EU completely misses the target on rating agency reform – a Mindful Money view

17th January 2013

The European Union has voted overwhelmingly to clamp down on ratings agencies, but Mindful Money asks why they bothered if they were going to miss the target so spectacularly.

What has happened?

The European Parliament has just voted by 599 votes to 27, with 68 abstentions for a ‘clampdown’ on ratings agencies reported here on trade website Money Marketing.

It means, among other things, that agencies will only be able to pass their verdict on sovereign ratings – i.e. those applying to countries – three times a year at specified times and when the bond markets are yet to open.

The legislation says that a rule breach will allow investors to sue for damages irrespective of any contractual relationship – admittedly quite a tough rule.

They won’t be allowed to recommend policy changes to Governments. This is a bizarre requirement in Mindful Money’s view which actually undermines the usefulness of a rating in the first place.

Agencies cannot issue ratings or must disclose that ratings may be affected if a shareholder or member holding 10 per cent of the voting rights in the agency has invested in the rated entity. Mindful Money thinks the focus is on the wrong conflict of interest. More on that later.   

The EU Parliament also says it wants the investing institutions themselves to carry out more work rating creditworthiness – not necessarily a bad thing – and to encourage the EU to create its own creditworthiness assessment.

Why is this the wrong approach?

It is very difficult to know where to start. But here is the first issue. The EU is attempting to get a stronger grip on agencies when they downgrade or conceivably upgrade countries. The fear is that these ratings can become self prophesising, that they have exacerbated the eurozone crisis and that when they rate countries they are somehow serving their own interests.

Mindful Money suspects that this is – mostly – nonsense.  

In terms of grading sovereigns, this is where agencies for all their faults have been more or less in the right ball park, which is more than can be said for other things they have rated. Certainly we think investors and the world would be less well informed without them.

What is the real risk?

The real problem lies first with the inherent conflict of interest in the business model i.e. the  fund manager, the investment firm that created this or that financial instrument or package of financial instruments or the companies issuing bonds – generally pay the agencies to rate them.

For all their protestations there is a huge potential conflict in this model. There is an obvious temptation to rate a particular firm or instrument more easily in order to win more business.

This doesn’t mean it is happening, but the risk remains especially when the big three, S&P, Fitch and Moody’s have roughly 90 per cent of the market.

The biggest mistake was almost breathtakingly huge

The real mistake came during the first phase of the financial crisis or just before it, when the agencies followed the herd – into a crocodile infested river.

Where things went spectacularly wrong, it was in the rating of financial instruments such as mortgage backed securities, collateralised debt obligations and the like – packages of mortgage and other loans supposedly with mixed levels of risk, the attached insurance contracts or contracts derived from them.  

The underlying assets were mortgages and loans in the US or elsewhere, many of which were sub-prime though they could be buried quite deeply beneath other layers of 'financial engineering'. The whole thing was the biggest financial bubble the world has ever seen.  The agencies got the risk of these products spectacularly wrong.

By getting this wrong, the agencies also completely miscalculated the ratings of financial institutions reliant or at least significantly exposed to billions of pounds, euros and dollars worth of these instruments.

For example – Lehman Brothers, Bear Stearns, RBS, UBS, HBoS to mention but a few – in fact a big proportion of the City of London, the investment arms of Europe's banks and
just about all of Wall Street.

This failure has nothing whatsoever to do with downgrading France, the UK, Spain or Leichtenstein or indeed any sovereign, either three times a year or every other week in the middle of the night or the middle of the bond trading day. 

One initiative that may improve things 

The ratings agencies are now scrutinised in the US, EU and UK by regulators including the UK consumer watchdog Financial Services Authority though smaller players say this has simply played into the hands of the big three. 

Two solutions not embraced

1) Set up a supra-national state backed rating agency. This idea still has support and a passing mention in this EU legislation. But it looks very unlikely to happen and has zero support across the Atlantic.

2) Set up a body which will effectively designate which agencies rate which products and instruments on a number of criteria or at least enforce a rotation every few years. This required legislation has been stymied in the US and appears to have been dropped from the EU proposals.

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