Lorenzo Peracchione, Analyst, Mandarin Capital Partners
August 5th 2011: A terrible tsunami hit the United States of America, subsequently spreading across all the 5 continents. Such calamity, however, had nothing to do with atmospheric forces but was, once again, financial in nature. The triggering point is identified in the downgrading of US sovereign debt from “AAA” to “AA-plus” by Standard & Poor’s. Such unprecedented event discarded the dogma of American creditworthiness, a belief that nobody had dared to challenge since 1914.
Repercussions on financial markets were fierce and took a global scope. In two days (Friday 5th and Monday 8th), NYSE and NASDAQ Composite Indexes lost 12.19% and 8.63% respectively. In Europe, over the same period, the FTSE All Shares and the DAX Indexes went down by more than 6%. Not even China was spared by this tidal wave, as the 3.57% negative change in the SSE Composite Index and the extravagant appeals made by some disappointed Chinese investors in front of the China Security Regulatory Commission testify (A man showed up at the gates of the agency, totally naked, imploring the Chinese government to enact emergency measures to save the Chinese stock market).
Interestingly, already on Wednesday 3rd, when, after Obama ratified the bill increasing the US debt ceiling, Moody’s reiterated its “Triple A” assessment, the Chinese rating agency Dagong decided to downgrade US Treasury Securities from A+ to A rating. A rather unknown player on the international scene, Dagong clearly explained the reasoning behind its move. Relaxing the debt ceiling is not going to bring any stimulus to the American economy in the short term, but it will create incentive for moral hazard in the future. The risk is to fall into a vicious spiral of increasing debt and loosened controls, up to the point where the system will suffer a total breakdown.
Did Dagong’s decision to slash US rating somehow influence Standard & Poor’s to make the big jump? Could a downgrade be the only way to maintain credibility and to shrug off a possible image of political vassalage? Was S&P’s ultimately guided by thorough economic analysis or other kinds of considerations were deemed more relevant?
Answering these questions will be left to the sensitivity of each reader. The simple fact of identifying them as relevant dilemmas, though, demands a reflection on the role and functioning of those strange creatures called Credit Rating Agencies (CRA).
WHAT’S WRONG? Reliability Is Under Fire
Why do CRA exist? To provide a fair analytical evaluation of the ability of an economic entity to repay its obligations. These service providers perform a fundamental role in ensuring the stability and smooth functioning of a market economy. Imagine what could happen in the absence of reliable independent bodies able to certify the creditworthiness of business or other kind of economic counterparts such as national governments. Enormous due-diligence costs and delays would materialize due to the need to be sure about the reliability of unfamiliar economic entities.
Two keywords in this reasoning are particularly relevant, namely “reliable” and “independent”. Do CRA really possess these virtues? Experience seems to suggest that, at least under the current contextual conditions, they don’t. This means that their ratings cannot be trusted.
CRA gave a major contribution to the 2008 financial crisis by failing to account for market downturn risks when they granted the highest grade possible to CDOs (Collateralized Debt Obligations) and other asset-backed securities in the period 2000-2006. Despite spreading the plague, they were able to isolate themselves from its consequences. As discriminating between those able to pay and those unable to do it became more important, the profits of Big Three rating agencies remained healthy, while the global economy collapsed. McGraw Hill, holding company of S&P, posted net profits of $ 799.5 and $ 730.5 million in 2008 and 2009 (true, less than the slightly more than $ 1 billion realized in the golden year of 2007, but certainly not a bad deal in a time of planetary turmoil).
Whether the failures connected with CDOs where the outcome of negligence or of some other mysterious kind of influence does not change the inevitable conclusion: CRAs do not deserve unquestioning trust. Yet, political authorities in the US and in Europe seem to have increased their reliance on the prophecies of raters even more after the 2008 crisis. In Europe, Union-wide agreements that link the triggering of extraordinary measures exclusively to the breach of specified rating thresholds have been signed. Now, making the default or the crisis status of a country a direct consequence of a rating downgrading is not certainly a proof of heavenly wisdom. Ratings of CRAs are supposed to be used as a benchmark against which to check the validity of internal assessments when defining economic policies, but national governments and supranational organizations should not have the right to delegate macro-economic analysis entirely to third parties, especially when those parties are few and profit-driven.
WHAT NEEDS TO BE CHANGED? A Market Is A Market
The main problem with the Big Three rating agencies (S&P’s, Moody’s and Fitch) is that they are 3. Institutions worldwide seem to have forgotten that the market for rating is actually a “market”.
Basic economic theory teaches that when in a market suppliers are few, they are able to steal part of the rent that in a competitive setting would be pocketed by consumers. In an oligopoly situation, the price of the good or service provided exceeds what clients would actually be willing to pay for the value that the product or service really represents to them. This means that customers pay too much for the quality they receive or, seen from another angle, they receive too low quality for the price they pay. Again according to classical theory, in this process, a portion of value is inevitably destroyed resulting in a loss for the whole ecosystem.
In the hope that readers will forgive this scholarly – and, for most, superfluous – digression, it is worth remarking that these observations apply perfectly to the market for rating, but with a fundamental, dramatic complication. Ratings on sovereign debt, indeed, have fundamental political implications, beyond economic ones. In a world in which the privilege of making prophecies is the exclusive right of 3 titanic entities, the potential for conflict of interest is enormous and the reliability of the same ratings is questionable by definition.
Therefore, governments and international policy bodies have to remember that a market is a market. For those who advocate the survival of a system based on a market economy, this means that, in order to function properly, a market must be competitive. Continued reliance on the Big Three is neither desirable nor sustainable. The realm of CRAs should be characterized by a wider range of opinions and perspectives, so that the ghost of political influences overruling sound economic analysis could be dispelled. For this reason, the entry of new players in Western rating markets should be actively encouraged. New voices like that of Dagong (however painful its verdict might have been in the events of the past few days) should be welcomed by the European Union and the United States as the best therapy to the illnesses of the rating world. An increased number of CRAs, and increased competition among them, is, somehow paradoxically, the only weapon that could win the battle for truly “independent” and “reliable” ratings.
Lorenzo Peracchione, Analyst, Mandarin Capital Partners