Rating agencies want to play politics so need reform

23 December 2011 | By Samuel Dale

Just yesterday there was an example of the pessimism they can instill as when Co-operative Bank was put on negative watch for buying more branches and the entire banking system was under review for banking reform.

It seems that any action - whether that be to strengthen market share and increase competition or even reforming banking to make it safer - is risky.

In today’s market there may be some truth but it ignores the attempts to build a safer company and a safer system that are being made.

They were too optimistic in the boom by rating junk sub-prime deals with gold-plated AAA ratings and now the pendulum has swung too far towards extreme pessimism.

There was little audible criticism of Eurozone debt when it was being built up, particularly in Greece but now all three big beasts- Moody’s, Fitch and Standard & Poor’s - are in full attack mode.

Greece is now junk status, downgrades are daily occurrences and the whole continent’s credit worthiness is being eroded.

But much of the rating agencies’ proclamations follow the markets rather than lead them, which begs the question, what are they for?

A paper by the World Bank Group immediately after the financial crash highlights some of the problems with agencies.

It states: “Rating agencies have long been accused of being slow to react to market events. Examples include their failure to foresee severe financial problems of sovereign issuers (as in Latin American debt crises and the 2001 collapse of Argentina) and established corporations (Enron, Worldcom, Parmalat), including in the current crisis.

“More broadly, some empirical literature finds that ratings have little informational value and that rating changes generally lag the market: although ratings may represent relative credit risk fairly well, they may be less reliable as indicators of absolute risk and rarely appear to affect market prices.”

If they are not acting as an effective independent guide to financial markets then they are simply further undermining confidence and trying to influence political decisions through strong positions.

They may rarely affect the markets but they have a major impact inside the governments of the western world and make a big splash in the financial press.

There was outrage across Europe when all 17 Eurozone nations were put on negative watch by S&P just prior to the crucial summit earlier this month.

When defending the destabilising timing of its action S&P even admitted that it hoped the move would give leaders a wake-up call to get a deal done at the summit.

This seems an overt attempt to be a political player and a stark example of overreach for an agency meant to simply rate credit-worthiness of companies and countries.

Last summer the world’s richest and most powerful government was left humiliated by S&P’s decision to downgrade its credit rating from AAA after the rating agency claimed its spending cuts were insufficient.

It even revealed precise figures for the amount the US to cut from its public purse, amounting to trillions of dollars, an implicit threat to bow to its will or face further downgrade. No doubt the loss of AAA status in the US will be a major issue in the US presidential election next year, a fact that will no doubt delight the rating agency.

In the UK chancellor George Osborne has almost staked his entire political career on Britain maintaining his AAA status through spending cuts.

In the autumn statement it was hard to get the chancellor to shut up about low yields on gilts, which he puts down to the top credit rating for the UK. Here, the rating agencies are happy with the UK government’s policy so offer them a stay of execution.

But this happy arrangement is tough for the rating agencies as they need to be seen to be doing something negative hence this week’s announcement by Moody’s that the UK’s stable AAA rating makes it more likely to be downgraded if it suffers further economic shocks. But this announcement serves only to boost Moody’s political position.

France was furious when S&P issued an incorrect notice stating that the country had lost its prized AAA rating, despite the quick correction. Some market commentators doubted whether such a mistake could be made and questioned whether S&P had let the notice slip out as a warning to the French that they are coming for them.

Speculation has been rife for months that a French downgrade is imminent as politicians prepare the ground by claiming it is now not crucial to its debt repayment plans.

The reality is that none of these actions had much affect on the countries’ ability to repay their debts - US Treasuries have actually gone lower as the markets trust it more, Germany on negative watch has barely moved Bunds and S&P’s provocative move before the summit had only the most minor ripple.

There is no doubt that the ludicrous situation prior to the crash that saw vastly under-scrutinised structured finance given top ratings, was wrong.

But the current situation of rating agencies acting as political players rather than market leaders is wrong too.

S&P in particular has tried to influence the fiscal plans of the US and Europe with threats of downgrades.

Economic arguments are diverse and when entities act to re-enforce the prevailing political consensus then they are over-stepping their mark.

They are doing more than simply narrowly rate credit by moving deep into fiscal policy of countries, stunting reform, trying to restrict completion and influence European leaders with maximum impact timing.

These agencies suffer from a paralysing conservatism at a time when overhaul of the political, economic and financial system is desperately needed.

The European Union is planning reforms to curtail the influence of these big beasts as they try to bring down governments.

France and Germany want their actions and statements more closely monitored and controlled and it’s hard to disagree.

These organisations need a narrow focus to rate credit, because currently they are trying to do so much more.

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