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| Traders in New York. A downgrade from one of the Big Three credit ratings agencies can send markets into a panic. Photograph: Mary Altaffer/AP |
"Thank
you for calling Moody's," says the automated voice. "Your call may be
recorded for quality purposes. If you would like a rating, press one." I
press one. There is a brief musical interlude. "Hello, Moody's," says
another voice, eventually. "What rating would you like?"
As you may
have deduced, I am on the phone to Moody's Investors Service. Along with Fitch,
and Standard & Poor's (S&P), Moody's are one of the Big Three credit
ratings agencies. They sound like a trio of preppy clothing companies, but in
fact they are some of the most powerful players in world finance. Specifically,
they rate the "creditworthiness" of companies and currencies. In the
process, it is hoped that they give investors an idea which investments are
safest to make.
"Hello,
Moody's!" I say. "I would like to know the rating for UK sovereign
debt." It's a topical question. The eurozone crisis has seen countries'
ratings fall across the continent. Chancellor George Osborne has staked his
reputation on helping the UK avoid the same fate. My adviser will ideally come
back to me with three particular letters: AAA. This is the highest rating
Moody's offers. Then comes AA1, and the scale goes down to C. Anything at or
below BBB is known as "junk".
"The
UK has a rating of AAA," says Ms Moody. But then comes the hammer-blow:
"We also have a negative outlook for the UK." This negative outlook –
which Moody's announced on Monday – isn't quite AA1, but it's the preamble to
it. The lower their outlook, the more likely Moody's thinks the UK government
is to default on its debts – and the less likely it is that people such as me
will want to lend it money. The lenders that do remain will be more nervous
about the prospects of getting their money back – and so they'll charge higher
interest rates. And the higher the interest rates, the steeper the government's
debt repayments, and the more likely it is to default. And so it goes on.
It is an
Escherian cycle, and one in which the credit ratings agencies – many argue –
play too powerful a role. "I am no fan of conspiracy theories," said Rainer Bruederle, a former German economic minister, after S&P threatened
to downgrade 15 EU countries in December, "but sometimes it is hard to
dismiss the impression that some American ratings agencies and fund managers
are working against the eurozone." But Europeans aren't the only ones up
in arms. "S&P has shown really terrible judgment and they've handled themselves very poorly," said US treasury secretary Timothy Geithner after
S&P downgraded America's AAA credit rating in August. "They've shown a
stunning lack of knowledge about basic US fiscal maths."
The
agencies say they're simply telling it like it is. After all, the US congress
spent most of last summer dithering about how to rescue the American economy.
All winter, European leaders have flip-flopped about how to save the euro. Both
quagmires, S&P argues, logically make it likelier that the governments
concerned will renege on their debts.
More people
would trust the agencies if they hadn't got so much so wrong so recently. In
2009 Moody's issued a report titled "Investor fears over Greek government
liquidity misplaced"; within six months, the country was seeking a
bailout. Meanwhile, S&P's sovereign debt team miscalculated US debt by as
much as $2tn when it downgraded America's credit rating last August. Small
wonder the Independent called the team's then head – the mustachioed, chain-smoking
David Beers – "the most powerful man in the world that you've never heard
of".
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| Sub-prime mortage lending led to record numbers of foreclosures in the US. Photograph: David Mcnew/Getty Images |
As for
their recent decisions, few believe that the agencies are wrong – but some
think they're wrong for speaking up. By highlighting the seriousness of the
situation, finance ministers argue the agencies are making things worse,
because of the cooling effect their downgrades have on investment. "The
rating agencies fuelled the crisis in 2008," raged Christian Noyer, the
governor of the Bank of France, in December, "and we can question whether
they are not doing the same thing in the current crisis."
Noyer's
view highlights the paradoxical position ratings agencies find themselves in.
Today, they are said to be too quick to downgrade government bonds. Five years
ago, by contrast, they were too slow to downgrade the toxic debt that caused
the financial crisis. "During the sub-prime mortgage crisis," says Larry
Elliott, the Guardian's economics editor, "the ratings agencies were very,
very lax."
In layman's
terms, the 2008 crisis started when thousands of US homeowners stopped paying
interest on their mortgage. The crisis spread because thousands of bankers and
fund-managers had foolishly backed those mortgages, and so lost a lot of money
themselves. They did this partly through their own lack of foresight, but also
because of the ratings agencies' failure to warn them of the risks involved. In
the run-up to 2008, a staggering proportion of mortgage-based debts were rated
AAA, when in fact they were junk. The same goes for groups such as Enron,
Lehman Brothers and AIG. Days before they went bust, Moody's, S&P, and
Fitch all still rated these failing companies as safe investments. Shockingly,
more than half of all corporate debt ever rated AAA by S&P has been
downgraded within seven years, according to research by economist Sukhdev
Johal.
Part of the
problem is that ratings agencies are funded by the very companies they rate. If
you want to be rated, you must pay an agency between $1,500 and $2,500,000 for
the privilege, depending on the size of your company. In theory, this creates a
conflict of interest, because it gives the agency an incentive to give the
companies the rating they want. It could explain why, for much of the past
decade, agencies seemed happy not to question either the risks banks were
taking, or the accuracy of their accounts. "We rely on audited
statements," one senior analyst told Alexandra Ouroussoff, an
anthropologist who spent six years interviewing people involved with credit ratings agencies. "We are hamstrung by audited statements. If lying
accountants sign off on a fiction ..." The analyst – known as Jane – left
the sentence unfinished, but her inference was clear: the agencies are only as
effective as their clients are honest.
There is a
flipside. On the one hand, it is claimed the agencies do not deal robustly
enough with the companies who pay them. On the other, it is said they are too
aggressive with the companies who don't. In 1998, Moody's wrote to a German
insurance giant called Hannover Re, according to research by the Washington Post's Alec Klein. Though Hannover was not a client of Moody's, the agency said
that it had nevertheless decided to rate them free of charge. Ominously, the
agency hoped that in the future Hannover would be interested in paying for the
service itself. "We need to act," said Hannover's chairman, Wilhelm
Zeller.
Unfortunately,
Hannover did not act soon enough. Moody's began rating Hannover's debt status,
but the insurance company had already enlisted the services of S&P and AM
Best (another, smaller agency). In 2003, Moody's downgraded its debt to junk
status, and because of the respect paid to Moody's valuations, shareholders
panicked, sold their stock, and Hannover Re lost $175m (£111m) in an afternoon.
Moody's declined to comment for the Washington Post piece.
It's an
example that highlights the power of the Big Three, who collectively rate
around 95% of debt. "They have built up such a franchise," Zeller
told the newspaper, "it's difficult, if not impossible, to do anything
against it." There are more than 150 ratings agencies worldwide, but in
order to have any credibility, companies really need at least one of Moody's,
S&P and Fitch on their side, and preferably all three. The first two firms
each control around 40% of the market. Fitch has about 15%, and is usually
engaged when S&P and Moody's disagree significantly about the
creditworthiness of a debt. This generally happens because S&P measures how
likely a debtor is to default, whereas Moody's rates how long the default is
likely to last.
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| A former Lehman Brothers employee leaves the office after the bank filed for bankruptcy in 2008. Photograph: Rex Features |
It wasn't
always like this. At the beginning of the 20th century, there were no ratings
agencies, and very few ways of telling which of the many emerging securities
were worth investing in. There was a gap in the market, and the first person to
fill it was a Wall St errand boy called John Moody. In 1900, aged 32, he
published Moody's Manual of Industrial and Miscellaneous Securities, a
compendium of information on thousands of financial institutions. The book sold
out in months, and an industry was born. Poor's Publishing Company (the
predecessor to S&P) emerged in 1916, Fitch in 1924.
Until the
1980s, the Big Three were still primarily North America-based, and demand for
their services was not high. This was because they rated the debt markets,
whereas at that time companies still did half their borrowing from banks, and
invested in things in which they had personal knowledge. "In the old days,
few bothered to engage a credit ratings agency because they dealt with what
they knew," writes Ha-Joon Chang, a heterodox (or leftwing) economist and
author of 23 Things They Don't Tell You About Capitalism. "Banks lent to
companies that they knew or to local households, whose behaviours they could
easily understand, even if they did not know them individually. Most people
bought financial products from companies and governments of their own countries
in their own currencies." But from the 80s onwards, as the financial
system became more deregulated, companies started borrowing more and more from
the globalised debt markets, and so the opinion of the credit ratings agencies
became more and more relevant. All three agencies are still headquartered in
America, but they now have offices in hundreds of countries, thanks to the
rapid expansionist tactics Hannover Re experienced at first hand.
For
countries such as Britain, the USA and France, the threat of a downgrade is not
as serious as it has been for other European countries. Moody's negative
outlook did not hit the pound or government bond prices hard, and the FTSE 100 was
affected only slightly. Even if Britain's rating fell to AA1, the state is
unlikely to be seriously affected because most other countries are in the same
boat, and investors have to put their money somewhere. "In this respect,
AAB is like the new triple-A," says Heather Stewart, economics editor for
the Observer.
But in many
other areas of the financial system, the agencies still wield tremendous power
– power that many believe needs more regulation. "The obvious solution
would be to take this public service into public hands," Aditya
Chakrabortty has argued in these pages. "Let's have a ratings agency run
by the UN, funded by pooled contributions from both lenders and borrowers ...
Let's make the ratings business a utility, rather than a semi-cartel that
intimidates elected politicians and rakes in excess profits. It's time to break
up the bullying double-act."
Others are
more pessimistic about the effect regulation could realistically have.
"Whether [or not] an intentional masking of risk by analysts was a
significant factor in precipitating the banking crisis ... the focus on
irresponsibility serves to deflect attention from the more important question:
the question of the accuracy of the risk-modelling techniques," writes
Ouroussoff, who is also the author of Wall Street at War. In other words, the
problem posed by credit ratings agencies lies not so much in their alleged
malpractice or negligence, but in the sheer impossibility of rating
creditworthiness in the first place. It's a problem that derives from the
difference between quantifying risk and predicting uncertainty. Credit ratings
agencies aren't bad at doing the former; at calculating, through mathematical
formulas, the statistical likelihood of, say, more than 5% of homeowners
defaulting on their mortgage. But they're arguably bad at doing the latter; at predicting the unpredictable, or anything that can't be included within a statistic: the
possibility, for example, that vast swaths of the banking industry might,
through sheer stupidity, have handed out mortgages to people who couldn't
possibly pay them back.
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| Are Rating Firms Getting a Free Pass? (Illustration by Topos Graphics) |
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