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Rating agencies' credibility tumbles

| 11/21/2011 10:31 AM Monday

“With great power comes great responsibility”, reads an oft-quoted adage. That doesn’t always seem to be the case with credit rating agencies, which have been in the news lately for the wrong reasons. With Standard & Poor’s (S&P) facing the ire of the French government after it sent out an erroneous email indicating that it had lowered France’s sovereign debt rating, and Moody’s downgrading Indian banks, which were upgraded shortly after by the S&P, a crucial question is moot – are the credit rating agencies really taking their jobs seriously?
 
If one looks at the job of the credit rating agencies, their prime role is basically to keep global investors well informed about the risks related to debt securities such as government bonds, mortgage-backed securities, corporate bonds, collateralised debt obligations, certificates of deposit, etc. The analytical reports of these agencies informs investors about whether issuers of debt – be it a company, financial institution or a government – will be in a position to honour their commitments with timely payment of interest on the debt. Hence, it is of utmost importance that these reports be error-free, with sound reasoning on the factual and the judgmental side for the rating assigned, since they can have a cascading impact on stock markets globally.

However, the very fact that these agencies have not been consistent in their performance, and have failed to foresee or anticipate events – thus proving to be more reactive than proactive in their research reports – only raises doubts about their abilities. Take the example of the Indian banks itself, in the case of which, two rating agencies have provided diametrically opposite views. While the performance of the banking system is a reflection of the current state of the economy, the very fact that S&P has put an upgrade on the sector creates a disconnect, considering that inflation continues to remain high and the rising rates have only dented growth.

Similarly, the downgrading of the Indian banks by Moody’s at this juncture, when the entire sector is comparatively in a much better shape than its counterpart in Europe (who by the way also enjoyed better ratings till recently) again raises the need for an untimely aggressive step and unnecessary revision of ratings. This has resulted in these agencies receiving a lot of criticism not only from the governments, but also from experts across the globe. In fact, there are some other companies too, which were in the news for all the wrong reasons, but previously enjoyed top ratings from these credit rating agencies.  

Of course, this isn’t the first time that these agencies have come under strong criticism. It is still very difficult to forget the biggest debacle of these agencies, where they completely failed to detect the problem that led to the sub-prime crisis. In fact, they were roundly criticised for failing to correctly calculate the risks associated with the mortgage-related securities, which enjoyed top ratings prior to the collapse of the housing market. In 2007, when the housing prices started to collapse, Moody’s downgraded 83 per cent of the USD 869 billion in mortgage securities, which had enjoyed AAA ratings just a year ago. If that wasn’t enough, in 2001, these agencies were also criticised for keeping Enron’s investment grade high, despite the fact that it was imminently on the verge of a collapse. In a lapse certainly no lesser, these agencies failed to detect the Asian currency crisis of 1997-98, which led to a currency collapse and recessions across eastern Asia.
 
Having said that, the credit rating agencies themselves have been adamant and have stood firm by what they have said in their reports, whether about the downgrade of the US from AAA to AA+, or about slashing the ratings of Greece, Portugal, Ireland, etc. to junk status.

If one looks at the rating process of these agencies, it can be seen that though the country analyst generates the initial report, it is kept for open discussion in front of the committee, which can include the country analyst, bank analysts, etc., who debate and discuss the report at length before arriving at a consensus. Thus, it becomes more of a committee decision than just an analyst influencing the final rating. Despite using consensus intelligence though, the results have been far from satisfactory.

Though historically the agencies have been more reactive than proactive, one school of thought also says that they seem to be getting increasingly proactive, and the US downgrade, or for that matter of those of the Euro zone countries, seems to be the result of the same. While there could be a line of thought which says that the agencies shouldn’t be criticised for their failure this time, these proactive steps haven’t gone down well with the governments, mainly those of the US and the European nations, who have already been voicing their concerns in this regard. While the US government called the S&P downgrade a terrible judgment and a stunning lack of knowledge with a call to diminish the importance of S&P’s verdict, the Euro zone feels even more strongly about these ratings.

It is common knowledge that the European officials have accused the rating agencies of showing preferential treatment to the US, despite its economy having carried massive levels of debt and an unsustainable deficit. In fact, the Euro zone believes that this excessive speculation has led to an acceleration of the sovereign debt crisis, which has not only weakened investor confidence, but also deepened the debt woes, leading to panic in the global markets, thus making the financial rescue package a complex task.
 
Credit rating agencies have indeed enjoyed a demi-god status due to the blind faith of investors, who have refrained from going beyond the information made available in reports to do their own homework. This has benefitted these agencies, which have made huge profits. At the height of the credit boom for a three-year period ending 2007, the operating profits of S&P and Moody’s grew by a massive 73 per cent and 68 per cent to USD 3.58 billion and USD 3.33 billion respectively, compared to the three-year period ending 2004.  

However, we believe these are the things of the past, and going forward, the agencies would have to show more accountability for their opinion. Already in July 2010, the US enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which empowers the Securities and Exchange Commission (SEC) to examine the nationally-recognised statistical rating organisations (NRSROs) annually, with the power to even suspend an agency temporarily or permanently for giving inaccurate ratings. Besides, the SEC would prescribe rules with respect to credit rating procedures and methodologies, while also asking the NRSROs to publicly disclose information on ratings (initial and revised), the methodology used and the data relied on. This is primarily a step to evaluate the NRSROs.

That apart, the Euro zone has implemented the European Securities and Markets Authority (ESMA), an independent authority to protect investor interest through regulation. Also, with the three rating majors being from the US, the European officials are calling for a European credit rating agency to reduce the influence of the existing agencies. It remains to be seen how successful this would be.

What is more important though, is that the onus lies on the credit rating agencies themselves to play a more proactive role than a reactive role, as has been seen yet. Considering the fact that investors continue to place utmost trust and blind faith on the agencies’ recommendations, this only increases the responsibility of these agencies further to provide not only unbiased analyses, but also reports which are factually error-free, besides providing a solution to the problem or the event analysed in the report. This will definitely add more value for the end users.

 

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