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.
