There are any number of organisations and individuals who can be blamed for the credit crunch, but right up there at the top of any league table of culprits – along with the bankers, credit-drunk consumers, half- asleep policy makers and incompetent regulators – would have to be the credit rating agencies, those shadowy creatures that sit in judgment over the trillions of dollars of debt that swirl around the world's money markets. By assigning a top-notch, triple-A rating to many of the products that emerged from the boom in "structured finance", the credit rating agencies played a pivotal role in fostering the mad dash into sub-prime mortgage lending which eventually triggered the worst banking crisis since the Great Depression. The rating agencies had thought the risk of default negligible, yet when the balloon went up, many of these "asset-backed securities" turned out to be worthless. To make matters worse, the agencies then rushed to catch up and, by downgrading vast tracts of debt previously thought safe, helped prompt an extreme retreat from risk that caused the banking system to fail and economies to collapse into recession. The sub-prime meltdown is only the latest offence in a serial list of failings, be it the Latin American debt crisis of the 1980s, the Far Eastern crisis of the 1990s, Enron, and just about any other major default you can think of in recent history. In all cases, the rating agencies failed to see it coming. The charge list is damning, yet despite this latest, calamitous example of wrong-headedness, little is being done to reform the industry, curb its powers, or monitor its activities. With fiscal deficits around the world going out of control, the focus of credit markets has shifted from sub-prime to sovereign debt. It's not just the future of mortgages and corporations that the agencies preside over. Like Caesar, they can dispense life and death to entire countries, too. Discredited the agencies may be, but governments still hang on their every word and live in terror of a downgrade from the ranks of "teenage scribblers" they employ. The greater the perceived risk of sovereign default, the more that has to be paid for borrowings and the less there will be for spending on hospitals, schools and public services. Whole teams of British Treasury officials are employed to sweet talk the agencies into a fuller understanding of the security of our fiscal position. Since the economic crisis started, Ireland has already been stripped of its Aaa credit rating, and though there is as yet no serious threat to Britain, the rating agencies have warned that unless more is done after the election to address the explosive growth in public debt, the UK, too, could be vulnerable. Only this week, Moody's placed Britain in a less safe category of Aaa-rated nations than Germany and France. Many of the peripheral eurozone nations are already directly threatened with downgrades from lower ratings. So who are the credit rating agencies, why are they are so powerful and, given their manifest failings, why does anyone still take them seriously? Part of the problem with credit rating is that there are only three organisations of any importance that do it – Fitch, Moody's and Standard & Poor's. Rating the world's debt is an expensive business, requiring thousands of analysts around the globe. Only three agencies have attained the critical mass necessary to allow for a comprehensive service. Undue reliance on this limited choice of credit assessments has accentuated the consequences of any misjudgment. Necessarily in many respects, investors have become overly reliant on their judgments. The range and quality of debt instruments available on world markets is so vast as to be virtually impossible even for very large, institutional investors to assess individually. Investors have thus become ever more dependent on the agencies to do it for them. This in turn has encouraged a herd-like approach to debt, which is universally and sometimes blindly accepted as of good quality if the agencies say so. The consequent "outsourcing", or abdication of investment judgments to a relatively small number of rating agencies, was one of the key causes of the explosive growth in credit markets, for if debt issuers managed to pull the wool over the eyes of the agencies, they would also gain the support of investors, who would buy oblivious to underlying risks. As the good times rolled, almost any old junk became repackaged as gold standard credit and was awarded a triple-A rating. What began as a public service to bond markets became an accident waiting to happen. As Lloyd Blankfein, chief executive of Goldman Sachs, has observed, in January 2008 there were only 12 triple A-rated companies in the world and only about the same number of countries too, but at the same time there were 64,000 structured instruments, such as the notorious Collateralised Debt Obligations (CDOs), which were rated on the same basis. Bizarrely, securities backed by mortgages sold to people without the income to service the debt they were taking on were being judged a better credit risk than the sovereign government of Japan, with the ability in extremis both to raise taxes and print money to avoid a default. The agencies had failed to model adequately for a fall in the housing market or a rise in individual mortgage defaults beyond historic norms. Worse, their entire business model had conspired to produce just such a catastrophic oversight. Ever since the development of the photocopier, it has been increasingly difficult for the agencies to charge investors for their services. So they take their fee from the debt issuer. The potential for conflict of interest is obvious. What little competition there is among the rating agencies seems confined to that of producing the most favourable rating, for no debt issuer wants to pay for an adverse assessment. Predictably, regulators have compounded the problem by themselves blindly placing too big a reliance on the ratings. Because banks were required to hold less capital against Aaa-rated securities, they maxed out on CDOs. Worse, one of the reasons British banks ran out of money to pay their depositors was that with regulatory approval they were holding a substantial proportion of their liquidity pool, designed to meet heavy withdrawals, in triple A-rated American mortgage-backed securities that turned out to be worthless. In defence of the rating agencies, they didn't ask to be trusted as completely as they were and have never pretended to be able to predict individual defaults. As Chris Huhne, a former managing director of Fitch Ratings and now the Liberal Democrat home affairs spokesman, points out, the function of a credit rating is to assess the probability of a default based on analysis of historic data. With Aaa-rated securities, the risk of default is meant to be negligible, maybe 0.1 per cent, but every now and again even a triple A will go belly-up. The problem occurs when there is financial innovation, and therefore no data by which to judge the security. This lack of history will invariably make the product more risky, but like a new-born baby, the security will be sold as flawless. If the product begins to gain traction, everyone wants a part of the fees it generates, including the rating agencies, and all caution is thrown to the winds. This time it's different, the debt issuers promise; but of course it never is. There's a pretty extensive history with sovereign debt, the latest area of explosive growth in credit markets, so you might think that at least the rating agencies would get this one right. Ignoring devaluation and inflation, which can be as effective a method of default as the real thing, Britain has only once in the entire history of government bond markets been in technical default on its debt – on war loans during the 1930s. There is virtually no chance of that mishap being repeated. Yet because of the deep recession and the co-ordinated fiscal approach to it, the rating agencies feel obliged to assess the possibility of meltdown, where the country becomes incapable of servicing its debts, or prints so much money that the debt becomes worthless. On this front, there's very little for the agencies to go on, since never before have so many big advanced economies all at the same time been so fiscally challenged. Some are plainly going to be better than others at easing themselves out of the mire. Conscious of the mistakes made over sub-prime, the agencies are applying an ultra-cautious, safety first approach. All the same, it's odd, to put it mildly, that Moody's thinks France more secure in its triple A-rating than Britain, even though France's debts will end up as big and it has no plans for fiscal consolidation. When a fiscal crisis hits, it tends to do so rapidly without much warning. A dime to a dollar that when it does, the rating agencies will again be left struggling to catch up – and their clients wondering what on earth happened.Credit rating agencies: the untouchable kings of finance
Their judgments can change the fortunes of nations, but why do the rating agencies still wield such power, asks Jeremy Warner.
Friday, 11 December 2009
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