Who rates
the raters?
Junk
Investment
C
redit rating agencies have been
thrust into the spotlight once more
as the result of the recent credit
downgrades of some European countries
and the US. Now caught in the centre
of a political and economic scandal of
global proportions their future looks far
from certain.
A credit rating agency (CRA) is a
privately owned company that assigns credit
ratings to debt, effectively providing an
opinion on the likelihood of it being paid
back or not (a default). The three largest
CRAs are Standard and Poor’s (S&P),
Moody’s and Fitch. The grandfather of these,
S&P, can trace its origins back to 1860
when Henry Poor published his ‘History of
Railroads and Canals in the United States’.
Today, hundreds of CRAs operate
around the world but in order to ensure
their credibility the US financial watchdog,
the Securities and Exchange Commission,
ruled that only those designated Nationally
Recognised Statistical Rating Organisations
(NRSROs) would be permitted for
regulatory purposes in the US. S&P, Moody’s
and Fitch were all recognised as NRSROs
in 1975 and, despite the addition of seven
more NRSROs in 2007, the ‘Big Three’
still dominate the marketplace today,
together accounting for an estimated
95% of market share.
As shown in the table (above right),
ratings range from low risk debt which is
termed ‘Investment Grade’ to high risk
debt termed ‘Speculative’ or ‘Junk Grade’.
The rating received will determine the
cost of debt.
S&P
& Fitch
Moody’s
AAA
Aaa
AA
Aa
A
A
BBB
Baa
BB
Ba
B
B
CCC
Caa
CC
Ca
C
C
D
D
Lowest
Risk
across the line from objective to subjective
decisions, and have only exacerbated the
sovereign debt issue.
European officials launched a scathing
attack on the CRAs and publicly accused
the Big Three of favouring the United States,
however, it was not long before the rating
agencies turned their attention to the US.
On 5th August this year, S&P stripped the
States of its coveted AAA status, downgrading
it one notch to AA.
With a renewed sense of urgency, US
authorities resurrected the Dodd-Frank Wall
Street Reform and Consumer Protection
Act, which was designed to have a significant
impact on almost every aspect of the
America’s financial services industry, hoping to
hold the CRAs liable for their decisions.
In addition, Europe also tightened up
its regulation and launched its own watchdog,
the European Security and Market Authority
(ESMA).
Increased governance from both sides
of the Atlantic should hold CRAs more
accountable for their actions, however,
arguably the more power that governments
have over the agencies, the more influence
they may yield – a conflict of interest already
exists as a result of the issuer-pay model
(companies paying the CRAs for their ratings).
It would seem that CRAs are destined
to carry on but tighter governance and
increased transparency will significantly
reduce their power. In the longer term,
increased competition should also dilute
the Big Three’s influence.
Ultimately, too much reliance was perhaps
placed on the CRAs in the first place. Naive
investors bought bonds based entirely on
their ratings, believing that a AAA rating
discharged the need for vigilance. As S&P
itself states: “credit ratings are expressions
of opinion about credit risk.” So, give the
agencies credit at your own risk.
Highest
Risk
The role of the CRAs has grown in
importance over the years and, as the
reliance on them increases, their ‘opinions’
have carried ever more weight.
Historically, the CRAs have been slated
for being too reactive (Lehman Brothers held
a AAA rating just a month before it went
bankrupt) but now the pendulum appears
to have swung in the opposite direction. In
early 2010, Greece, Portugal and Ireland were
all downgraded to Junk status and there are
rumours of more to come.
CRAs argue their decision was warranted
due to the risk of contagion, as fears of
government defaults spread through the
markets, but many believe they are straying
Haig Bathgate, Chief Investment Officer
e. [email protected]
Catriona Livingstone,Trainee Investment Manager
e. [email protected]
Investment 3