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Editors Soapbox

MICHAEL WILSON SAYS IT’S PAYBACK TIME FOR THE PONTIFICATORS

When you were at school, didn’t you just hate the classroom swot who always seemed to have the teacher’s ear? The smarty-pants with the straight tie and the shiny shoes who could always tell you why Sir was right, and why Smith and Adams over there clearly hadn’t done their homework? And didn’t you just love it when the little creep came unstuck?

They don’t come much more unstuck than agencies, has been getting a blast of downright hatred from the press, the politicians and the on 5th August to downgrade the mighty US government from its coveted AAA rating to just AA+, in view of Washington’s huge current deficit and its messy threshold-raising exercise. It was the first time in 150 years that Uncle Sam had scored less than a Triple A, and it hurt the nation’s pride. Sensibly, S&P’s two rivals, Moody’s and Fitch, decided to hold their ratings steady and didn’t get the flak. For the time being, at least…

“When you were at school, didn’t you just hate the classroom swot? And didn’t you just love it when the little creep came unstuck?”

Obviously, S&P and the others are perfectly entitled to give anybody any rating like – they are, after all, independent companies. Subject always to the proviso that they might lose their privileged status as “nationally recognised” assessors in America if they get it too badly wrong, too often. But what seems doubly ironic is that the rating agencies’ own past errors are still writ large across subprime mortgage crisis which brought about the collapse of (AAA-rated) Lehman Brothers and generally got us all into the mess we’re in now. That hurts.

A Comedy of Errors

Didn’t S&P and the others dish out all those ludicrous triple A ratings for the subprime bonds that the wide boys of the banking world had been parcelling up for our delectation? Yes they did. And didn’t S&P’s chief have to resign in 2007 after the scale of his team’s mistakes became apparent? Yes he did. And weren’t the big three ratings boys still giving a clean bill of health to Enron just days before it collapsed in 2001? Affirmative also.

Weren’t the agencies right at the heart of the Basel II banking accord, which required every bank in the world to present full audits of its lending risk portfolios so that the powers that be could decide how much capital it ought to be setting aside against any possible default? Yes they were. It was a development that gave the rating agencies huge and unprecedented power in the commercial banking world.

“Politicians are getting hot under the collar about the “issuer-pays” arrangement between banks and their credit assessors.”

Pause for effect. With hindsight, we know just how good those risk assessments were, because half the world’s banks have spent the last four years in chaos. And who exactly was paying the agencies to produce those superfine assessments? We’ll give you a clue. It wasn’t the governments or the financial regulators. Sure enough, it was the client banks themselves, who would have been awfully cross about getting a sub-optimal credit report…

There are currently a lot of politicians, especially in Europe, who are getting hot under the collar about this cosy “issuer-pays” arrangement between the banks and their credit assessors. So should we be surprised that the ratings agencies are quite fantastically profitable? Moody’s is currently reckoned to be running an operating margin of 35-40%. And over at McGraw Hill, the publishing outfit which owns S&P, investor pressure is growing to split off the golden goose from the rest of the flock so that its true value can be appreciated in all its own burnished glory.

And yet…

There are two sides to every story. The International Monetary Fund gave the rating agencies a pretty good assessment last year, when a special study found that every single country that had defaulted on a debt since the mid-1970s had been flagged up by the agencies at least twelve months in advance. And this year, too, all the European countries which got into hot water with their debts had been flagged up several years ago.

You might be inclined to say that these extreme examples are just the lowhanging fruit. If you couldn’t see that Ireland and Greece were on the skids at least three years ago, then you’d be better advised to get a white stick and a Labrador. It’s the trickier middleground countries – Mexico, South Korea, Brazil – where the true expertise is needed. And to be fair, most of those ratings have been reasonably accurate. But when it comes to the banks, nobody would really dispute that the agencies’ rating assessments have been pretty dismal.

Consider also the extreme responsibility which goes with being a ratings agency. It was that fateful downgrading of AIG’s credit status in 2007 that started such a run on the world’s biggest reinsurer that it had to be propped up by the Federal Reserve, simply in order to prevent businesses from Boston to Beijing from waking up to find they had no valid insurance policies any more. Recall the shocking effect of Moody’s or S&P’s downgrades on manufacturing companies from Sony to General Motors – and, more specifically, the outward stampede of cash from their stocks – and you start to wonder why anybody would want to be in this line of business at all. Unless it was for the money, of course.

Europe’s Experiment

But let’s look at one of the newer developments here. You might have heard that the G20 Group’s coordinating body, the Financial Stability Board, has demanded that its members find ways of keeping the ratings agencies’ assessments far away from the rulings on how much capital a bank should have, or on things like margin agreements. But Europe’s response is rather different.

It’s not, in fact, a solution so much as a sidestepping process. The European Central Bank is discussing an idea whereby the shaky economies of Portugal, Ireland, Italy, Greece and Spain (the unflatteringly-named PIIGS), and all the others too, would be eligible for support from a new kind of so-called ‘eurobonds’ that would be jointly underwritten by all the Euro Club governments, and most of all by the ECB.

Yes, that’s rather a radical solution. It implies that the credit pool will be underwritten by the whole vast Euro-zone economy, without regard to country risk. And that in turn would make the need for approval from an outside ratings agency redundant.

There are more radical mutterings in Europe, where pressure is growing for a panstate ratings agency that wouldn’t be a paid entity at all. During the last year Europeans have been outraged at the way Moody’s & Co launched blistering downgrades on Greece, Spain, Portugal and Italy – in each case, just in time to trash a major restructuring announcement. There have even been claims that the three American agencies are driving down the euro so as to make the embattled dollar look better. (Perish the thought.) An official ratings agency, some say, would obviate this problem nicely.

America’s Regulatory Lash

The United States has already taken up the running with rather more practical gusto. The Dodd-Frank Act, which passed into law in July 2010, gives the government just two years in which to come up with a better alternative.The Act doesn’t pull its punches – and it would have been even tougher if the Administration hadn’t backed down on a critical issue at the very last moment.

“The US has already taken up the running with rather more practical gusto.”

Influential protagonists such as Al Franken (Democrat) had tried to insist that the ‘issuer pays’ model should be completely outlawed. That was enough to send the industry into frothing-mouthed mode, and the proposal was defeated. But another report by the Securities and Exchange Commission and the New York Attorney General had lambasted the industry for slovenliness and complacency – and had dragged up several very juicy internal emails that proved its point.

the authority to dictate terms to the United States Government,” said Congressman Dennis Kucinich (Democrat) in July, as Moody’s discussed a possible downgrade (that, in the event, never actually happened). “Moody’s is representing people who stand to gain from the U.S. being able to issue more financing. This is an unwarranted interference in the political process and continues to raise questions about conflicts of interest among the rating agencies.” Okay, yes, we get your point.

Aye, and There’s the Rub

All in all, the opprobrium being heaped upon the ratings agencies is not unexpected. But it leaves aside the awkward question: what would we do without them?

Imagine a world in which a fund manager had no tools at all for assessing the credit status of a developing country, apart from his own acute mathematical ability of course. Think of the trouble we’d have in figuring out whether Bank A was sounder than Bank B – especially if we didn’t have access to their backroom files – and the prospect of something very close to anarchy heaves into view. And double those doubts if the banks happened to be in a part of the world where financial regulations were, ahem, flexibly applied.

So what do we do? Among the saner suggestions would be to abolish the ‘nationally approved’ tags that lend what might often be a bogus credibility to the agencies. (I’m thinking not least of the Chinese agency that savagely downgraded the United States last month because it was feeling piqued over the US deficit.)

“Does ‘three strikes and you’re named and shamed’ sound like a good start to you?”

Another, better way would be to improve the transparency of the vetting process so as to make sure that agencies couldn‘t simply reward themselves for slack work or even cover-up jobs. But hey, perhaps the best way would be to go the other way completely? Let’s mix a metaphor. Does “three strikes and you’re named and shamed” sound like a good start to you?

Do you have a good reason for the Editor to jump back onto his soapbox? Not that he needs any encouragement, please send your requests to editor@ifamagazine.com and stand well back!

Michael Wilson says:

How does the scale system work?

Ratings agencies haven’t altered their methods in the 150 years since they were first invented. A combination of intense mathematical study with ‘fingertip feel’ analysis – not to mention a lot of phoning your friends – results in a hybrid product which is, unfortunately, far too obscure for the average layman to tackle or contradict with any conviction. “Because everyone knows we’re good at it” is about the best account you’re going to get.

Each of the ‘big three’ (S&P, Moody’s, Fitch) has its own classification system, which makes it hard to compare the ratings. But in very broad terms, the top of the quality spectrum is dominated by a group of what we normally call Triple A governments (or companies) – which at the time of writing included Britain, Germany and France. (Though France’s position was under review.) Because these governments’ debts are regarded as 100% secure, their Triple A rated bonds can get away with paying smaller yields than those of their slightly less distinguished competitors – which now include the AA+-rated United States, of course. That in turn means that the capital value of any triple-A bonds you hold is at a maximum.

It also means that any downgrade is going to wipe huge chunks off your bond portfolio!

There’s nothing terribly bad about being an A anything, except that the yields are higher and the prices are consequently lower. Anything from BBB upwards (Standard & Poor’s) or Baa (Moody’s) qualifies as ‘investment grade’ and might be considered suitable for your pension portfolio. But ‘sub-investment’ grades which fail to make these levels are strictly for risk-takers in their various guises.

Brazil opens the batting for government paper at BBB- from S&P, and Turkey and the Philippines score a mere BB. Ireland currently merits a Baa3, which is just above junk. There are hundreds of large companies on significantly lower ratings, and their high yields on their corporate bonds are reflected in sometimes large “spreads” over German bonds, a popular benchmark, or else against US Treasuries. Their prices are consequently lower to accommodate the risk of default, however small.

Which is a good thing for an income investor or a risk investor, but a source of worry for those who insist on sleeping tightly. You pays your money and you takes your choice.

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