Credit rating agencies: crises catalysts?
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Amid the lack of fiscal discipline among the PIIGS countries, few recognized the strong influence on the role of the credit rating agencies (CRAs) behind the miserable Greece debt turbulence that possibly induced the massive global equity sell-off last week.
Standard & Poor downgraded Portugal and Greece’s bonds in the middle of the ongoing Greece rescue plan talks. Greek bonds were trashed below investment grade to BBB–, the highest junk bond rating by S&P, while Moody’s and Fitch maintained their AAAs rating. Standard & Poor dropped the last straw onto the back of the groaning camel by downgrading the bonds of Spain from AA– to AA the following day. The action came with impeccable timing that not only complicated the exploration of the Greece restructuring plan by the ECB and the IMF, but also heightened negative emotions permeating the already fearful market.
S&P claimed the downgrades were incidental and by credit committee collective decision. As per S&P, the decisions had to be released immediately to prevent leakage. However, the timing of such moves remains controversial. To a certain extent, the downgrades were reactions to the previous selloff of the troubled European sovereign debts and came at a time when there were chances of stabilization. S&P’s action catalyzed the panic-selling, but, because of the time lag, in fact the downgrades demonstrate very little indication of the credit worthiness.
The creditability and the effectiveness of credit agencies have been questioned since the Enron scandal, in which the problem company failed to preserve its investment grade rating only four days before its bankruptcy filing. In the midst of the financial crises in 2007-2008, both AIG and Lehman Brothers kept their investment grade rating until the very last moment before these gigantic financial conglomerates collapsed. In most of those incidents, although pre-crises alerts were not considered to be the CRAs’ intent or preference, they did in fact trigger a death spiral of the underlying asset prices. This happened because their continuous downgrade actions directly added fuel to the fi re-sale conflagration that reduced the troubled financial institutes to virtual financial ash.
In the aftermath of the 2008 financial tsunami, the CRAs were blamed for their role in rating the complicated residential mortgage-backed security (RMBS) and commercial mortgage-backed securities (CMBS) collateral debt obligations (CDO) and thus further pumped up the dangerously inflated US housing bubble.
Without the support of the CRAs, none of the investment banks in Wall Street could have packaged these complex structured products and attracted billions of dollars to fund the US housing bubble. The fact that CRAs were paid to rate these complicated investment products also raises questions about their independence and objectivity, especially when the quality of risk assessment for these complicated products was considered questionable. A good example is the Abacus ABS CDO, which was structured by Goldman Sachs for John Paulson, a hedge fund manager, to short the mortgage markets.
The collateral of Abacus was rated AAA by both S&P and Moody’s, but these were downgraded to junk status within a year. Nevertheless, while the investment bankers took their lumps, CRAs were questioned but never punished.
The rating agency system has evolved since the 1930s. when regulators encouraged banks and institutions to rely on CRA independent ratings in assessing credit worthiness of different debts. Among the 10 Nationally Recognized Statistical Rating Organizations (NRSRO) recognized by SEC, the big three, namely Standard & Poor, Moody’s and Fitch, according to a congressional report, dominated 98 percent of all the rating services and collected 90 percent of total rating revenue, by some accounts.
Traditionally, institutions such as insurance companies have relied extensively on the CRAs’ services, as there are investment restrictions on the percentage of their investments to be maintained within investment grade and on disposal of junk-graded assets in their books. Under the framework of Basel II, there are requirements on the components of assets within their balance sheet and these requirements are heavily reliant on the CRAs gradings.
The CRAs also have significant influence over many indexes components; in many cases the constituent companies or issuers may have to be removed as a direct result of downgrading. Therefore, the gold label of triple AAA or investment grades from the big three have not only affected a country or a corporation’s ability to raise capital, but have also impacted the demand curve of the assets being rated.More oft en than not, the effects of these ratings have also rippled through other sectors or, as in the recent case, the market as a whole, because of the whole financial systems’ tight bonds with the rating mechanism.
The recent development has once again triggered scrutiny of the CRAs. Bill Gross of PIMCO, the firm managing the largest fixed income portfolio in the world, challenged markets to disregard the rating agencies, because of their “timidity and lack of common sense”. He argued that the rating mechanism adopted by SEC starting back in 1975, in recognizing these CRAs, was the direct cause of the big three’s current debt-rating dominance.
More importantly, the National Association of Insurance Commissioners is moving ahead on a proposal to have PIMCO rate CMBS assets, rather than rely on the big three.
In Europe, in light of the developments in Greece, Austria’s central bank governor has also promoted the idea of establishing a separate rating mechanism of European bonds, which would be serviced and rated by the ECB itself.
For China, this ongoing debate over rating agencies is substantial.
The central government has been working years to prepare its financial system to be mature enough before finally opening it up to volving both learning from the Anglo-American market forces as well as developing an independent, domestic rating system, which would allow participation from different domestic and foreign foreign financial and capital markets. Beijing has allowed the establishment of independent rating organizations such as China Cheng Xin International Credit Rating Co, Ltd, which is 49 percent owned by Moody’s.
The strategic JV structure helps domestic talents accumulate overseas experience and knowledge. However, in light of the recent developments in continental Europe and the demonstration of the destructive power of rating agencies, the central government should consider a parallel development inrating agencies.