March, 2013

Ratings Agencies Highlighted But Downgraded

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After many decades of relative public obscurity, ratings agencies have lately been grabbing headlines for all the wrong reasons.  On 5 February 2013 The Wall Street Journal’s front page was covered with news the US Justice Department was planning to sue Standard and Poors (S&P), the ratings agency owned by publishing giant McGraw Hill, for USD$5 billion over its rating of collateralized debt obligations (CDO’s) before the global financial crisis.

Here we will look at why are the opinions of credit ratings have become to have such significant influence, how changes in those opinions (downgrades or upgrades) can influence governments and policy, and how all of this power has become concentrated in the hands of only a few firms.

The Big Three

There are three dominant global ratings agencies, S&P, Moodys and Fitch who are collectively referred to as “The Big Three”.  These firms combine to control 95% of the U.S. ratings market and in 2003 were the only nationally recognized statistical rating organistions (NRSRO’s) by the US Securities and Exchange Commission.

The list has since expanded to nine as the US government sought to encourage a more competitive market after the GFC. Interestingly in the commission’s 2012 Annual Report on Nationally Recognized Statistical Rating Organizations it notes that it denied an application by Dagong Global Credit Rating Co Ltd, a rating agency based in Beijing China, to become an NRSRO. There is only one non US based ratings agency on the list, being the Japan Credit Rating Agency Ltd.

Despite this attempt to encourage competition, the graphs below illustrate the relative market share of recognized ratings agencies, and the dominance of The Big Three.

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The Role Of Rating

The role of a ratings agency is to assess the creditworthiness of issuers, meaning the likelihood that their debt will be repaid in full and in a timely manner.

Investors use credit ratings to help assess credit risk and to compare different issuers and debt issues. For example individual investors may use credit ratings in evaluating the purchase of government or corporate bonds and how they will impact the risk profile of their portfolio. Institutional investors such as superannuation funds, pension funds, banks, and insurance companies often use credit ratings to supplement their own credit analysis on specific debt issues.

Issuers, including corporations, financial institutions and governments use credit ratings to provide independent opinions on their creditworthiness and the credit quality of their debt issues. Issuers may also use credit ratings to help communicate the relative credit quality of debt issues to potential investors. A sovereign debt issuance without a credit rating by at least one of The Big Three would simply not be purchased by many governments and institutions that are major investors in those markets.  Many mutual funds, insurance corporations and superannuation funds are prohibited under their investment mandates from purchasing securities which are not rated.

As a general rule the better the creditworthiness of an issuer or an issue is, the lower the interest rate required to be paid to investors. The reverse is also true: an issuer (including governments) with lower creditworthiness will typically have to pay higher interest rates to attract investors.  With record high government debt levels, and interest payments representing a large proportion of government outflows, it is very clear that The Big Three US based ratings agencies have a very significant influence on government budgets around the world.

This graphic shows the current ratings of sovereign debt by S&P for countries around the world.

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Greece is coloured red and rated ‘highly speculative’ whereas Australia is coloured blue and rated ‘prime’.  A three year chart comparing yields on Greek & Australian government bonds is below. In April 2010 yields were roughly equal. However in 2012, after Greece had been downgraded by the global ratings agencies, investors were demanding a 37% yield for holding Greek government bonds compared to only 4.1% cent for the equivalent Australian government bonds.  Greece was then unable to meet the higher interest payments and required a bail out package, which came with significant austerity measures, to maintain solvency.

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The graph below shows relative bond yield movements during 2012 around the time many European nations were being downgraded. This chart highlights two important impacts of a ratings downgrade, firstly after a nation is downgraded the yield demanded by investors to hold that nations bonds will rise. Secondly, other countries can be impacted if investors believe that they are subject to the same market forces that gave rise to the downgrade. For example the yields for Italy rose significantly after Portugal was downgraded. For the most indebted countries this can become a vicious cycle, as already stretched budgets result in ratings downgrades, which lead to higher interest rates and interest payments, further exacerbating already precarious budget positions.

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Potential Conflicts of Interest

Critics of the ratings industry maintain there are conflicts of interest when rating agencies receive payment from the issuers whose securities they are evaluating. If the issuer can ‘shop’ for another rating by a different rating agency, the agency, in order to gain favor with the issuer and retain its business, may issue a credit rating that is higher than the agencies’ objective analysis would otherwise determine. Another potential conflict is that large investors may exert an undue influence on an agency’s rating results since it is in the investor’s interest to have the ratings support their investment strategy. For example a ratings agency may be tempted to maintain a high rating for an large issuer in order to avoid negative consequences, whether they be legal, financial or both.  After all ratings agencies are businesses requiring revenue from their clients to operate.

Before the GFC the CDO’s that caused huge financial losses in many of the world’s banks had been given the highest possible ratings by S&P, Moody’s and Fitch. The US Justice Department announced on 5 February 2013 that it was suing S&P for USD$5 billion. The Justice Department alleges:

S&P’s desire for increased revenue and market share in the RMBS and CDO ratings markets led S&P to downplay and disregard the true extent of the credit risks posed by RMBS and CDO tranches in order to favour the interests of large investment banks and others involved in the issuance of RMBS and CDOs who selected S&P to provide credit ratings”.

S&P is denying the charges stating the “… Department of Justice lawsuit would be entirely without factual or legal merit.” It is expected S&P will use the same 1st Amendment defence they have used in several civil suits claiming that their ratings are only an opinion.

The lawsuit has left market commentators asking if this is not payback for S&P stripping the US of its AAA credit rating on 5 August 2011. This is denied by US Attorney General Eric Holder who said the lawsuit had “no connection” to the downgrade when quizzed by media last week.  It is interesting to note that Moodys and Fitch who gave the same CDO’s their highest credit ratings, and who have never downgraded the US, are not being sued by US Department of Justice.

Conclusion

In the context of record and growing global debt levels the role and influence of ratings agencies has increased significantly.  With 95% of the ratings market, The Big Three are now able to impact global government budgets, through ratings downgrades and upgrades, more than any other single factor.  It is apparent that a government that loses control of its budget, soon loses control of its sovereignty.

Whilst the Big Three are clearly US centric, it appears the US government is now attempting to turn the tables back on S&P with its US$5 billion lawsuit.  With the outcome of that suit many months away, the ratings agencies will be aware that a verdict in favour of the Department of Justice will likely lead to a flood of similar lawsuits both domestically in the US and from investors around the globe that have lost billions on RMBS and CDO’s that attracted the highest of ratings before the GFC.

One positive impact from the lawsuit is that ratings agencies are now voluntarily attempting to create some independence in their business models, addressing ‘ratings shopping’ and reliance on positive ratings to retain clients and revenue.  Although industry participation in this regard should be welcomed, there still remains no legislative response to enforce independence despite the billions required by governments around the world to bail out banks and insurers who suffered losses from inaccurate ratings prior to the GFC.   Perhaps these  governments remain fearful of being downgraded by The Big Three.