Wednesday 14 November 2018

EU could give US ratings agencies run for their money

Peter Casey tells how the credit ratings agencies screwed Ireland – and suggests how we stop the madness happening again

BULL: Photo: Daniel Acker
BULL: Photo: Daniel Acker
Peter Casey

Peter Casey

While the financial crisis of 2007-2008 was global in scope, it hit few countries harder than Ireland.

The catastrophe was compounded by many elements, but a single catalyst made it explode.

As the US Financial Crisis Inquiry Commission concluded in 2011, the crisis could not have happened without the credit ratings agencies (CRAs).

In hindsight, an obvious conclusion. During 2000-07, one of the so-called big three CRAs, Moody's Investor Services, gave AAA ratings to some 45,000 mortgage-backed securities, 83 per cent of which were ultimately downgraded.

The track record of the other two big three firms, Standard & Poor's and Fitch Ratings, is comparably dismal.

Between them, the Big Three today issue 98 per cent of all US credit ratings and 95 per cent worldwide.

As history makes clear, their corner on the ratings market comes not from being great at what they do but from the monopoly US law grants them.

The US Securities and Exchange Commission (SEC) currently anoints nine CRAs as "Nationally Recognized Statistical Rating Organisations" (NRSROs), of which the Big Three are by far the biggest.

The law requires issuers of securities traded in America to hire an NRSRO to rate each investment it offers. By law, these companies have the authority to distinguish "investment grade" from "speculative" securities.

Since 1936, the SEC has effectively outsourced much of its regulatory authority to these publicly traded, for-profit enterprises.

And yet the government is not their customer. The security issuers are – the very firms that are being rated. They pay the bills that keep the Big Three in business.

And a very good business it is. S&P reported $2.61bn in revenues for 2009, Moody's $2.032bn in 2010, and Fitch Ratings $732.5m in 2011. During 2004-2009, the ratings club had profit margins of 50 per cent.

The potential for conflict of interest in this arrangement isn't just obvious – it's blatant. Indeed, worse than blatant, because the conflict isn't the only reason for a sorry string of catastrophically wrong ratings.

In addition to facilitating the global subprime mortgage Armageddon (2007-2008), the Big Three failed to detect the greatest financial disasters of the past 40-plus years: the Penn Central Railroad bankruptcy (1970), the New York City financial crisis (1976), the default of California's Orange County (1994), multiple crises and collapses in Russia and Asia, the implosion of the Long-Term Capital Management hedge fund (1998), and the epic bankruptcies of both Enron and WorldCom (2001).

Besides conflict of interest, sources of this ineptitude include inadequate analysis of historical data; bargain-basement analysts; and an inflated reputation (the US government uses the ratings as regulatory instruments, so they must be reliable).

Above all else, though, it comes down to a breathtaking absence of accountability, let alone legal jeopardy.

The CRAs are liable for losses caused by the inaccuracy of their ratings only if it is proved in court that they knew the ratings were false or they exhibited a reckless disregard for truth in issuing them.

Otherwise, CRA ratings have been consistently protected as "free speech" under the First Amendment to the US constitution.

Moreover, although a rating has the force of law, it is always issued with a disclaimer to the effect that "ratings are statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities".

Translation? The US government says you have to take me seriously. Just don't take me seriously.

So let's go back to the mid-2000s, when Irish banks, heavily dependent on foreign investment, poured that investment into property loans.

These inflated the valuation of Irish property and blew a bubble bound to burst when the global interbank market froze in 2007-2008, prompting account withdrawals that drove Irish banks to the brink of insolvency.

With loan money unavailable, the property market collapsed and, with it, the principal asset of Ireland's six main domestic banks evaporated.

In early 2009, the Irish government began covering the banks' liabilities. In October, it committed to a monumental re-capitalisation scheme.

How, we still wonder, could Ireland's biggest banks, best-known business people, and government experts have ignored overwhelming evidence that US subprime mortgages were a disaster?

Dumb greed surely played a part, but, just as surely the ignorance was abetted by the Big Three, which gave the Irish banks and Irish subprime funds "investment grade" ratings long after they had slid into junk status at best or near-insolvency at worst.

The CRAs drove Irish investors, financial managers, and the government down a very dark road.

So, picture yourself shivering by the side of a country lane in the pouring rain because your tank is empty even though the needle of your fuel gauge showed full. Upset?

Now add to that scenario your discovery that the people who made the gauge made their money by making it wrong. Now you're mad as hell.

The gauges made by the CRAs, bought and paid for by their client financial firms, persistently pointed to AAA, prompting the Irish financial community to drive on empty.

Could it happen again?

Well, on July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, which removes CRA ratings from free speech protection.

This was a step in the right direction, but, four years later the provision has yet to be applied because of delays in revising SEC rules.

Okay, Dodd-Frank also requires each CRA to publicly disclose how its ratings have performed over time, and the law also tries to remove from the ratings the halo of US government authority by purging all federal statutory references to CRAs. The references have yet to be purged.

Dodd-Frank also calls for new regulations to avoid assessing creditworthiness solely based on CRA ratings.

These regulations, too, have yet to be enacted.

Clearly, America's steps toward responsibly regulating rating enterprises – whose effects are global – have been excruciatingly halting.

The EU is talking about setting up a European competitor to the Big Three.

That would be a bold step, much needed to hold financial reporting to strict account enforced by legal jeopardy.

But we need it now.

Neither the Irish economy nor that of the international community can wait another year, let alone another four.

Peter Casey is executive chairman of Claddagh Resources, and a panelist on RTE's 'Dragons Den'

Twitter: @TheDragonPeter

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