Never before in history have so few people held the fate of the global economy in their hands. Not the giants of Wall Street, but three small private companies— the top credit-rating agencies— have emerged as the arbiters of the world’s economic fate. As politicians huddle in Washington and Brussels, debating a way out of the US and eurozone debt crisis, businesses around the world keep their eyes peeled on the rating agencies’ decision to grade the sovereign debt issued by governments. Lowering the AAA grade by just one point could trigger a flight from bonds with cascading consequences throughout the economy.
One can’t help but wonder how the governance of global finance shifted to these agencies. After all, these same agencies awarded AAA ratings to toxic bonds that imploded in 2008.
Ever since liberalization of banking rules and freeing of capital movements in the 1980s, the power of the "big three"— Standard & Poor’s, Moody’s and Fitch— has grown. The issuers who intend to sell bonds or other forms of debt— usually companies, but also countries, NGOs or special-purpose vehicles— pay the credit agencies to rate the bonds when first issued and afterwards. Although there are other ratings agencies, these three have legal standing in the US where many fund managers use the ratings to select "investment grade" debt that offers good chance of repayment.
The first ratings agency, Moody’s, began in 1907, mainly to rate railroad bonds. Many railroads took on too much debt, and investors found it difficult to discern if the bonds were shaky or sound. By combining credit reporting— how much debt had been issued and if the payments were being made— with analysis of company’ prospects, investors had a better idea of what they were buying.
The idea took hold and spread to other companies, local and national governments, and even to international organizations like the World Bank. More recently, investment banks and companies created "special purpose vehicles," often complicated and hard to analyze, but given ratings in the same way as easier-to-understand bonds. That was the case in 2008 with bundles of US subprime mortgages.
The agencies failed miserably, some argue with willful ignorance, in rating many mortgage-backed securities, and this played a role in bringing about the global financial crisis. The finance industry shouldn’t have been too surprised, after the same firms failed to downgrade Enron’s debt until a few days before it went bankrupt in 2001, of little value for investors. Failing to foresee the complexity and low quality of many mortgage-backed securities, rating highly dubious mortgages contained in complicated packages as AAA or the highest quality, the agencies gave investors a false impression of safety. For some critics, the lack of due diligence suggested more of an interest in getting paid than in accurately researching the securities.
Indeed, in some cases the agencies gave unsolicited ratings of a debt issuer and then asked the issuer to pay up for continued ratings. If the issuer doesn’t pay, the unpaid ratings agency can downgrade the bond! This raises the cost of issuing new debt and can depress the stock price. This strikes some commentators as more like a shakedown than an honest sales pitch. The fact that the paid agencies rate the same company highly may or may not prove that the unpaid ratings agency is wrong.
Remarkably, the ratings agencies don’t face major reform in the US Dodd-Frank financial legislation nor has legal importance of their ratings for investors changed. Some fund managers who must follow a "prudent man rule" in investing appreciate the safe legal harbour of an investment- grade rating— one reason so little has been done, even though other critics have charged the agencies with having a cosy oligopoly. So, a group of three legally recognized agencies that have failed miserably in rating hundreds of billions of dollars of securities remain in place, fending off major challenges from reformers in the US.
New challenges come from overseas. One loud criticism comes from China. China has several ratings agencies. One of the better known, Dagong Global Credit Rating Agency, applied, but was refused official US rating agency status. Dagong rates the debt of many nations without being paid. It rated the US debt at an A+, the third level down but still investment grade, when the second round of quantitative easing started last November. Dagong doesn’t yet have an international following despite its track record of correctly criticizing mistakes of the established agencies.
The agencies have been more proactive recently in rating sovereign debt, downgrading or threatening to downgrade both European and US bonds. Maybe chastened by the public criticism, if not sanctions, the agencies have changed their ways. Or maybe because the issues at stake are sovereign debt of governments, without the commercial complicity that brought the 2008 disaster, explains the agencies’ recent conservative behaviour.
And that conservative response, of course, has invited criticism from Europe. Angry EU officials charge that the agencies are unfair and insensitive to political nuances. Some have suggested setting up a European, semi-official rating agency, even though Fitch is owned by a French company.
Yet in the case of Greece, the agencies had little choice but to recognize reality. Saying that Greece is likely to default in whole or in part on its public debt requires less analysis than cursory knowledge of current events as debate rages within the eurozone over who should be forced to "voluntarily" extend maturities and reduce interest rates. Similarly, when debt is greater than 100 percent of GDP, devaluation impossible and fiscal tightening a condition of aid, it’s unclear how 6 to 7 percent interest rates can lead to anything other than eventual default. The possibility of a lax monetary policy creating inflation, thus reducing debt burden, is also out of the question, given German influence over the European Central Bank. So, in this case, the agencies offered an accurate if belated and unwelcome message to those who would rather "extend and pretend" than deal with the facts and logic of the situation. Still, having an "outside" rating group rank sovereign governments rankles and may eventually lead to further attempts at "fair" competition.
No doubt, when they work, the agencies play a useful role. The question is if a better model is available that would avoid the current shortfalls.
One proposed reform entails creating a group that would assign a major ratings agency randomly to a debt issuer. This would reduce incentives for collusion between the agency and the issuer, though it would do nothing to address oligopoly problems. Another would be to outlaw unpaid ratings, avoiding the shakedown problem. A third proposed reform, opposed by many investors, is to remove the legal force of a rating from any agency. Agencies could still provide ratings, but the ratings of a bond at investment-grade BBB or higher would not automatically provide legal cover to a bond buyer for a pension fund if the investment collapsed. In other words, the pension fund or other investment fiduciary would have to do additional due diligence to show it had been prudent. These proposals have little chance of moving forward, so the current system is likely to remain in place until the next disaster provides another reason to rethink the status quo. Meanwhile, trillions of dollars in investor assets must go somewhere, and there are not many AAA debt issuers. So the capital market keeps it eye on the rating board of the three flawed agencies.
David Dapice is associate professor of economics at Tufts University and the economist of the Vietnam Program at Harvard University's Kennedy School of Government. Rights: Copyright © 2011 Yale Center for the Study of Globalization. YaleGlobal Online