Our reliance upon credit ratings agencies could prove very damaging to the global economy
The recent downgrade of the UK’s AAA sovereign credit rating by Moody’s Investors Service highlights the continuing influence of credit rating agencies.
They are among the most puzzling institutions of our times. The raters became a focus of political and media attention during the Asian financial crisis of 1997-8, with people questioning the accuracy and timeliness of their ratings after successive episodes of rating ‘failure.’ The global financial crisis of 2007 further intensified these concerns, whilst the advent of the European sovereign debt crisis from 2010 onwards only demonstrated their continuing importance and renewed longstanding concerns about their competence.
Yet, despite everything thrown at them in recent years, the agencies are actually becoming increasingly important non-state actors. Because they are private bodies, they seek to turn political problems (for example, the funding of a bridge’s construction) into ostensibly technical issues. This transformation reduces the scope for political debate. So, looked at in this way, the downgrade by Moody’s has arguably reinforced George Osborne’s ability to reject the advice of critics to break with his austerity strategy.
Many people blamed the rating agencies for being too generous in their ratings of the mortgage-backed securities at the heart of the housing bust. This issue is at the centre of the recent civil suit filed in California by the US Justice Department against Standard & Poor’s (S&P). Before structured finance (which is the name given to the new financial techniques used to fuel pre-crisis mortgage lending), Moody’s and S&P played the role of a judge or a referee in the funding process. They stood back from the action and made rating calls as necessary. This claim to dispassionate authority is what allowed them to build their reputations.
The problem is that structured finance is only possible with the active involvement of the rating agencies in designing financial instruments. The essence of structured finance is the legal rights to revenues organised in securities contracts. These legal underpinnings give different rights to different tranches. Some, such as owners of the AAA tranche, had the right to be paid first, while others had to wait in line. This was how a mass of not very creditworthy sub-prime mortgages could produce AAA bonds.
Agencies and their ratings created the distinct tranches or levels of specific structured finance issues. Yet, because of the complexity of the legal documentation and protection necessary for these tranches, they did not stand back as they normally would. In structured finance the rating agencies acted more like consultants, helping to make the securities themselves and indicating how they would rate them if they were organised in ways that offered specific legal protection to investors.
Concerns about how the agencies are funded also became widespread with the onset of the sub-prime crisis. The idea was advanced that the ‘issuer-pays model’, although established for forty years, is actually a scandalous conflict of interest, precisely because it means that the agencies have incentives to make their ratings less critical than they otherwise would, if investors, the ultimate users of ratings, were instead the people who paid them. Critics called for an end to this model of rating agency funding.
Given the emergence of these background issues, a vigorous (although often poorly informed) debate about the merits of regulating rating agencies has taken place since the onset of the financial crisis. Behind the rhetoric, it is very clear that officials in both the US Securities and Exchange Commission (SEC) and the European Commission are reluctant to regulate either the analytics of the rating process itself or the core business model of the major rating agencies (the ‘issuer-pays model’ described above). While a successful suit by the Justice Department could destroy S&P, the effect would, however, be to make rating practices more conservative, rather than eliminating them.
Credit rating agencies serve an increasingly capital-market-based financial system in which banks do not lend money, but rather help clients secure funding in the markets. This form of market institutionalisation is growing around the world, displacing traditional bank lending. This means more, not fewer, ratings in future. Indeed, it can be argued that the agencies have a good track record rating corporates and governments over extended periods of time.
But our reliance on credit rating agencies is nevertheless problematic. They serve narrow interests, not society as a whole; they promote certain policy models, rather than others; and in times of crisis the interests they serve can make crises worse as investors seek to exit a country or a company because of a significant rating downgrade.
Despite some volatility, the UK seems, luckily, to have managed to avoid this scenario. Why? Because Moody’s downgrade was so limited, because other states were worse off, and because there are so few AAA sovereign ratings left.
In the good times the agencies may have appeared to offer a neat, market-based, and above all private, way of managing risk and regulating financial markets. But, when things get bad, as they always do eventually, and as they manifestly have, at least for now, the question is: are rating agencies equipped with the sense of wider responsibility and systemic regard that we need?