Who needs a financial rating?

The recent flare-up in relations between rating agencies and the governments of the world's leading countries has once again brought to the fore the debate about the role of ratings and their “producers” in the modern financial system.

The practice of specialised companies “calculating” a borrower's creditworthiness rating emerged at the beginning of the last century. The business idea was a multi-parameter analysis of the borrower's condition by independent analysts in order to assess its ability to meet its debt obligations (the idea belongs to the American John Moody, who developed the first assessment methodology in 1900). In effect, this led to borrowers being ranked according to the calculated probability of their default (see Table 1).

Over time, this practice became extremely widespread. Today, both large investment companies and individual investors look first and foremost at the issuer's rating when building a portfolio of debt obligations (and sometimes shares). Moreover, financial institutions everywhere formalise their investments according to ratings. As a rule, the higher the rating, the larger the relative volume of permissible investment in the issuer's debt obligations. That is why a high rating has become the key to a broader investor base and, consequently, to cheaper financing. In other words, a high rating has become every borrower's dream. This encourages issuers, on the one hand, to genuinely maintain financial discipline and, on the other, to pay rating agencies well for their services.

As a result, the rating business turned into an extremely profitable industry, and the leading rating companies (today these are three American agencies: Moody’s Investor Service, Standard & Poor’s and Fitch Ratings) became large, highly profitable corporations.

Until the financial crisis of 2007-2009, the established practice of using credit ratings drew no particular criticism. Of course, there were individual scandals, such as the bankruptcies of top-rated issuers (Enron 2001, Parmalat 2003). From time to time, facts also emerged pointing to the possible “corruption” and “political bias” of the respected agencies. But in the overwhelming majority of cases, ratings did reflect the borrower's reliability, helping investors find their way in the global ocean of debt obligations, which had grown enormous.

However, as early as the end of the last century, discrepancies between the market yield of bonds and the issuer's rating began to appear more and more often. That is, between the market's and the rating agencies' assessments of a debtor's reliability.

On the one hand, this was due to the acceleration of the processes affecting issuers' condition, and the agencies simply began to lag behind with their assessments. On the other hand, the market, which had gained strength (read: speculators), increasingly began to drive prices one way or the other, not always in line with the borrower's fundamentals.

But the first truly serious complaints about the work of rating agencies arose after the recent global financial crisis. Recall that the financial crisis of 2007-2009, which nearly brought down the entire global financial system, began with problems in the US subprime mortgage market. The catch is that low-quality American mortgage debt was packaged into bonds that, for some reason, received high ratings from the leading rating agencies. With good ratings, these securities were successfully sold all over the world and, in large volumes (in line with their ratings), ended up among the assets of leading banks. After the price bubble in the US real estate market burst, these securities fell sharply in value, which led to the first significant losses in the system. Subsequently, a chain reaction of forced sales plunged the global financial system into a full-scale crisis that almost ended in its complete collapse.

When, after the crisis was over, people began looking for those responsible, it was impossible to ignore the role of the rating agencies. Opinions on their share of responsibility differed, up to the extreme view voiced by Henry Waxman, chairman of the US House Committee on Oversight and Government Reform: “The activities of the leading US credit rating agencies were one of the main causes of the financial crisis.” The agencies themselves partly admitted their fault, later acknowledging that “there were few grounds for assigning the highest rating to thousands of mortgage securities.”

The second round of tension with the “producers” of ratings came against the backdrop of the eurozone debt crisis. At first, the leading rating agencies failed to keep pace with the situation and began downgrading the troubled eurozone countries long after market prices had fallen significantly.

Later, however, despite the assistance programmes adopted by international institutions, the agencies began mercilessly cutting the ratings of the PIGS countries, ignoring the fact that these programmes genuinely improved the borrowers' solvency. It can be said that such actions by the rating agencies contributed to the spread of the crisis. Moreover, after the adoption of the second Greek rescue plan, which included a voluntary write-off of a small part of the debt by investors, two of the three agencies threatened to assign Greece a D (default) rating.

All this caused extreme irritation among the leaders of the leading EU countries. The American agencies were accused of making political decisions aimed at creating conditions of unfair competition. And now the idea of creating alternative, European structures is being seriously discussed in Europe.

But soon the leading rating agencies fell out of favour with the US authorities as well. In April 2011 S&P, followed in July by Moody’s, lowered the outlook on the US sovereign rating, and Fitch threatened to do so in the near future. This caused undisguised irritation among the American establishment.

And a genuine scandal, with the effect of an exploding bomb, was S&P's decision of 5 August 2011 to downgrade the US rating from ААА to АА+.

How sensitive the system is to such formal decisions was shown by the ensuing collapse in prices on the world's leading stock exchanges, which threatened a repeat of the global financial crisis.

And the fairness of this decision is far from obvious. That S&P's decision may have had a political background is also indicated by the fact that it drew extremely harsh criticism from the Republicans but only moderate criticism from the head of the White House. After all, the agency justified its action not only by the increased volume of government debt but also by “the inadequacy of the adopted plan to reduce budget deficits in order to stabilise the dynamics of public debt over the medium term.”

This refers to Obama's significant concession to the Republicans on raising taxes. As a result of these concessions, Obama's plan to cut deficits by $4 trillion over 12 years was replaced by a much more modest plan to cut them by $2.4 trillion over 10 years.

Nor is the US government's debt itself all that simple. US gross public debt did indeed reach 100% of GDP in August 2011, and there are no countries in the world with such a ratio and the highest rating (see Table 2).

But the public debt of the US (and of Japan) has a specific feature that is not typical of most developed countries. Up to 35% of US public debt is held by government bodies (including, admittedly, the “not entirely” governmental Fed), and the “net” public debt is estimated at only 74% of GDP. This is less than that of the leading eurozone countries (including Germany at 83%, France at 82% and England at 80% - 2010 data), which retain the highest rating from S&P.

It should also be noted that the other two leading agencies found no compelling reasons for a current downgrade of the US rating, affirming it in August at the highest level, ААА.

Incidentally, the increasingly frequent cases in which the leading agencies assign borrowers different ratings (during the eurozone debt crisis these sometimes differed by as many as 3 notches) are also a cause for concern. Which rating should one use, then, and which of them reflects the situation more accurately? Taking advantage of this conflict, the European Central Bank has already stated that it will continue to accept Greek bonds as collateral as long as at least one of the three agencies does not lower their rating to default (now it only remains to persuade at least one agency).

In other words, today there is clearly a very serious crisis both in the system of assigning credit ratings and in the practice of using them. How to get out of it is not yet clear. In theory, the services of rating agencies could be abandoned altogether. In the stock market, similar analytical work is carried out, without being spun off into a separate business, by analysts at banks, investment companies and even some private investors. Given today's technology and prompt disclosure of information by issuers, this work is not all that transcendent.

There is one more argument. If the growing armada of speculators in the market is not stopped, the importance of fundamental assessments of issuers will diminish.

And if there is no difference, why pay more?

Table 1. Moody's estimate of the probability of borrower default depending on the assigned rating.

Table 2. Ratings of countries with a public debt-to-GDP ratio above 100%