THUMBS UP THUMBS DOWN THE POWER AND INFLUENCE OF CREDIT RATINGS AGENCIES In this month’s Economic Barometer, Karim Nakhle looks at credit rating agencies, particularly the big three, Moody’s, Standard & Poor’s and Fitch. How exactly do they rate companies and governments? What purpose do they serve? How do they influence business and investments? And most importantly what is their net effect on the currently fragile global economy?
ith the recent and well-publicised downgrading of the United States’ (US) government credit rating from AAA to AA+, and a recent warning that Japan and China might suffer a similar fate, as well as the fact that the US Justice Department has launched an inquiry into the role Standard and Poor’s (S&P) played in the subprime crisis that sparked the economic downturn of 2008, international credit rating agencies (CRAs) have been in the news often lately. This has sparked much public interest in and questions about these sometimes-mysterious organisations. WHAT DO CREDIT RATINGS AGENCIES DO? Before any individual can qualify for a credit card, banks will run a credit check on their solvency. Similarly, the ratings agencies run credit checks on companies, countries and financial products. CRAs specialise in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities, debt obligations as well as the debt instruments themselves, and assigning credit ratings accordingly. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organisations, or national governments issuing debt-like securities (such as bonds) that can be traded on a secondary market. A credit rating for an issuer considers the issuer’s credit-worthiness (its ability to pay back a loan), and affects the interest rate applied to the particular security issued. Countries are rated on a sliding scale. The US, for example, had a top rating of AAA, which allowed it to borrow cash at cheap interest rates, before being downgraded to AA+ this year. Thus the lower the rating grade, the higher interest payments a nation must pay to attract investors to buy its bonds. Anything that slips to junk status – as Ireland, Portugal and Greek government bonds are rated – is considered a highly speculative investment. Furthermore, the pool of eligible investors is reduced and indeed many institutional investors, such as government pension funds, are forbidden to invest in junk-rated bonds, providing a good example of how the sway of ratings agencies can be considerable.
Traders work in the Standard Poor’s (S&P) 500 options pit at the Chicago Board Options Exchange on April 27, 2011 in Chicago in the United States. Credit ratings, whether they be of nations or corporations have the power to widely influence market volatility. (Image Brian Kersey/Getty Images)
WHO ARE THE CREDIT RATING AGENCIES? Historically, CRAs were created to give investors an unbiased assessment of investments, and investors paid for access to these ratings. However, in the 1970s CRAs started charging the issuers of new investments fees for ratings. In 1975, US legislators – ostensibly fearing a spate of unscrupulous ratings agencies – designated Standard & Poor’s, Moody’s and Fitch as the only organisations banks and brokers could use to evaluate the credit-worthiness of their products. Modern rating agencies thus fall into two categories: (i) recognised; and (ii) non-recognised. The former are recognised by supervisors in each country for regulatory purposes. As mentioned, the ‘big three’ are of course S&P, Moody’s Investor Services and Fitch Ratings. All originate in the US (although Fitch has dual headquarters in New York and London), which are internationally recognised and used all over the world. In the US, the ratings agencies are referred to as Nationally Recognized Statistical Rating Organizations (NRSRO). As of April 2011 only 10 NRSROs, were recognised by the American Security and Exchange Commission (SEC): Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, Morningstar, Inc., Dominion Bond Rating Service, Ltd (DBRS), M. Best Company, Japan Credit Rating Agency, R&I Inc. (Rating and Investment Information, Inc.), Kroll Bond Rating Agency and Egan-Jones Rating Company. Many further international CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor (II), and Euromoney are ‘non-recognised’ and there is a wide disparity among CRAs. They may also differ in size and scope (geographical and sectors) of coverage and there might be wide differences in their methodologies and definitions of the default risk, nullifying objective comparisons. WHY DO they WIELD SUCH INFLUENCE? Investors across the world look to credit rating agencies in order to judge where to place their investments in the market. For governments, the ratings agencies have a lot of power over the popularity of bonds: cash given to governments by investors that, over time, will pay a return on the original investment – unless that government defaults. The downgrade of Ireland as an example, signalled Moody’s belief that Ireland has a higher likelihood to default on investments. And therefore global investors have little appetite to invest in those bonds. In the new financial architecture, CRAs became more important in the management of both corporate and sovereign credit risk. Their role has received a boost from the revision by the Basel Committee
Ratings agencies have been criticised for having too much clout in jittery markets during the financial crisis. TheEDGE
on Banking Supervision (BCBS) of capital standards, for banks culminating in Basel II and Basel III. HOW ARE GOVERNMENTS RATED? In rating sovereign debt, agencies look at economic and political risks. Economic risks include the existing debt burden, growth prospects and fiscal flexibility, while political risks include leadership stability, consensus on economic policy objectives, and barriers to global trade. Ratings depend on whether sovereign debt is denominated in local currency or foreign currency, because governments can often generate enough local currency to nominally meet local currency obligations, using open market operations (or quantitative easing). Printing currency in this way has inflationary implications, and S&P considers the risk of implied default through a devaluation of the currency. In the latest ratings craze, the buzz among financiers, investors and economists is all about who is going to downgrade which government next. Some feel it is a dangerous game being played by some CRA analysts, one that is contributing to continued economic volatility. WHERE TO FROM HERE? Credit ratings agencies have recently come under intense scrutiny. After watching many highly rated commercial debt securities become worthless several years ago, markets are now questioning the quality
Qatar and many of its neighbouring Gulf states such as Oman, Saudi Arabia and Kuwait are considered stable by the big ratings agencies. of CRA decisions to either downgrade or affirm the ratings of corporate and of sovereign debt. However, studies show that poorly rated corporate debt does default more frequently than highly rated debt. Some have argued this is not necessarily true of sovereign debt, but the relatively few instances of sovereign default since the growth in sovereign debt ratings, show that the predictions of CRAs might be correct more often than not. Ratings agencies have been criticised for having too much clout in jittery markets during the financial crisis. They were widely attacked for failing to warn of the risks posed by certain securities, in particular mortgage-backed securities, resulting in the US Justice Department inquiry. Having completely missed the build-up of risk that led to the global financial crisis in 2008, the agencies are now competing with one other to be the first to identify risks that may lead to the next crisis. At a time when the global economy is fragile and market sentiment is sensitive, unbalanced and unjustified rating decisions can initiate damaging self-fulfilling prophecies and certainly strengthen the arguments for tighter regulation of the rating agencies themselves. Nevertheless, for the time being they still seem to have the power to shake and rattle the global markets as they please. Below is a comparison in the ratings of the ‘big three’ recognised ratings agencies, Standard and Poor’s, Fitch Ratings and Moody’s. Because each agency’s approach is different, they are colour-coded in three categories.
Comparing the Agency Ratings
Deven Sharma, then-president of Standard & Poor’s, testifies before a subcommittee of the House Financial Services Committee in Washington, DC in the US on July 27, 2011. In September Sharma announced his decision to step down from his post and leave S&P as the ratings agency continues undergo the inquiry by the US Justice Department for its role in the positive rating of subprime mortgage securities just before the global downturn. (Image Corbis)
AA+ AA AAA+ A ABBB+ BBB BBB-
Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
AA+ AA AAA+ A ABBB+ BBB BBB-
BB+ BB BBB+ B BCCC
Ba1 Ba2 Ba3 B1 B2 B3 Caa Caa3 Ca
BB+ BB BBB+ B BCCC+ CCC CC
High Grade Upper Medium Grade
Lower Medium Grade Non Investment Grade Speculative Highly Speculative Substantial Risks Extremely Speculative