x Abu Dhabi, UAEFriday 21 July 2017

Tide turns on rating agencies after S&P's dubious downgrade

Since Standard & Poor's downgraded US credit-worthiness, critics have been finding problems with what credit ratings agencies do, and how they do it.

Crowded out by the downgrade of US debt and the tumble in the markets earlier this month, a letter sent to the US Securities and Exchange Commission made a telling point. Deven Sharma, the president of Standard & Poor's, argued that the credit rating agencies should not be forced to disclose errors in their calculations, as mandated by the Dodd-Frank Act passed by Congress last year to overhaul the securities market.

Coming only three days after the US Treasury Department found a $2 trillion (Dh7.35 trillion) error in S&P's initial reasoning for the US downgrade, the timing could not have been more inopportune. With mounting pressure in Europe and the United States for increased regulation, the agencies' approach to evaluating risk - and their inability to comprehend the political risks to their own businesses since the 2007 subprime crisis - have inherent problems.

A common explanation has been that S&P was forced to act on US debt to get ahead of the curve, after moving slowly on the subprime mortgage crisis, Lehman Brothers' subsequent collapse and Ireland's sovereign debt. But in its haste, S&P missed an important point: a downgrade of US debt was only as significant as investor reactions. S&P's decision raised questions about rating agencies' own accuracy and role in the markets.

The global market slump after the US downgrade was primarily in equities. Investors were escaping risky assets in favour of safer investments, namely gold, Swiss francs and US debt. Theoretically the debt downgrade should have resulted in yields rising as investors demanded more interest to hold more risk. With the yield on 10-year treasuries falling, and shorter term treasury yields already close to zero, the market has signalled confidence in US debt. This is not a new phenomenon. The downgrade of Japanese debt a decade ago from AAA had little effect on the sovereign debt yield.

Historically, markets have been better than the rating agencies at evaluating risk. The US statistician Nate Silver has shown that the market for credit default swaps, where investors bet in favour of a debt default, is a far more reliable indicator.

The publicity around the US downgrade brought to the fore all of these issues: a $2 trillion error, debt markets ignoring the downgrade, and the pattern of the agencies' lagging behind more reliable indicators. The increased visibility coupled with the bad press from misjudgements exposed by the financial crisis raised questions about the agencies' future. The growing antagonism expressed by governments around the world lends weight to those questions.

In the United States, the Dodd-Frank Act empowers the SEC to strengthen its regulation of the rating agencies, but to date the commission has failed to do so because of a lack of resources. But as can be seen in the defensive letter sent by Mr Sharma, who recently announced his imminent resignation from S&P, the slow wheels of bureaucracy are turning.

At the same time, two Congressional committees are investigating the actions of the credit rating agencies since the 2008 crisis. Members of those committees have expressed not only their disappointment in the downgrade of US debt but also the view that the SEC, among other regulators such as the Federal Reserve and Office of Comptroller of the Currency, was moving too slowly in implementing the new regulations of the Dodd-Frank Act.

The animosity towards the agencies is even more pronounced outside the United States. European Union members have been particularly vocal on recent downgrades of the sovereign debt of Greece and Portugal, among other countries, as euro-zone states spiral further into debt. Downgrades lead to the austerity measures demanded by the credit agencies, which in turn lead to further downgrades as growth stalls. In the euro-zone debate about its future, reining in the ratings agencies has not been forgotten.

An immediate expression of this sentiment occurred at the beginning of the month when Italian police raided the Milan offices of Moody's and S&P. The investigation focused on whether the rating agencies respected Italian financial regulations after a wave of panic hit the Milan bourse in the wake of the Greek debt downgrade.

Perhaps, with all the problems of the agencies' analysis and methodology, the most damning point may be their inability to see the political risks of their own actions in such cases.

After S&P's downgrade, the other two main rating agencies, Moody's and Fitch, both reaffirmed the AAA rating of US debt. But as David Levey, the former director of sovereign ratings for Moody's, wrote (in typical wonk-talk): "Market participants would find ratings almost impossible to use without comparability of meaning. So - in a sense - the markets more or less force equivalence of meaning on the agencies."

What that means in everyday terms is that markets imagine that the agencies all represent the same view. It also means that in the reaction to any one of their ratings, they will all be in it together.

 

Talha Aquil is a financial services consultant and political risk analyst