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Credit Rating Agencies and All That Jazz
August 2011


In 2009, Eurozone debt levels suddenly gripped the media and the three main rating agencies, Standard and Poor’s (S&P), Moody’s, and Fitch (in order of size).
However, since the establishment of the Euro system in January 1999, not even the Greek government’s grave admission on November 15, 2004 that it had violated the conditions to join the Eurozone in 2001 was serious enough for the agencies to sound the alarm. Athens revealed that its deficit has never been below 3% since 1999, as EU rules demand, reported the Guardian (May 5, 2010).
It was not until December 2009, five years after Athens’ admission of violating Eurozone conditions that the agencies chose to embark upon a sustained downgrading of Greece’s long-term debt. It is as if Greece’s debt had leaped from zero to 115% of GDP (IMF, 2009) overnight.
In quick succession, the three agencies attacked the long-term debt rating of not only Greece but also those of Ireland (66% debt to GDP, when the downgrading started; IMF, 2009) and Portugal (83% debt to GDP, when the downgrading started; IMF, 2010). Within a few months, the three countries were downgraded from being among the world’s better rated to the world’s worst rated—Greece; from A- in December 2009 to junk by April 2010, Ireland; from AAA in March 2009 to junk by July 2011, and Portugal; from AA in March 2010 to junk by July 2011.
How credible is rating agencies’ analysis?
The short answer is, not much. Their business model is flawed. They are often contradictory with one another on the rating of the same entity. They are always steps behind important events. For example, S&P reaffirmed its AAA rating for Lehman Brothers Holdings Inc.'s financial products unit on Sept. 12, 2008, three days before the bank failed (Bloomberg, August 8, 2011). In the case of Enron, despite growing question marks regarding the company’s dubious financial position and integrity for months the agencies maintained Enron’s investment-grade rating until four days before it filed for bankruptcy on December 2, 2001 (EIN News, August 6, 2011).
Rating agencies suffer from an inherent conflict of interest—They are paid by the entities they rate. When the rating is unsolicited the agency is denied access to the management of the rated entity, distorting the quality of the rating. The exaggerated AAA ratings hastily showered on mortgage-backed securities (paid for by the banks) contributed to the real estate and banking meltdown in 2008 and to the severe recession that continues to afflict the world today. In April 2011, a Senate panel accused the rating companies of engaging in a "race to the bottom" to assign top grades on mortgage-backed securities in order to win fees from banks, said (Bloomberg, August 8, 2011). Before the financial crisis, banks shopped around to make sure rating agencies would award favorable ratings, paying upward of $100,000 for ratings on mortgage bond deals, according to the Financial Crisis Inquiry Commission and several hundreds of thousands of dollars for the more complex structures known as collateralized debt obligations (The New York Times, August 17, 2011).
Nobel Laureate Paul Krugman said in a New York Times column (August 7, 2011): "These are the last people whose judgment we should trust."
Questionable motives
What might lurk behind the sudden and unrelenting attack against Greece, Ireland, and Portugal? What benefit might be gained from, for example, Fitch and S&P’s warning that the French plan in June 2011 for a partial rollover of maturing Greek debt would be treated as an event of default? Is the warning intended to limit EU leaders’ options to help Greece? How different is this warning from preventing the firemen from reaching the site of a fire? Might the agencies act to magnify current market turmoil by attacking Italy, Spain, and France? Are the agencies carrying out a political agenda to break-up the Euro and halt Germany’s growing economic power? Are the agencies driven to help speculators profit from short-selling Eurozone bonds?
As if to compound the frenzy, the Mail on Sunday wrote on August 7, 2011 that, according to its sources, the huge French bank, Societe Generale, was in a “perilous” state and possibly on the “brink of disaster”. However, two days later, August 9, 2011, the Mail retracted the story: “We now accept that this was not true and we unreservedly apologize to Societe Generale for any embarrassment caused.” Meanwhile, Societe Generale’s share price tumbled and financial markets gyrated violently for days; prompting Belgium, France, Italy, and Spain to ban short-selling on select stocks for 15 days or longer.
Short selling
Short sellers thrive on bad news. Speculators bet that the price of a particular bond or stock will go down due to a future downgrade, negative media reporting, or malicious rumor. Short sellers would borrow, say, today a particular security for a month and sell it for $100. Within the month, when/if the price of the security falls to, say, $80 they would buy the security back in order to return it to the lender on maturity; thus, realizing $20 gain. "Naked" short-selling happen when speculators sell a security they have not even borrowed.
On the other hand, long position investors thrive on good news. They consider that the future price of a stock or a bond will go up. Good market news typically drive long position investors to hold on to the security, even buy more, in the hope of further price rises.
Short sellers must have profited greatly from the assault on Greece, Ireland, and Portugal. Short sellers must be hopeful that uncertainty and market gyrations would engulf Italy, France, and Spain. Bad news from the rating agencies, negative media reporting, and fabricated malicious rumors would help.
European leaders reaction
Eurozone officials feel the rating agencies, controlled by Anglo Saxon parties (Fitch is based in London and New York but is majority owned by a Paris firm), have an agenda to undermine their economies, even break-up the Euro to impede economic growth in the Eurozone and contain Germany. In 2009, the “freewheeling Anglo Saxons model” of finance was blamed  for the 2008 global economic downturn by the French President (The Telegraph, December 2, 2009).
Criticizing the agencies, German Chancellor Angela Merkel, referring to the EU, IMF, and European Central Bank, stated: “I trust above all the judgment of these three institutions” (Reuters, July 6, 2011). German finance minister Wolfgang Schaeuble said: “We must break the oligopoly of the rating agencies” and European Commission President Jose Manuel Barroso revealed that “Europe was looking at getting away from its reliance on the mainly U.S.-based rating companies and weighing possibilities for legal redress”.
It is curious that Britain, an EU member, though not the Eurozone, has been defending the agencies. A House of Lords sub-committee supported European debt downgrades. To policymakers in the UK’s upper parliamentary chamber, any move by the European Union to suspend credit ratings for countries being bailed out is “wholly impractical and smacks of censorship” (The Financial Times, July 20, 2011). British unease about Germany’s growing power is not new. Two months before the fall of the Berlin Wall, former Prime Minister Margaret Thatcher told President Gorbachev that neither Britain nor Western Europe wanted the reunification of Germany and made clear that she wanted the Soviet leader to do what he could to stop it (The Times, September 2009).
To insulate the Eurozone from disruption by rating agencies and speculators, taxation and spending policies in the Eurozone must be made centrally. The German Chancellor and French President made two important decisions in this direction at their August 16, 2011 meeting in Paris. The first would create a “European economic government” to coordinate the economic and financial policies of the block. The second is the enactment of constitutional amendments in the 17 Eurozone countries requiring balanced budgets by the summer of 2012 (BBC, August 17, 2011).
If the two decisions will be implemented successfully the Eurozone would be able to ameliorate the birth defect that has afflicted its economic and financial management since birth; namely, the absence of a centralized fiscal policy-making body. Since the European Central Bank already controls monetary policy, adding centralized fiscal policy making would create an effective Eurozone monetary and fiscal union, which should enhance the financial stability and creditworthiness of Eurozone countries individually and collectively.
German economic ascendancy
Germany is Europe’s dominant economic power. IMF data for 2010 shows that Germany’s $3.3 trillion nominal GDP is the world’s fourth largest (Japan; $5.5 trillion, China; $5.9 trillion, USA; 14.6 trillion). Germany is the largest economy in Europe, accounting for 20% of European nominal GDP and 27% of the Eurozone nominal GDP.
WTO data show that with $1.12 trillion in exports of goods in 2009, representing 9.2% of world’s exports, Germany is the world’s second largest exporter (China; $1.2 trillion).
Growth in external trade is the engine behind German prosperity. Deutsche Bank research shows that Germany’s exports of goods and services represent almost one half of GDP, that between 2000 and 2008 exports grew by 66%, and that the Eurozone is Germany’s biggest trading partner—more than 50% of Germany’s external trade.
Helping Germany’s external trade growth has been the introduction of the Euro. The Euro has eliminated currency risk fluctuations within the 17 Eurozone states. German exporters and importers benefited also from the removal of customs duties, tariffs, and border control and from the Single European Payment Area, which made electronic payments throughout the Eurozone as domestic payments.
The Euro has become the second most important reserve currency in the world after the dollar. IMF data show that at the end of 1999, the year of creating the Euro system, 18% of official foreign exchange reserves were in Euro (71% in U.S. Dollar). At the end of the first quarter of 2011, the share of the Euro stood at 27% (61% in U.S. Dollar).
A proposed solution to current credit rating deficiencies
With a flawed business model and a professional record tainted by blunders why is it that the credit rating industry has gained so much influence? The answer is that the good housekeeping stamp of the big agencies has for decades been required by America’s banking and financial regulators to ensure that banks and mutual funds and others hold on their books AAA or investment grade securities.
The world will be a better place without profit-driven credit rating industry. To ensure intellectual honesty and professional integrity and technical competence in an area so crucial for American and world financial health a not-for-profit credit rating board, similar to America's Financial Accounting Standards Board (FASB), need to be formed.
The new board would be composed of full-time members drawn from public accounting, industry, academe and government (FASB has seven members serving for a five-year term renewable for an additional term). To ensure impartiality and independence, board members should sever all ties to firms and institutions prior to joining the proposed new board. Assisting the board would be a staff of professionals and support personnel.
Like FASB, the new board, would be made subject to oversight by a foundation. The Board of Trustees of the foundation would be selected by professional organizations concerned with accounting, finance, economic, and credit issues. The foundation would fund the new credit rating  board.
Funding the foundation should be the Federal government. Rating reports would be posted free of charge on the Internet. Cost to taxpayers? Extrapolating from the annual revenues from ratings of the big-three agencies the answer would be in the region of $5 billion per annum. Such an amount is a small premium to pay for intellectual honesty and professional integrity and technical competence in credit rating.