A downgrade spiral

Europe is at the mercy of scrupulous credit ratings agencies while Brussels scrambles with the introduction of suitable regulations to combat their lethal effect


Pulitzer award winner Thomas Friedman famously said in 1996: “There are two superpowers in the world today in my opinion. There is the US and there is Moody’s bond rating service. And believe me, sometimes it is not clear who is more powerful.” These words still ring true, as the oligopoly of the three US-rooted credit rating agencies (CRAs) – Standard & Poor’s, Moody’s, and Fitch Ratings – all possess the power to destroy a country, simply by downgrading its government bonds.

The role and influence of CRAs has long been debated in North America, but criticism has been more frequent from European quarters of late, after CRAs were accused of heavily affecting the European markets. CRAs are frequently proclaimed to be financial market gatekeepers, due to their role in ranking the probability of a company, nation or financial product repaying the debt it has acquired. As the European economic downward slope began to take its toll, CRAs were among the first market partakers to be held responsible by critics, policymakers and government officials.

Honest origins
CRAs were originally fairly trivial players in the markets and enjoyed a reputation for earnestness and frankness. Information about financial products and their issuers was simply published by CRAs and helped add transparency, while investors could choose to use the data to make judgement calls about valuable investments.

The difference at that time was that there was no legal obligation behind the information, as it was strictly edifying. In that environment and framework, CRAs merely supplied financial markets with what is perceived as their most valuable asset: data. That is, until regulations came in, distorting the rules of the game; and CRAs started getting their income from investors who subscribed to their advice and ratings.

It was not until the US government decided in 1975 that an official stamp is necessary that things started to change for the worse. This change is now considered one of the key factors why CRAs have an immense influence on the European markets and beyond. The SEC, because of its need to manage the potential threats investors and banks took, decided it was required to ascertain an official classification of what risk entailed.

The simplest way to go about this was to name the three chief CRAs, Moody’s, S&P and Fitch, as the official ones, and give them the power through the benefit of being a new legal force. From the time of the law passing, additional agencies became part of the same club, but the original three CRAs preserve their dominating status as the most influential financial market CRAs.

The cost of this lawmaking shift can be felt today as European economic markets face the abundant consequences following the establishment of this oligopoly, which guaranteed the CRAs a solid flow of income. Worse still, it shaped the effective compulsion for the issuers of financial products to use those products ratings, seeing as capital requirements and the arrangement of investors’ portfolios relied on these ratings of CRAs. This was because the lower the bank’s portfolio risk of assets, the less capital it had to carry and the more funds it could invest. In addition, top rated assets permitted banks to free up capital, meaning they vigorously sought out such assets.

The omnipotent agencies ensured that ultimately a product’s significance was now particularly contingent on their ratings as issuers were required to submit their products to them. Rather than receiving the money from investors as before, they were now remunerated unswervingly by the issuers of financial products. It is no surprise then that the end result was a radical transformation in the CRAs business formation. Today the three key CRAs dominate 95 percent of the market, which is undoubtedly a sign that there is not enough competition in this area.

Yet many ask nowadays how it is possible for US investors and then Europeans, all the way across the Atlantic Ocean, to blindly trust the ranking and verdict of durability and solidity of assets just because the CRAs judged them that way. The answer is simple: CRAs, in spite of their alleged defective processes and questionable reliability and impartiality, could only have the benefit of such magnitude because of bureaucracy and regulations.

The ratings industry today
Downgrades by the three big CRAs have emerged more and more as Europe faces unparalleled political disorder and social clashes over cutbacks in public spending and mounting taxes for the public. Sadly this scene is set against the ubiquitous backdrop of overwhelmingly elevated unemployment. The European crisis continues to infect nations such as Ireland, Greece, Portugal, Spain and more recently Italy as a result of downgrades, and the affected economies have been rocked by a recurring chorus of assertions by the CRAs.

The agencies appear to be in an antagonism with one another that manifests as a habitual lowering of ratings and continued pressure on states due to the expectation of downgrades.

Regardless of the debate that envelops CRAs, it has to be appreciated that they have a significant purpose, as they supply financial markets with data by issuing ratings of both financial products and issuers of financial products. In addition the ratings determine investor portfolio arrangements and influence the price of financial products. CRAs moreover sway investors’ reliance in financial products issuers and so the cost of borrowing of governments and businesses equally. A recent downgrade of ratings in both Greece and Spain that caused a sharp climb in both the interest rate of their treasury bonds and CDS confirms this. The quantity of capital that banks are obliged to hold consequently depends on the letter gripping the assets they own, which makes CRAs especially controlling and prominent.

Previous CRA downfalls
In the US, CRAs continue to be under close scrutiny for having given investment grade ratings to mortgage-backed securities based on high risk subprime mortgage loans. US regulators are now reported to be considering civil fraud charges against CRAs as part of a wider investigation into the sale of mortgage debt which led to the financial crisis. The CRAs, which through their inaccurate ratings falsely predicted market conditions, are now blamed for their partial contribution to the financial crisis.

A recent report issued by a senate subcommittee revealed a list of features responsible for the inaccurate credit ratings linked to collateralised debt obligations and mortgage-backed securities. The report’s findings and recommendation to the SEC are predicted to also heavily impact on the methods used by CRAs overall, including when rating European government bonds and instruments. Some of the more apparent downfalls of CRAs listed in the report were found to be pressure put on the CRAs by investment banks to drive up ratings; CRAs’ drive for market share while competing against the other two big agencies; imprecise rating models; and inadequate rating and surveillance resources. The subcommittee also found that federal regulations that restricted certain financial institutions in the purchase of investment grade financial instruments encouraged investment banks and investors to pursue high ratings, leading to credit rating agencies providing those top ratings.

The report urged the SEC to make use of its regulatory authority to rate CRAs in terms of their performance if the CRAs show signs of knowingly or recklessly failing to conduct a sensible and rational investigation of the rated security. It was moreover pointed out that the SEC needs to examine and inspect CRAs to preserve an environment that does not promote conflicts of interest among employees and puts at risk the accuracy of the agency ratings.

The Dodd-Frank impact
While policymakers in Brussels and politicians internationally have been endlessly deliberating various channels to make rating agencies more accountable and rating procedures more transparent, Europe continues to struggle with CRA downgrades or their threats of looming downgrades. Suggestions to revamp CRA regulations range from increased disclosure requirements to eradicating references to credit ratings in rules and regulations. However, the one thing they all seem to have in common is the attempt to strip CRAs of their intemperate power.

The US has already incorporated changes in the newly implemented Dodd-Frank Act, which brought in a chain of reforms in the credit rating agency system. These comprised the establishment of the newly operational SEC Office of Credit Ratings, responsible for supervising the credit rating industry (among others) by conducting statutorily-required annual examinations, whose reports must be made public. The act also authorises the SEC to discipline, impose fines, and remove CRAs and connected employees from the register for infringing the law, and gives them the power to deregister a CRA for issuing poor ratings.

In addition – and perhaps more importantly – the Dodd-Frank Act permits investors to file private cases of action against CRAs if they intentionally or recklessly fall short of conducting a realistic, reasonable investigation of a rated product. Furthermore, CRAs are now obliged to establish in-house controls to guarantee high quality ratings, and divulge data relating to every issued rating, their rating technique, and the methods used.

The domino effect
The globe’s financial markets are so interlinked that bad news for Europe often translates to a domino effect all the way across to the US. At the end of June McGraw-Hill, the parent company of S&P, announced that due to Europe’s debt crisis investors in the US government bond market could be hit by severe losses. Should S&P or any of the other chief CRAs downgrade the US, it is highly likely that treasuries would plummet in worth by up to $100bn.

This would come much closer to reality if the US, the world’s largest economy, loses its AAA rating. If this happens the US could experience higher bond yields and lower prices, which again would signify the US treasury shelling out $2.3bn to $3.75bn more yearly in interest on financing a revised $1trn annual budget deficit. Although the risk of a downgrade for the US is remote, it seems investors are anxious about a more fragile economic environment and financial contamination stemming from the Euro debt predicament.

It remains to be seen what the other CRAs have planned after S&P followed through on its threat to downgrade the US rating to AA+ with a negative outlook, after the resolution to lift the treasury debt ceiling failed to meet its requirements. Moody’s and Fitch both said they had no immediate plans to follow suit, but the former had previously observed a reassessment may be warranted.

Violent overthrow
While the CRA commotion in both the sovereign and corporate debt space from Athens to DC injured risk appetite numerous times over the past few months and simultaneously infuriated policy makers, investors and the general public with the effects of downgrades (or threats of them), the business model of CRAs once more became the primary focus in Brussels in June. A top German economist even went as far in calling for a ‘violent overthrow’ of US CRAs, because they significantly shape the future of the nations they rate without consequence to them.

Thomas Straubhaar, director of the Hamburg Institute of International Economics, told the press after S&P dropped Greece’s rating to CCC junk bond status that he felt CRAs were anachronisms from the 1990s, which US regulators had ‘imposed’ on Europeans and other nations. The CCC rating, which is only four steps away from default, did not phase the CRA as it commented afterwards that the downgrade was due to complex political and economic conditions, which meant efforts by the EU and the IMF to save Greece were looking increasingly unstable.

It was especially the ill-timed drop in the rating system that infuriated Straubhaar and other critics, as the drop makes it even harder for Greece to restructure its debt and take steps in the right direction to fight its burgeoning economic crisis. The general consensus is that an untimely downgrade – as experienced by Greece in June and Portugal just before that – also threatens to overwhelm other EU nations. Straubhaar appealed to the German government intently to assist in the creation of a revamped system to cease the influence emerging from US companies as he said that US input was unsuitable for Europe and caused problems in the long run.

Frankfurt – a new CRA home?
It is CRAs’ critics such as Straubhaar, and other sceptical voices emerging from various European quarters, who are looking at whether Frankfurt, Germany’s financial hub, could be the centre for hosting a European credit rating agency to challenge the US CRAs. An initiative was launched by the German stock exchange Deutsche Börse, the consultancy Roland Berger, and the government of Hessen (the federal state that includes Frankfurt), to try to determine if Frankfurt could present an alternative to the big three.

Emerging discussion, which highlighted the importance of a complete and truly independent agency, came just a few weeks after the European parliament asked for additional action to be taken to either fix existing CRAs or look at the prospect of establishing a new, independent “European rating foundation.” Other options that were considered in an attempt to increase competition in the sector included the idea of a network of smaller European credit rating agencies. Yet, as anticipated, the notion of a part publicly funded European rating agency is generally perceived as challenging, and European officials have acknowledged that the idea requires “some further analysis.”

ESMA’s role and beyond
At long last, after numerous attempts to draft a directive to control what is often perceived as irresponsible action taken by CRAs, the final draft of the CRA II Regulation was passed in May. Approving the law meant that from the beginning of July, the European Securities and Markets Authority (ESMA) will be the sole controller of CRAs in Europe.

ESMA’s role– technically speaking – is the regular inspection of the registered CRAs. Obligatory registration for CRAs and succumbing to assessments with ESMA is now the order of the day, in addition to the agencies having to display sufficient internal measures to attend to conflicts of interest and assure for the exposé of such divergence in an appropriate and timely manner. ESMA will be given the authority to request information, to launch investigations and to carry out on-site inspections.

One continually deliberated area of the new regulation is the registration of non-European CRAs, which momentarily is governed by a legal code declaring that ratings issued in a non-EU country can be used only if the regulatory regime in that country has been judged to be comparable to the one in the EU. Presently the US is generally seen as comparable, while Japan has been proclaimed fully equivalent. ESMA is now closely observing how the newly passed Dodd-Frank Act will change US legislation with time. Despite there being provisional requirements, ESMA will ensure that the work of both European and non-European CRAs will not be concerned by the new licensing needs.

Critics are weary of CRAs as economic market gatekeepers, and their often superfluous decisions are exactly the market malfunction that the new EU regulation looks to cure. Although CRAs are often given the stamp of sketchy performers due to their alleged unreliable ratings, it would not be realistic for investors and governments to plainly cease using CRA ratings. The continuous emphasis on revolutionising the business model applied by CRAs, while simultaneously lessening the dependence on ratings, seems on the whole to be what CRA critics hope to set right.

Brussels will need to make certain there are additional actors in the market, to depart from the destructive supremacy of the big three CRAs. This will also ensure greater competition in the rating agency market. The principal test for Brussels will be to find a means to overcome the prevailing payment and allocation system. The model with the issuer paying is a deeply flawed structure that will unavoidably lead to conflict of interest, with the entities being rated literally paying the CRAs for the ratings they obtain.

There are several proposals of alternatives the European Commission could consider to modify a newly created CRA. Varying the current structure through an ‘investor pays’ system, the creation of a ‘postponed payment’ system, a ‘pay upon result’ type structure or even by stripping CRAs of their legal status and going back to basics where investors can chose to ignore the CRA published data are all viable options that could be considered by Brussels.