Who'll tame the power of rating agencies to break governments?
THE anxiety with which the Government awaits the decision of the bond rating agency Moody's on whether it will raise its rating of Irish government bonds to 'investment' status is a reminder of US author Thomas Friedman's assertion that there are two superpowers in the world, the United States and Moody's Bond Rating Service. According to Friedman: "The United States can destroy you by dropping bombs and Moody's can destroy you by downgrading your bonds."
The downgrading in 2010 of Irish government bonds to near junk status by the agencies led to the interest rate on Irish government bonds rising to an unaffordable level, so that Ireland had to seek the EU/IMF bailout.
The first rating agency was established in 1909 by John Moody to rate railway bonds. Poor's was set up in 1916, the Standard Statistics Company in 1922 and Fitch's in 1924. Poor's and Standard merged in 1941, leaving three agencies dominating the market for bond ratings. Bonds were rated AAA, BBB etc . . . with pluses and minuses to give finer gradations.
Many of the bank failures in the US during the Great Depression were due to banks buying risky bonds on which the issuer subsequently defaulted. To prevent a recurrence of such investments, US bank regulators prohibited banks from investing in any bonds below 'investment grade'. This led to the ratings of the three agencies acquiring the force of law.
When the agencies were originally established, they sold their ratings to bond investors, but in the 1970s the rating agencies changed from an 'investor pays' to an 'issuer pays' model. Requiring issuers to pay created a conflict of interest, as a rating agency now had an incentive to give a good rating to a dubious bond, lest the issuer seek a rating from a competing agency.
Although the judgment of the rating agencies has statutory recognition, the ratings are always qualified by the disclaimer that ratings should not be relied on in making investment decisions.
Until the 1990s, the agencies argued that bonds given lower ratings had a higher rate of default than those given higher ratings. As the ratings were partly based on observing the spreads on relevant bonds over low-risk government bonds, they simply reflected the market's view of the bonds and did not provide any additional information.
The agencies were also very slow to change ratings when a company's performance changed, arguing that they "rated over the cycle". The folly of this approach was shown by the fact that rating agencies were still giving Lehman Brothers' bonds an 'investment grade' rating on the morning the bank declared bankruptcy.
When the bonds backed by subprime mortgages proved worthless, it was discovered that the agencies were closely involved in the design of the bonds that they were rating. Many bonds rated AAA were downgraded to junk bond status after the banking crisis.
In the wake of the subprime disaster, the rating agencies have lurched to the opposite extreme and have downgraded many corporate bonds, but, more importantly, they are eager to offer unsolicited downgrades on sovereign bonds.
While Moody's has upgraded its rating of Irish bonds from 'negative' to 'stable', the 'stable' rating prohibits some pension funds, insurance and investment funds from investing in Irish bonds.
The failures of the rating agencies have led the EU to propose new rules governing the selection and payment of agencies and the establishment of a European authority to regulate the ratings agencies and that agencies be prohibited from issuing unsolicited sovereign debt ratings. The EU proposes that responsibility for sovereign debt rating in the EU be assigned to an independent EU agency.
These proposals are being fiercely resisted by the three global agencies and the EU has dropped the proposal that debt issuers would have to rotate between agencies.
Despite their abject failures, the agencies still retain the power to impoverish countries and governments seem unwilling to curtail this power.
Sean Byrne lectures in economics at the Dublin Institute of Technology