Published most Fridays

Friday, 22 April 2011

Credit Reference agencies - How on earth can we trust them?

So, the other week, Standard & Poor, one of the largest credit reference agencies in the world, downgraded the outlook on US debt. What does that mean?

It, a private company, told the most powerful nation in the world to change its fiscal policy. I can guarantee that S&P making that statement will have more impact on US policy than any or all of the opposition to any US policy in the last 20 years.

Which must make it frustrating to be, for example, Hugo Chavez.

Above: He wishes he was a credit reference agency (Hugo, not the parrot)

The US isn't the first country to suffer from credit scrutiny. The Portuguese & Irish crises were exacerbated by ill-timed rating downgrades; the British government has been running scared from these agencies since 2007. Why are they so powerful? How many aircraft carriers do they have?

In 1996, Tom Friedman said "There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful."

It wasn't always like this

At the start of the twentieth century John Moody, a former journalist with an entrepreneurial streak, saw a gap in the finance market. Investors too often bought on trust because they were in the dark about credit quality. Moody set about publishing information on stocks and bonds to help them.

The business grew but Moody’s maintained its founder’s hawkish devotion to accuracy and steadfast focus on investors’ long-term interests. It was renowned for erring on the side of caution when assessing risk and turned work down if it didn’t meet its lofty standards. If anything, the institution saw itself as a public servant.

Moody’s and Standard & Poor’s – among the handful of agencies approved by the American regulator – grew to dominate the bond rating market. By the 1970s the financial sector had become more complex, increasing the agencies’ costs, so they began charging issuers as well as investors for rating services. But this shift laid the foundations for the massive conflict of interest that would later undermine the rating agencies’ integrity.

The idea is, they provide investors with objective and trustworthy guidance. Perfectly above board. But there is a huge conflict of interest that results from the agencies being paid by the issuers of the debt

The fact that major financial institutions only trusted Moody’s and S&P to rate significant issues created a dangerous duopoly: most deals required two ratings. “We had no competition and a steady stream of work,” recalled a senior ex-Moody’s managing director. “It was perfect. I used to think to myself ‘there’s no way we can screw this up’.”

In the mid-1990s this duopoly was broken by the emergence of Fitch. An injection of private equity investment had propelled Fitch, previously a minor player, into becoming a serious rival.

Moody’s were still keeping to the judicious values of their founder. Under corporate chief Tom McGuire, an ex-Jesuit priest, Moody’s culture remained pure. Analysts didn't enter dialogue with bankers and certainly didn’t return calls from the people they were analysing.

But the entrance of Fitch had turned the market on its head. Keen to expand its market share, Fitch was happy to co-operate with issuers’ needs. This shift, in turn, encouraged S&P to be more accommodating. In contrast, issuers saw Moody’s as arrogant and inflexible and it began to lag behind the competition. In 1996, Fitch and S&P rated five times more commercial mortgage-backed securities’ deals than Moody’s.

Moody’s brought in a management consultant to try and fix its woes, and in the resultant shake-up, Tom McGuire departed along with other top people.

This created an opening for a clutch of senior players within Moody’s who argued it should pursue a more profit-focused direction. The company, they figured, possessed a first-rate brand and, in times of plenty, should cash in. The advocates for change argued that Moody’s should develop more amicable relations with Wall Street and increase the number of deals it rated.

The management of the company was gradually wrestled away from older staffers who clung to its former values; the new school’s victory was sealed in September 2000 when it took the company public. Being held by shareholders created yet another pressure - Moody’s now faced short-term pressures to demonstrate earnings growth.

Moody’s dialogue with Wall Street improved. But this exchange of information gradually became a negotiation as the last vestiges of Moody’s old culture were broken down. It became normal in structured finance deals for analysts to tell issuers what they needed to reach investment grade, and analysts grew accustomed to tweaking the requirements on a deal a little to keep a banker happy.

The banks began playing the rating agencies off one another and shopping around to see who would rate an issue more favourably. Former Moody’s Asia structured finance chief Ann Rutledge told me in 2008: “An analyst would help the banker that was issuing the debt by relaxing the constraints on the deal a tiny bit. But the impact on the rating could be huge.”

The effect, as the big three agencies fought to hold onto market share, was that thousands of deals were put together with costly levels of investor protection reduced. This corner cutting was exposed when the wheels came off the US housing market, sparking hundreds of billions of dollars’ worth of losses on under-collateralised debt.

How it all went wrong

Here's a good example of how the process went wrong: in the late-90s a Miami-based company freight company sought to borrow $140 million against 14 aeroplanes. Unfortunately the numbers didn’t work. The notes backed by the planes only rated as triple-C, or non-investment grade. This meant the deal could not fly.

To resurrect the transaction, the triple-C ratings would have to be raised to triple-B. “A leap, in order of magnitude, equivalent to turning a Robin Reliant into a BMW,” recalls a former Moody's analyst who worked on the deal.

To get around the problem, Moody’s extended the predicted useful life of the 14 planes from the normal 25 years to 100 years to generate more cash flow. Moody's simply redefined the longevity of an aeroplane to generate the right rating.

This shift in standards might have mattered little if it had only affected the shelf life of a few aeroplanes. But, from 2002 onwards, structured finance witnessed the rapid rise of the collateralised debt obligation. By 2006 CDO issues topped half a trillion dollars. CDOs’ opaque methodology took already sliced-up bonds and sliced them up further into new tranches based on risk and return. This meant certain tranches could be rated triple-A despite the fact that lots of sub-prime mortgages had been squeezed into the overall package.

And we all know how that turned out.

In the financial crisis, the three big credit reference agencies - Moody’s, Standard & Poor’s and Fitch - bungled the grading of hundreds of billions of dollars’ worth of debt with catastrophic results for the entire world's economy.

How can we trust them any more? Are they to blame for the credit crunch and the subsequent worldwide recession? The banks share some of the blame, obviously, as well as useless financial regulators - however, while equally culpable, the big three credit rating agencies seem to have gotten off scot-free, and are again on the rampage.

Following the 2007 disaster, the incoming administration in Washington vowed to address the ratings system. The EU meanwhile announced its intention to directly regulate ratings agencies for the first time. Other countries vowed to set up independent domestic agencies to reduce reliance on the big three. But this hasn't changed anything. Pressure from the ratings agencies has meant all that has come to naught.

Exactly the same underlying conflicts of interest that damned the CDO market are present in their ratings of sovereign debt; for example, in March Greek debt was downgraded. The cuts to the ratings help to push up the cost of borrowing for Greece on the international bond markets. That means all kinds of people increase their margins of profit - not least the reference agencies.

The truth is, the global financial system hinges on the accuracy of the credit rating agencies. As a result, these bodies are, it seems, totally unaccountable. And that can't be good for anyone. Even Hugo Chavez.


  1. They wouldn't be anywhere near as powerful if Governments didn't borrow.

  2. Excellent and informative post, thanks for sharing it, Willard.

  3. Few observations:

    -As the first poster points out, if a government doesn't borrow money, then the ratings agencies don't hold much power over you.

    -Most of their pronouncements on European bond issuers has reflected market sentiment, rather than made it.

    -The whole mortgage CDO situation was premised on the fact that as a whole, the US property market has never totally dropped. The idea was that if property in Illinois tanked, property in California would still be ok. The unthinkable happening, combined with unwinding of a low interest rate caused property bubble (which arguably caused the previous to happen) AND the fact that the mortgage system had been filled with fraud (check out the phrase Ninja Borrowers) was a cocktail for disaster.

    -To my mind, the credit crunch and subsequent recession is part of the unwinding of the debt/asset bubble of the 2000s. The root cause of this are the tremendous imbalances in the global economy between debtor and creditor nations. Truly colossal amounts of money have been chasing returns, which kept interest rates in countries like the UK and US rock bottom for too long. That money went primarily into property (for returns) and government bonds (for safety). The first is still unwinding, the second is starting to. What needs to happen is for the UK/US to spend less and save more and for Germany/China to spend more and save less. The currency imbalances enjoyed by these two nations exacerbate the situation. And before you defend these models of virtue, who do you bought all that duff Greek debt and lent against those Spanish properties? And who bought all that increasingly worthless US debt? Who lent money to nations so they could continue to buy tat ffrom the lender? THERE'S an unstable business model. The ratings agencies are a sideshow to the bigger issue lurking behind everything