|Rating rating agencies |
SPECIAL TO BUSINESS DAY Thursday, May 18 2017
Two rating agencies this year downgraded Trinidad and Tobago: Standard and Poor’s (S&P) and Moody’s.
Questions have arisen about the continuous downgrades we have experienced, especially as we are sitting on US$9 billion in reserves and well over US$5 billion in the Heritage and Stabilization Fund (HSF). Since we have relatively low foreign debt and low debt/GDP, why the continuous downgrade? To explain this let us take a closer look at rating agencies. There are what is called the Big Three global credit rating agencies - S&P, Moody’s, and Fitch Ratings - which control nearly 95 percent of the credit ratings market. They are all US-based and had all come under intense scrutiny since the global financial crisis of 2008/09. The ratings handed out by each of the Big Three strongly influence investor perceptions of the creditworthiness of global governments.
These credit ratings were meant to provide investors with information on the riskiness of various kinds of debt. Instead these agencies were accused of worsening the financial crisis and defrauding investors by offering overly favourable evaluations of insolvent financial institutions and approving extremely risky mortgage-related securities.
Critics alleged that they created complex but unreliable models to calculate the probability of default for individual mortgages as well for the securitised products created by bundling these mortgages.
Indeed, some of the models were criticised for using historical information that could not anticipate the problems that arose in the housing market since they never occurred before. This saw products that were AAA-rated during the housing boom, experience a sharp downgrade after the housing market collapsed. In fact, in 2007, as housing prices began to tumble, Moody’s downgraded 83 percent of the $869 billion in mortgage securities it had rated at the AAA level in 2006. One of the key criticisms of rating agencies is that issuers themselves must pay them to rate their securities. It is interesting to note the number of credit implosions ratings agencies have largely missed over the past decade.
In Europe, these agencies encountered further controversy over their sovereign debt ratings.
While the public debt of crisis-hit countries like Greece, Portugal, and Ireland was relegated to “junk” status, the agencies also downgraded the creditworthiness of France, Austria, and other major Eurozone economies. EU governments and European Central Bank (ECB) policymakers accused the Big Three of being overly aggressive in rating Eurozone countries’ creditworthiness, thereby exacerbating the financial crisis. They argue that the unduly negative evaluations accelerated the European sovereign debt crisis as it spread through Greece, Ireland, and Portugal, and Spain — all of which received EU-IMF bailouts. S&P’s April 2010 decision to downgrade Greece’s debt to junk status weakened investor confidence, raised the cost of borrowing, and made a financial rescue package in May 2010 all but inevitable.
Both the United States and Europe have taken steps to regulate the three main agencies and ensure more transparency and competitiveness. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and the European Securities and Markets Authority (ESMA), created in 2011, have attempted to hold agencies accountable and protect investors.
Meanwhile, agencies have faced intense legal scrutiny of their business practices, with S&P paying a record $1.37 billion in a 2015 settlement with state and federal prosecutors, and Moody’s coming under investigation by the US Justice Department. In the United States, in 2015, S&P also settled two other cases, paying $125 million to the nation’s largest pension fund, while settling with the SEC for $80 million in a post-crisis fraud case. While these sums combined are more than ten times larger than any other ratings agency-related settlement, critics argue that they represent a mere slap on the wrist for S&P, which as part of the deal was not forced to admit to any criminal wrongdoing.
While the Big Three now face more oversight — Moody’s too has come under Justice Department investigation since 2014 — neither their market domination nor their fundamental “issuer pays” business model has been challenged.
Unfortunately, in the on-going controversy over how strictly to regulate financial institutions and markets in the wake of the financial crash of 2008, regulation of credit rating agencies has dropped out of sight. Figuring out how to preserve the usefulness of credit rating agencies while fixing their weaknesses has proved challenging and in the seven years since enactment of Dodd-Frank, regulators have not followed through on many of the proposed reforms.
It is felt that the more power a government has and exercises with rating agencies, the more the rating agencies will be browbeaten into giving a generous rating to the sovereign. The best way to counter the monopolistic power of the Big Three is for investors to stop giving their ratings so much weight and do their own homework about what the real credit risk was in the bonds and safety levels of debt and related securities. This would have prevented the subprime bubble. The opinions of the credit ratings agencies can help arrive at a conclusion, but as events of the last decade illustrate, they have a history of getting a lot wrong.
In 2009 Moody’s issued a report titled “Investor fears over Greek government liquidity misplaced”; within six months, the country was seeking a bailout.
Meanwhile, S&P’s sovereign debt team miscalculated US debt by as much as $2 trillion when it downgraded America’s credit rating.
Global governments have argued that the agencies are making things worse, because of the cooling effect their downgrades have on investment. How do small countries like ours get investors not to rely solely on the opinions of these credit rating agencies to guide their investment decisions? One wonders what the benefit of a Fitch rating is for us. Would it really matter?