Meredith Whitney, from MW Avisory Group, said in November 2010, at a hearing in the US Senate, what the Main Street think about the rating agences industry: “Current construct of rating agences has little or no credibility, is not trusted and ineffective”. This industry has 72 agencies worldwide, but the market is a oligopoly: three majors – Moody’s, Standard & Poor’s and Fitch – have 90-85% market share. The discussion at that time was about the rating agencies behavior during the bubble times and then during the “first phase” of the credit default crisis in Europe.
Recently, professor Bertrand Candelon with specialists from the IMF published a working paper concluding that the donwngrades of Greece since 2009 had systematic spillover effects across Eurozone countries. The tipping point was in december 2009 when Fitch downgrades Greece from A- to BBB+. In last March Moody’s, Fitch and Standard Poor’s downgraded Portugal and Greece. Portugal was dongraded recently to near-junk by S&P and later by Fitch. April 1 Ireland was downgraded to BBB+ by S&P.
A virtual round table about the rating agencies was edited by Janelanaweb.com, listening in separate interviews to William White, former Head of the Monetary and Economic Department from May 1995 to June 2008 of the Bank for International Settlements and based in Basel, Bertrand Candelon, professor at Maastricht University School of Business and Economics, located in Netherlands, Franck Biancheri, leader of the Newropeans and research coordinator of the french forecasting consulting company LEAP in Paris, and Peter Cohan, professor at Babson College, blogger and analyst based in Boston.
Round Table edited by Jorge Nascimento Rodrigues (a) 2011
«The possibility of a vicious circle of increasing pessimism or a justifiable behavior?»
Q: These movements from the main rating agencies regarding Portugal are justifiable?
William White: For me to determine whether the recent rating changes for Portugal are justifiable, I would in principle have to know more about Portugal than do the rating agencies. I seriously doubt that I have such knowledge. What does potentially worry me, however, is the suggestion that Portugal was downgraded in part because the risk was rising of a market run on Portugese debt. Since market sentiment itself depends on ratings, and changes in ratings, this raises the possibility of a vicious circle of increasing pessimism. Personally, I would prefer that ratings not reflect such market sentiment, but that the rating agencies state that default rates could well rise above those consistent with the rating, if market sentiment turned sour.
Bertrand Candelon: Let us first remember the objective of a credit rating agency. Rating should indicate for investors the long run economic perspective of the country. It means that they should avoid to modify the rating across the cycle or after any temporary shock. In the case of Portugal, a downgrade would thus mean that the public finance situation becomes critical and is less sustainable in the long run. Foreign investors are thus exposed to higher risk when lending to Portugal. The downgrade is justified if it is the case. Everybody is aware that the fiscal and political situation in Portugal as in Greece is critical in many ways. Nevertheless, 2 arguments may go against the downgrade: First, European Union (alone or with the IMF) has the capacity to bail-out Portugal as Greece (which would not be the case for Spain). It is thus very unprobable that Portugal will default stricto-sensu. Second, as we show in the paper (Arezki, Candelon and Sy) downgrade has an impact on financial markets (pushing down the stock market global and subindices and increasing the CDS rate), that would 1) affect the other european countries as well as 2) Portugal itself potentially creating a vicious circle. In other words, even if Portugal situation is becoming unsustainable in the long run instead of solving the problem, it will add to the financial instability in Portugal and in the whole Europe. The solution will come from the economic side. A big one shock I think it is probable especially if Ireland is downgraded again [as it was in April 1]. It looks like the greek downgrade near to junk we have in the paper. My strongest fear at the moment is related to Spain because of the financial amount it represents (difficult to bail out). Let’s hope it will not be the case.
Franck Biancheri: No, in the sense that they do not treat all countries in the same way. Portugal, like Greece, is being obviously ‘targeted’ by the 3 main credit agencies, while Japan, UK, .. are not when their econmic and financial situation is getting more and more problematic. This is a clear example of the antiEurozone strategic positionning of these 3 anglo-saxon agencies. Their first role is to defend and protect the US/UK dominance on world finance, and obviously not to defend and protect the investors.
Peter Cohan: While painful for Portugal, the rating agencies’ movements are justifiable. S&P concluded that commercial borrowers are less likely to get paid because Portugal may need to restructure its debt before borrowing from the EU rescue fund and that such restructuring might push repayment of those loans to a lower repayment priority level than repaying the EU rescue fund loans. Moreover, S&P is concerned that the EU rescue fund reduced the amount of up-front cash it would pay and did not specific how it would use the funds. Portugal, which has about 9 billion euros ($12.8 billion) of bond redemptions coming due in April and June, must deal with these challenges in the face of political uncertainty after Socrates failing to get lawmakers’ support for austerity measures.
«A role for a trusted agency like the BIS or diversification of rating agencies will not fix the problem with its payment business model»
Q: In the rating agencies industry, do we need a global diversification of these type of companies?
William White: It certainly would be desirable to get more resources into the credit evaluation business. More rating agencies is one possible route. Another is to try to exploit the evaluations being done routinely by investors who are not rating agencies. I suggested a number of years ago that these investors should be given a common rating schedule and that they should then send their ratings of individual entities (sovereign or private) to a trusted agency like the Bank for International Settlements. The BIS would then assemble these evaluations and publish the full probability distribution of the results, respecting the privacy of the contributors. Knowing the degree of uncertainty around the average rating would be very helpful to investors.
Bertrand Candelon: We must realize that CRA (credit rating agencies) are independent firms, with benefits and market positioning. The market is actually oligopolistic and composed by S&P, Moody’s and Fitch. So it may be that to get credibility, a CRA decides to lead the sequence of downgrades. For example in the case of Portugal, S&P was the first in 2009 to downgrade followed by Fitch in 2010. To this respect, one idea would be to create new CRA aiming at creating an efficient rating world. Potential problems may be that 1) it may take some time before a new CRA gain enough credibility on the market to compete with the existing ones, 2) it will not prevent fron selffulfilling mechanisms (a sequence of actions disconnected fundamental factors) and 3) if the country is really suffering from long-run economic problem a simultaneous downgrade of all the CRA will have huger effect on financial stability. Besides in our paper which covers the period 2007-2010 we only find weak evidence of such sequence.
Peter Cohan: There are plenty of problems with the ratings agencies as they are now. The financial crisis might not have happened, for example, if the ratings agencies had not been paid by the banks whose investments they were supposed to be rating. However, it is not clear to me that global diversification would necessarily fix that problem.
«An euroland rating agency: yes, but it must be independent from the political authorities»
Q: Europe must have companies of this type, like China and Canada have?
William White: I do not see why the nationality of a rating agency matters. Surely, the important thing is the competence of the evaluators. Indeed, I think it might even be counterproductive to have a national rating agency, since they might be too soft on their own sovereign and other national entities. This danger would be even greater if the sovereign was also the regulator of the rating agency, and therefore had the means to punish them.
Bertrand Candelon: First, I am not familiar with the CRA organization in China or Canada. If you think about the idea of creating a European CRA (as it was the idea of the European commissaire Michel Barnier), I think it would make sense. 1) it will increase the information space (in Asia 6 CRA are coexisting) and 2) lead the other CRA to focus more on the long-run. Nevertheless, it has to gain sufficient credibility and also to be somehow independent from the political authorities: After all if a country is running unsustainable macroeoconomic policy in the long-run it has to be downgraded, whatever the potential consequences, this is the duty of CRA.
Franck Biancheri: Of course we need it and it’s taking place. China has its own agency, which by the way stripped the US, UK, France from their AAA status. Euroland needs one too.
Peter Cohan: It makes sense that Europe should have its own rating agencies. The question is who would pay for them – as I mentioned before this is the critical question. If ratings agencies get paid by the institutions that issue securities, then their objectivity will be compromised. That’s because the securities issuers will be able to encourage the ratings agencies to compete with each other for lucrative fees in exchange for putting a good rating on their securities.
« Ratings agencies are supposed to anticipate the crisis, otherwise what is their rating worthwhile for? The government might analyze the rigor of the ratings agencies’ methods»
Q: Is it criticial do regulate this field, regarding what happened during the bubble times?
William White: “Critical” is a very strong word. Undoubtably, however, the rating agencies made big mistakes in the area of structured products. It is now clear that these ratings were essentially impossible to make (and the structured products to price) because they were so highly dependent on assumptions about correlations in movements of underlying prices about which we essentially knew nothing. The next question, however, is whether any regulatory body would have realized this and acted on it before the mistakes were made. Interestingly, the Committee on the Global Financial System, which meets at the BIS, did publish such warnings about structured products well before the crisis. For whatever reason, these warnings were totally ignored by rating agencies and by those both selling and buying such products.
Bertrand Candelon: Again the role of a CRA is to rate according the long-run economic situation of the country. Nevertheless, as 1) this objective is debattable and 2) a rating change have huge consequence on financial markets in the downgraded country but also elsewhere, I think some regulation may be wishable. But how to do that? A first idea could be to supervise the models from which the rating are issued to insure they focus exclusively on the long-run. It could be for example feasible to create a European label for the rating model (without making them public of course). Another possibility may be to make the ranking more continuous (i.e. increase the number of ranking classes). The decision to downgrade of a notch should then become less important for the financial stability. Such a controle (I prefer this term to regulation) might be desirable.
Franck Biancheri: Ratings agencies are supposed to anticipate the crisis, otherwise what is their rating worthwhile for? And indeed, they obviously are unable to do so. Since 2008, they did not see a single big shock coming … while they have been ultra-proactive about a shock which will never come … the suppose to be ‘Euro crisis’. Another clue that their role is not a technical one, as they pretend, but a very political one : to defend and protect the existing financial system and its dominant powers. nothing more, nothing less.
Peter Cohan: The best way to regulate this field is to change the way ratings agencies get paid. The way to do that is to make the people who use the ratings – e.g., investors – pay the ratings agencies for their time to do the ratings. This would represent a radical shift since the ratings agencies are now paid by the securities issuers instead of the securities buyers. But this change is hardly radical – most people are quite comfortable with the idea that if they use a service, they should pay for it. What seems strange to me is that the creator of a security would pay a ratings agency to create an objective analysis of that security – this turns the ratings agency into a member of the sales force for the security issuer rather than a watchdog. If we could get securities buyers to pay ratings agencies, we might still want government to produce objective ratings of the ratings agencies. The government might analyze the rigor of the ratings agencies’ methods and give them quarterly scores on the accuracy of their predictions which would be published and promoted in the media. The government might also threaten to de-commission a ratings agency that fell below certain specific standards.
«The current downgrades are the inevitable byproduct of too much “good news” in the decade preceding the crisis»
Q: Most of today hard critics blaming the rating agencies’ recent movements in the sovereigns (downgrading Greece, Ireland and Portugal) said nothing when the same agencies rated AAA a lot of countries in the bubble epoch, fueling the credit bubble…
William White: Here we have human nature at its most shortsighted, always wanting to be told good news, even if the longer term implications are quite to the contrary. In fact, the current downgrades are the inevitable byproduct of too much “good news” in the decade preceding the crisis. These beliefs made it very easy for borrowers on the periphery of the Euro zone to build up debts, on very easy terms, to the point where the capacity to service those debts was eventually thrown into question. That is the heart of the current set of problems. Moreover, blame must be put on both lenders and borrowers. Both of them made serious misjudgements about what would prove sustainable and what would not.
Bertrand Candelon: Indeed, this is the symmetric problem and the proof that they were rating trough the cycle. A long-run analysis would have revealed that these countries were in a bubble, meaning that in the long run it will, for sure, explode. In such a case, a downgrade or at least a negative revision could have expected. Again, I do not say it would have avoid the explosion of the bubble but it may have limited its volatility.
Peter Cohan: Thanks to debt-fueled bubbles, economies go through cycles of credit expansion and contraction about once a decade. During the periods of credit expansion, the biggest fear among all market participants – including ratings agencies – is failing to keep up with their peers in grabbing a piece of the expanding bubble. During the real estate securities bubble, the ratings agencies were competing for lucrative fees from the securities issuers – and they could only win the competition by agreeing to AAA-rate increasingly dodgy securities. Since the financial crisis began, however, we are still in a period of credit contraction. This means that the ratings agencies are going to bend over backwards to be strict and disciplined in their evaluations because that is what their customers want. However, when credit expansion resumes, there will be nothing to keep the ratings agencies from loosening up again – unless the rules are changed as I suggested they ought to be.