The conundrum facing the three major ratings agencies - Fitch, Moody's and Standard & Poor's (S&P) - has always been that if they don't adjust their credit ratings for a borrower soon enough, they are blamed for anything that happens in the meantime. If the borrower defaults and the agency's rating indicated that the likelihood was low, investors tend to blame the agency for not foreseeing problems.
This is obviously a shortcoming in the way investors and markets interpret ratings in the first place. A rating merely indicates the likelihood of a default. But an "AAA"-rated borrower can default, just as a C-rated borrower might not. A credit rating is merely a measure of relative risk designed to help lenders decide how much they should charge borrowers to compensate them for taking that risk.
But more dangerous is that ratings are self-fulfilling: as soon as an agency lowers a borrower's rating to indicate a lower perception of creditworthiness, it lowers the borrowers actual creditworthiness, exacerbating whatever problems might have prompted the downgrade in the first place. That is the puzzle facing ratings agencies in the UAE as they react to the decision by Dubai to renegotiate some of the debts at Dubai World, and its two property subsidiaries Nakheel and Limitless.
The decision has shattered an assumption that had supported ratings for government-owned companies: that if they ran into any trouble servicing their debts, the government would provide them with whatever cash they needed. This assistance was known as an "implicit guarantee", like that which Fannie Mae and Freddie Mac enjoyed for years. Last year, when the subprime crisis hit, the US government made good on the assumption that they could rely on aid by bailing them out, saving a shattered housing market, the US financial system and its economy.
The ratings agencies came in for a lot of criticism in the crisis because many of the subprime mortgage-backed securities at the centre of the crisis had "AAA" ratings. This criticism centred on the inherent conflict of interest between ratings agencies, which are paid by borrowers so investors have a better idea of how likely the borrower is to repay them. The criticism was largely unjustified. As I mentioned, even "AAA"-rated borrowers can default, however unlikely that is.
The agencies are determined not to be caught out again and so are being especially conservative in their appraisals. Dubai World is only the latest in a long-running reappraisal by the agencies of implicit guarantees in the UAE. It started in April, when S&P reacted with downgrades to a statement by Nakheel that when it came to finding the cash to pay off its US$3.5 billion (Dh12.85bn) Islamic bond, all options were on the table.
All options? The only option a credit-ratings agency wants to hear is that a borrower plans to pay off its debts. Alluding to any other option seemed to raise questions about the willingness or ability of Nakheel's owner, Dubai World, and its owner, the Dubai Government, to ensure Nakheel's solvency. Moody's was the latest to begin questioning its assumptions on government backing. In October, the prospectus for Dubai's new $6.5bn bond programme made it clear that government-owned firms could not necessarily count on funding from the Government's Financial Support Fund, prompting another series of downgrades from Moody's.
Last month's announcement has prompted all three agencies to move again, this time eliminating assumption that government-owned companies enjoy implicit guarantees. Obviously, the Government could still move to back some companies, and not all companies would necessarily need any such bailout. But the onus is now on the Government to do what the US government did with Fannie and Freddie: clear up which companies enjoy guarantees and which will have to stand on their own.