Greece, have gotten multiple-notch downgrades. Typically, if a country is downgraded by more two or three ratings, this signals a mistake has been made. Greece’s debt was downgraded four notches in June 2010 alone. In August 2011, S&P downgraded U.S. debt — and since then, despite lingering debt problems, U.S. Treasuries were one of the most popular trades of the year, returning three times as much as AAA corporate bonds.
While it is true that rating agencies do not face the same inherent financial conflict of interest rating sovereign debt as they do rating corporate debt, palpable political pressure clearly now plays a role driving decision-making. The agencies can’t go too slowly, but they are also under pressure not to downgrade at all.
“Senior people at the ratings agencies are incredibly cognizant of rude telephone calls and abuse from European politicians,” says Gabriel Sterne, a former economist at the Bank of England who is now at Exotix, a boutique investment bank. “I don’t think you should be sensitive to it and I think you should call it according to how you see it. But that’s a very idealistic view.”
Sterne’s analysis seems to paint a less idealistic picture of reality. In a recent paper, he looked at the difference between sovereign ratings and credit default swap, or CDS, spreads (which show how much banks charge for selling insurance protection against debt default, and thus are a good measure of assumed risk). His research found that the agencies, in fact, rate the debt of troubled European countries 5-6 notches higher than do markets.
This reflects an inherent problem of transparency. Although ratings agencies publish how they measure sovereign default probabilities and downgrade risk, they don’t reveal their specific calculations. It’s hard to judge, then, whether they are sticking by their equations. Moreover, the gaps exposed by Sterne’s analysis seems to indicate that the markets don’t really care what rating an agency assigns to a sovereign. Certainly the impact of the downgrades to AA+ has been limited, as the large majority of investors no longer make a major distinction in their investment-grade indexes of securities rated BBB or higher.
Markets can’t just write the agencies off, however. Although upgrades and downgrades in general do not have a significant impact on CDS spreads, rating movements in and out of “investment grade” categories can have a more significant impact. “When you get downgraded to junk, it really matters because some investors have to shed the bonds,” says David Watts of CreditSights, a research firm.
More broadly, however, the recent problems highlight that ratings agencies are not serving their initial purpose — making information cheaply available, so that markets would have more participants and thus become more liquid. Though the EU has pushed through reforms twice since 2009 — and have plans for more, including introducing another ratings agency to the mix — S&P, Moody’s (MCO), and Fitch are deeply embedded in the regulatory and legislative system and there is no easy way to change this.
The lesson for investors is clear: Buyer beware. Over-reliance on ratings led to calamitous results in 2008. If investors are fooled twice, the shame is squarely on them.
