This Valentine’s Day: give credit the competition it deserves
stephen clarke, 14 February 2012
Bankers, politicians, regulators, economists, imprudent mortgage lenders, credit rating agencies… the list of villains in the story of the financial crisis is long and each group has been keen to rectify their tarnished image. The need for a bout of rehabilitative PR may explain the active, almost combative stance taken by the ratings agencies recently, with Moody’s placing the UK’s credit rating on ‘negative outlook’ today.
In the build-up to the financial crisis the big three credit ratings agencies (Moody’s, Standard and Poor’s and Fitch), who control 95 per cent of the market, were accused of being asleep at the wheel: ‘AAA’ ratings were routinely given to the mortgage backed securities that eventually suffered large losses and brought the financial system to its knees. The ratings agencies, along with risk-management departments across the financial sector, ignored the fact that securitisation had not reduced the risk of holding mortgages whose chance of default was highly correlated. The ratings agencies also failed to notice the problems arising in the Eurozone, almost treating each country as if they had the same economic fundamentals (Greece and German bond yields were virtually identical at the beginning of 2007).
It is perhaps no surprise that since 2007 the ratings agencies have been keen to distance themselves from criticisms that they are inept or adopted the interests of those they were meant to be neutrally assessing. Standard and Poor’s downgraded America’s credit rating last year, along with a handful of Eurozone states, and Moody’s seems to be responding in kind in 2012, taking a more critical look at a number of European countries.
On the face of it this reinvigorated activism on the part of the ratings agencies is encouraging, more critical oversight is exactly what ratings agencies should provide, one could even argue that it is better for a credit rating agency to be bearish than bullish. Nevertheless two criticisms have been levelled at the ratings agencies, one of which is unfair, whereas the other deserves fuller examination.
The first criticism; that the ratings agencies actions are reflexive and arbitrary and in many respects do not have the ‘desired’ effect is unwarranted. Many note that when S&P’s downgraded the US, American bond yields scarcely budged and even fell. Others note that a downgrade of Greece is a bit like putting a no swimming sign on a beach after a tidal wave has hit. In both cases S&P’s actions did not alter perceptions a great deal, investors continue to view US bonds as safe and few are willing to touch Greek debt. Nevertheless this misses the point, the job of a ratings agency is to rate bonds, or other financial products as accurately as possible, it is what investors or regulators do with those ratings which is important and this is where the other criticism is important.
The main problem with the ratings agencies is that there is little, if any, real competition. The top three firms control 95 per cent of the market, but the top two (Moody’s and Standard & Poor’s) control 80 per cent and in many cases where these two agree a further rating is rarely sought. This lack of competition has two ramifications: first, investors are robbed of dissenting and contradictory voices that could improve the accuracy of a rating by drawing attention to a flaw in the analysis by the big two or three. Second, regulators are stuck enforcing rules that rely too heavily on the ratings of two or three firms. In many cases ratings are used to govern how investors, especially institutional investors or banks, invest money or match assets and liabilities. This is itself can be problematic if rules replace prudency. It would perhaps be better if a stronger fiduciary duty replaced dogmatic adherence to rules. Nevertheless if rules using ratings are necessary, and there is probably a place for them, then it is better if there are more bodies providing these ratings. There are hundreds of national and regional agencies that could increase their share of the market if antitrust and competition authorities took action and rules could be altered so that those required to hold assets of a certain quality could make investment decisions based on a weighted average of ratings rather than just one or two.
The Dodd-Frank reforms in America have already restricted or banned the use of credit ratings in some situations; a better response would be to allow more competition into the market. This should be borne in mind by regulators in other countries as they implement their own reforms.