Human beings want to know where they stand in relationship to others. Being first is important. Capitalist competition pushes the desire of many egos to be #1. Indeed ranking starts early: Being the first to arrive at school, to be on the first team, or to be “in” with the top group in high school. “Rating” persists all through our lives whether it be in selecting starred restaurants, starred videos, or a top brand. Nowhere is it more difficult and important to establish rankings than in economics, and the scandalous misjudgments made by the global rating agencies have led to disastrous consequences, which have not been adequately dealt with.
Whatever group is putting together rankings or ratings, one has to trust their results or they have no meaning at all. That is the question which makes me scratch my head because the top three rating and rated agencies in the US (and the world), Standard and Poor’s, Moody’s, and Fitch all were integral to the greatest economic fraud in history: They handed out top ratings (also known as AAA) to junk bonds which underpinned the real estate market in the United States. This resulted in the economic crisis of 2008, leading to trillions being lost on global financial markets. To date no individual and no company has been fined, jailed, or simply put out of business for this massive and overwhelming fraud. That disturbing lack of a verdict is what prompted me to write this blog entry.
The three principal agencies in question argue in the US courts that their ratings are independent opinions and not statements of fact, and that their legal liability is limited because they have First Amendment protection. The Obama administration has made a conscious and continued effort to avoid criminal prosecution of those responsible at Fitch, Moody’s or S&P but has focused instead on exacting civil penalties from the perpetrators of their criminal acts. The US Justice Department lawsuit for some $5 billion against S&P for issuing ratings that were disastrously off the mark is still under way. S&P will have to prove that their ratings expressed honestly mistaken opinions rather than ones motivated by the desire for higher profits. Most probably there will be settlements of this and other civil lawsuits that are now in process, but nobody will go to jail. More important, no deterrent is likely to result or be established.1
Rating agencies did not exist as businesses until the 20th century. In 1900 John Moody, then only 32 and a Wall Street observer of the tangled and uncertain world of railroad bonds, put together a compendium titled: ”Moody’s Manual in Industrial and Miscellaneous Securities.” This accessible format was such a success that it ultimately launched a new industry. In 1913 Moody’s expanded its service to include a letter-rating system which it borrowed from mercantile credit rating agencies to indicate creditworthiness. His company was also the first to charge modest subscription fees to investors. Poor’s Publishing company followed in 1916, Standard Statistics in 1922 and Fitch Publishing in 1924. All three American agencies provided independent analyses of bond creditworthiness.
The metrics employed by the agencies differed somewhat: ratings by Moody’s reflected what investors might lose in case of default while S&P’s estimated default probability. Of the large agencies, only Moody’s is a publicly held corporation that discloses its financial results. Its high profit margins, which at times have exceeded 50 percent of gross margin, reflect its exceptional pricing powers in this narrowly held industry. Until the 1980s Moody, like its two principal competitors, was principally based in the US, and demand for services was modest because they rated the debt market in an era where companies borrowed mostly from banks, dealing with structures they could understand and individuals they knew. Then, under Reagan and Thatcher, the financial system became less regulated and corporations began to borrow more from the globalized debt markets. As a consequence, evaluations of the credit rating agencies steadily increased in scope and importance as did concern and scrutiny about their reliability and alleged or suspected illegal practices.
In the mid-1990s, after the collapse of the energy firm Enron, both Moody’s and S&P became the target of dozens of lawsuits from investors alleging profound rating inaccuracies. Structured finance also entered the picture with such “financial engineering” marvels as “sub-prime mortgage backed securities” (MBS), collateralized debt obligations (CDO) and “synthetic and squared CDOs” which even most bankers found difficult to price or even to understand. However, these complex structures became increasingly profitable for the rating agencies. By 2006 Moody’s earned close to $900 million in revenue from structured finance. By the time of the crash of 2008, there were over $11 trillion structured finance debt securities outstanding in the US bond market. Of the mortgage backed securities that Moody’s had top-rated with AAA ratings in 2006, three quarters were downgraded to junk just two years later!
Executives from the big three explain that ratings are a simple symbol system to express relative creditworthiness or the risks involved. The rating grades (or relative risks) are usually expressed through a variation of an alphabetical combination of upper and lowercase letters. Generally the agencies have not been as vigilant with those corporations that paid them for high ratings but were aggressive in rating those that did not. The verdict is not yet out whether the ratings produced by the top three in evaluating the collateralized mortgage securities that were given gold-plated endorsements rather than branded as rubbish were the result of negligence or incompetence rather than greed and malpractice.2
Although there are over 150 rating agencies internationally, the two big American credit raters (Moody’s & S&P) control 80% percent of the global market and unbelievably are still the only ones to have high credibility. The big three issued over 97% of the credit ratings in the US, giving them powerful pricing leverage. This brought them profit margins of about 50% in the first decade of this century and levels have not fallen dramatically since then. Partly this is because by US law many investors are permitted only to buy bonds (for pensions and other holdings) that have AAA ratings. Banks, in turn, may adjust their risky investment packages in order to satisfy the rating services. Then bond investors will worry about the very willingness of the rating services to give better ratings in order to encourage banks to issue lower quality bonds. S&P, for example, developed and relied on models which took into account economic assumptions and potential losses in order to come up with inflated ratings. I am describing this spiraling effect only to show the reason I believe the current structure of these ratings groups should be terminated. My conviction is strengthened by the fact that these agencies also advise their corporate customers where best to domicile their headquarters and how best to circumvent national laws and avoid governmental taxation.
In the United States in 2010, in reaction to the disastrous impact of S&P and Moody’s ratings on the global economy, the Congress passed the Dodd-Frank Act which called for federal officials to review and modify existing regulations in order to avoid the reliance on credit ratings as the principal assessors of creditworthiness.
In an attempt to rescue its fallen standing, S&P took the unprecedented step in 2011 of downgrading the AAA ratings of US government bonds because of Washington’s inability to get its financials in order — as evidenced by the fiscal cliff on which it had then been balancing. The Secretary of the Treasury countered by saying that S&P had “shown a stunning lack of knowledge about basic US fiscal math.” He also pointed out that S&P’s sovereign debt team miscalculated the US debt by nearly $2trillion! When the Justice Department then asked for $5 billion in 2013 to recover losses it said federally insured institutions suffered as a result of these faulty ratings, S&P dramatically replied that the US government was only trying to retaliate for its downgrade. The courts may eventually rule that there is a conflict of interest for the Treasury to penalize S&P for having given a fair rating against its own interests.3 In the meantime S&P continues to offer underwriters more desirable bond ratings than their competitors in order to get their business.
“Sometimes it is hard to dismiss the impression that some American rating agencies and fund managers are working against the Eurozone,” said the former German economics minister Rainer Bruederle.4 In January 2012, amidst continued economic instability, S&P had downgraded nine European countries including the AAA ratings of France and Austria. In November 2013 S&P went further and cut down France’s rating from AA+ to AA, expressing doubts over France’s ability to restore growth. Economists like Paul Krugman viewed this further downgrade as politically motivated. France was raising taxes and rejecting austerity and this went against the right wing position that spending on benefits, health and social security should all be cut as well as taxes. S&P had been eager to demonstrate that its ratings were tough and principled in order to counter-act all the damaging publicity it had received for its role in the global crash.5
The potential for downgrades to destabilize member countries became so strong this year that the European Parliament agreed to a set of rules designed to slowly rein in S&P and Moody’s as well as the smaller rating agencies. The Brussels parliamentarians also wanted to encourage financial firms and others to do their own credit assessments. In the US, The Securities and Exchange Commission has had trouble hiring inspectors who will ensure that those who determine the ratings are not involved in marketing the services of their agency.
So we must ask, does a globalized world with many fragile and unstable economies really need such fundamentally implausible rating agencies as S&P and Moody’s? Managed by greedy fortune-tellers, these agencies have been seen to intimidate politicians, corrupt the markets, and destabilize national economies. New rules and regulations are not the answer. The response so far has been that the rating groups, aided by lobbyists, simply devise new ways to avoid any new rules and run in circles around the bureaucrats hired to monitor behavior.6
As the rating agencies have lost the confidence of the business community, I suggest that the time is ripe to create an over-arching international and inter-governmental agency to rate not only bonds and corporations but also sovereign debts. Such a public agency staffed by economists and administrators from the IMF, World Bank, the OECD and the United Nations could report to the G-20. Predicting uncertainty can never be perfect, but it would be far better for all the people and nations of this world if the giant ratings cartel was operated as a non-profit, public service. Perhaps it would be an organization in which bureaucratic boredom would prevail, as in many UN agencies, and where no one would be particularly concerned about the ratings it could routinely produce.
1Floyd Norris, “Stumbling over audits and ratings,” The New York Times International, August 22, 2014
2Sam Jones, ”When junk was gold,” Financial Times (Weekend),October 19, 2008
3Nathaniel Popper, “S&P’s rating habits,” The New York Times International, August 2, 2013, p.2
4Patrick Kingsley, “Making the Grade,” The Guardian, February 16, 2012
5Paul Krugman, “The plot against France,” The New York Times, November 12, 2013.
6Donald J. Johnston, “An alternative to the ratings agencies,” The New York Times, February 12, 2013