Financial Reform: Why credit the rating agencies?

Ilene Grabel

The credit rating industry is firing from both barrels.  The industry has launched a public relations effort that aims to delegitimize proposed regulations announced for public comment last month by the US Securities and Exchange Commission (SEC). The proposed regulations stem from the Dodd-Frank Act of 2010. At the same time the industry is taking its hubris to new levels by inserting itself aggressively and directly into public policy debates in the US and Europe.

This is a rather stunning reversal of fortunes for the rating agencies.  In the early days of the financial crisis, it looked as if the industry was in for a fundamental overhaul. At that time, it seemed that there was momentum in the US around the creation of a new rating industry model—in the new model they would operate as public utilities. Elsewhere in the world, discussion of the failings of this industry was part of broader conversations about the need to move away from a US-centered financial architecture. In Europe and Asia, in particular, the misdeeds of the rating industry led to calls to create new regional and/or national entities that would credibly and ethically perform this work.

An overhaul of the rating industry was long overdue. The current crisis made it simply impossible to paper over the industry’s multiple failings.  These include, but are not limited to, the conflict of interest that is an intrinsic feature of a business model wherein those whose securities are being rated pay for their ratings. Moreover, the industry’s analysts and the models they use have consistently failed to assess sovereign and private risk accurately. There is a revolving door between analysts and the entities that they rate. The structure of the industry means that rating firms have incentives to build business by offering more lenient ratings than their competitors. And the monopoly power of the industry is maintained by the fact that some entities (such as insurance companies) can only invest in assets that are rated, and these ratings must be performed only by firms that the SEC designates as nationally recognized statistical rating organizations.  And though the report by the US Financial Crisis Inquiry Commission (a Congressional panel) was disappointing in so many respects, it did correctly indict the credit rating industry, calling its three biggest firms “essential cogs in the wheels of financial destruction.” 

With all of this, there was reason to assume that the industry would face serious restructuring.  But its officials and supporters managed to lobby their way out of serious change under Dodd-Frank. Having won the major battle, industry spokespeople are now pushing back hard against all of the proposed new regulations that the SEC proposed last month. The SEC’s proposals do not get at the heart of many of the key problems that characterize the industry. But they are at a step in the right direction, and so should be imposed on an industry that has escaped all responsibility for a crisis to which it contributed so mightily. The regulations would mandate that rating firms periodically test the competence of their employees, strip references to credit ratings in securities offerings, prohibit rating firm analysts from issuing a rating if they also marketed their firm’s products or services, and would require that firms examine whether a former analyst awarded overly generous ratings to a firm that later hired that person. The SEC is also studying the issue of whether it should create an independent body that will assign performance ratings to raters, another initiative that is being opposed aggressively by the industry and Republicans.

At the same time as the industry is pushing against these rather modest regulations, it is working hard to elevate its role in the global economy.  The industry has long exploited its falsely claimed role as neutral judge and oracle on matters of economic and social policy across the globe. These roles are reinforced whenever the firms announce downgrades, threats of downgrades or changes in what they call “the outlook.”  Such decisions can and have helped to empower politicians and the business lobby since they are treated as serious evaluations of whether a country’s economic policies render a sovereign default more or less likely.  All of this matters because a threatened or actual downgrade means that a government has to pay more to borrow money. This is because when investors become convinced that there is a greater risk of sovereign default they will lend money to the government (i.e., buy its bonds) only if they are compensated for this perceived higher risk via a higher interest rate. Other interest rates in the economy generally rise accordingly. 

The credit rating agencies have been quite busy lately downgrading countries and also threatening to do so. For example, despite the humanitarian and economic challenges of the Japanese nuclear disaster at Fukushima in March, Moody’s announced earlier this month that it might downgrade its debt rating for Japan, joining S&P and Fitch in taking a more pessimistic view of the country’s economy. In the end, Moody’s kept its rating for Japanese bonds constant, but said its review of the rating for a possible downgrade had been prompted by  “heightened concern, that faltering economic growth prospects and a weak policy response would make more challenging the government’s ability to fashion and achieve a credible deficit reduction target.” Without an effective strategy, the rating agency said, government debt “will rise inexorably from a level which already is well above that of other advanced economies.” The Japanese government noted that it was disappointed, but that it was nevertheless forced to take the threat seriously

The raters have been notably effective in injecting themselves into the debate over the US debt ceiling.  Moody’s warned last week that it might downgrade the US government’s perfect credit rating if Congress did not increase the nation’s debt limit in the “coming weeks,” a message that seemed to appeal to both Democrats and Republicans looking to reinforce their position that their opponents are forcing the country into a financial Armageddon. Moody’s said pointedly that whether the US keeps its AAA rating “will depend on the outcome of negotiations on deficit reduction.” Fitch Ratings has since made a similar announcement. These warnings followed a similar one from S&P in April, when it lowered its outlook for the US credit rating (but did not lower the rating itself).

As the European crisis has contaminated the southern part of the continent, the region’s economies have been buffeted by a repeated chorus of pronouncements by the raters. For example, the rating firms seem to be in a new competition with one another that involves regular downgrades and threats of future downgrades for Greece and Portugal (and formerly for Ireland).  Indeed, earlier this month Moody’s lowered Greece’s sovereign rating so that it sits even deeper within the category that the rating firms label as “junk.”  These downgrades arrive when Southern Europe faces unprecedented political turmoil and social conflict over reductions in public spending and rising taxes, all against the backdrop of devastatingly high unemployment. 

The industry has gone even further than it has in the past by positioning itself above elected governments, between political movements and against civil society groups. The positions taken by the industry in these national contexts not only undermine democratic debate over fiscal policies, but also threaten economic recovery by empowering those forces that see economic and other crises as the ideal time to roll back social spending and dismantle welfare states.

It boggles the mind that the credit rating firms are not taking a standstill on pronouncements in Europe, Japan and the US while conditions are so fragile. It also strains the imagination that the firms are still claiming that they are being unfairly targeted for regulation.  The industry’s recent efforts can only be read as a campaign to protect the industry’s global influence and profits.  Let’s hope that civil society actors intensify their campaigns to expose the failings, corruption and undue influence of this delegitimized industry. 

For more on rating agencies, see Triple Crisis Blogger Kevin P Gallagher’s post in The Guardian, The Tyranny of bond markets.

6 Responses to “Financial Reform: Why credit the rating agencies?”

  1. Stephan says:

    The Japanese government should do what its predecessor did instead of take this threat from Moody’s seriously.

    Recall that in November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s made the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. By December 2001, they further downgraded Japanese sovereign debt to Aa3 from Aa2. Then on May 31, 2002, they cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana?

    What happened to Japan and the bond market? Nothing. The bond dealers simply ignored the idiots from Moody’s. The Japanese finance minister at the time even told the crooked ratings agencies to take a long walk off a short pier!

  2. Kevin P. Gallagher says:

    The rating agencies were the subject of some scrutiny regarding their poor method of rating private bonds and conflicts of interest in the immediate wake of the crisis. That waned due to the press and lobbying efforts by the agencies. What has not received scrutiny is the poor job the agencies do at rating sovereign bonds. Underlying their methodology is the now discredited and crudest form of New Classical macroeconomics. Therefore anything short of absolute austerity gets a downgrade or a warning. Since bondmarkets more than ever take their signals from the agencies, this is an urgent problem to address. The IMF, for all its faults, NEVER had this kind of power. And if the IMF did, at least it had the ‘check’ that actual governments directed it. With the agencies we are talking about three private firms that literally have the ability to zap a government’s prospects, and the health of an economy.

  3. […] Reform: Why credit the ratings agencies? (Triple Crisis) Ilene Grabel argues that the ratings agencies’ shameless efforts to manipulate American and […]

  4. Benedict@Large says:

    These rating agencies don’t even understand that the US, Japan, and a host of other countries (but not all countries) present zero risk of sovereign default, as they can always satisfy whatever debt exists in their own currencies. It seems to me that this makes their ratings for ALL currencies worthless at best and malevolent at worst. They should simply be shut down. If that is not possible, jail the principals. There are more than sufficient grounds.

  5. Ilene Grabel says:

    Thanks, all–I fully agree with the sentiments expressed. A strong public statement by civil society groups and sovereign governments against the rating agencies is long overdue. These poorly performing, ethically challenged firms should not be able to operate as a SEC-sanctioned duopoly, especially if they are going to continue to work against the modest reforms that the agency has recently proposed. And the fact that the firms are taking greater steps to position themselves as the ultimate arbiters of national economic and social policies simply boggles the mind. After all, we’ve seen that the rating firms are not even up to the task of rating private debt instruments (like collateralized debt obligations). How could it be that their pronouncements on things far, far more complicated—namely, the economic and social policies of sovereign nations in crisis—are given any credence?

    I should note here as well that on Tuesday, S&P announced yet another downgrade of Greece just as large-scale social protests against new austerity measures in the country are unfolding and the government is in an ever shakier position. Certainly the timing of the latest Greek downgrade helps to complicate an already impossible situation. The government finds itself caught in the cross hairs between the German government (which is sensibly pushing for a solution that involves the private sector taking a “haircut” on Greek debt, even involuntarily) and the European central bank (whose officials reject solutions involving involuntary haircuts). The rating firms have inserted themselves inappropriately into this conflict by arguing that even a rescheduling of Greek debt would be equivalent to a default. This makes it harder for the Greek government to make a case for rescheduling (let alone an involuntary haircut), though surely such strategies are warranted at this time. The recent actions of the rating firms in Greece make it more impossible than ever to accept the cynical claim that they are simply issuing neutral, technical “opinions” about the government’s prospects of default. Rather, the pronouncements of the rating firms powerfully shape perceptions as to what strategies are or are not viable in countries that are dealing with devastating crises.

  6. […] Reform: Why credit the ratings agencies? (Triple Crisis) Ilene Grabel argues that the ratings agencies’ shameless efforts to manipulate American and […]