3rd February 2012
Many believe the credibility of rating agencies generally has been permanently tarnished by the scandal mortgage-backed securities, but is there really any bias in their ratings? And if so, who has been worst hit?
In the middle of this month, S&P downgraded nine European countries, including France. Senior European politicians have been vocal in their criticism of ratings actions: "European Commission President Jose Manuel Barroso said Moody's decision to lower Portugal by four notches and maintain a negative outlook was fuelling speculation in financial markets. Europe was looking at getting away from its reliance on the mainly U.S.-based ratings companies and weighing possibilities for legal redress, he added.
"His view was seconded by Germany's finance minister, Wolfgang Schaeuble, who said Portugal's downgrade was totally unjustified in present circumstances, when the country was taking steps to put its finances in order."
European politicians accuse the rating agencies of bias against the Eurozone, while being slow to downgrade the US where the debt burden is equally huge. But there is a substantial body of thought that suggests that the rating agencies are simply doing their job. Jon LoGotti community member on the Huffington Post site says: "Rating agencies are finally doing their job and have become credible again…If a country has excess liabilities such as Greece, which will never be able to be paid back, then the only viable option is a default. Don't shoot the messenger…rating agencies are merely financial auditors."
Others see something altogether darker at work. While Aikaterina says: "The rating agencies will see a high grade for a higher fee. That's what they did in the US…It's not that the agencies have a bias against the EU, but that governments haven't paid them enough to buy or bribe them into giving investment grade ranks on their notes."
This is a myth that persists as a legacy from the mortgage-backed securities scandal. However, as credit consultant Marc Joffe points out in this piece, the issue of paying for ratings does not occur with sovereign debt:"The analysts who assign ratings to structured finance instruments and those that assess sovereign bonds are different people, working in different groups, using different methodologies. More importantly, the commercial considerations that might bias sovereign ratings are totally different from those that impact assessments of structured assets."
Joffe admits that credit agencies may have been slow to recognise the issues in developed markets, but that is not an issue of bias: "The leading credit rating agencies are belatedly awakening to the fact that a dysfunctional political system and long term fiscal imbalances have created significant risks for Treasury investors. Now these agencies, led by S&P, are beginning to provide investors with insight into the unfolding situation, largely free of the biases that affected them during the 2007-2008 credit crisis. That said, investors would ultimately be better served by measures of advanced economy sovereign risk that react more quickly and are less burdened by potential conflicts."
However, in this Joffe does reveal a more significant bias among the ratings agencies: that against emerging markets. This is something Stephen Grenville brings out in his blog here: "One other foible of the rating agencies is that emerging countries are consistently marked more harshly than the mature economies. Greece was still rated as 'investment grade' by one of the agencies until early this year, while good credit risks in well-performing economies, such as Indonesia, are still not rated 'investment grade'." Emerging market fund managers have commented that both strength in emerging markets and weakness in developed markets is assumed to be temporary, leaving a lingering bias.
However, there is a question over whether this matters. Investors are already breaking their reliance on rating agencies and the credit default swap market is often seen as equally important in judging a country's relative credit risk. Grenville concludes: "Financial markets are way ahead of the rating agencies, shifting their investments towards the high-yield countries such as Brazil and, in doing so, creating another problem: too much capital inflow and upward pressure on exchange rates. At the same time, markets have taken no notice of the Standard and Poor's downgrade of the US at the time of the debt ceiling impasse. A downgrade should have encouraged bond investors to demand a higher yield, but instead US yields have fallen sharply: investors, at least, still think the US is a safe bet."
Recently downgraded countries may be quick to see bias, but if anything, the rating agencies have been slow to downgrade the Eurozone and slow to upgrade emerging markets. This suggests that Eurozone markets may have had an easier ride than they could reasonably have expected.
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