Do Credit Ratings Still Matter?
In the four years since the banking crisis began, a familiar pattern has emerged regarding the nation’s credit ratings agencies: One will issue a downgrade, and the market generally reacts with a collective shrug of the shoulders.
When Standards & Poor’s decided last summer to downgrade the U.S., investors responded by purchasing even more U.S. debt. The same was true for U.K. debt in February after Moody’s Investors Service issued a “negative” outlook for the nation. And on Friday, one day after Moody’s downgraded 15 of the world’s largest banks, investors responded by sending up shares of the affected firms.
To some degree, the muted response can be explained by the the ratings agencies being seen as lagging indicators. Their analysts work with the same data as the rest of the market, so by the time a downgrade is announced, investors have already priced in the decision.
Another issue is the credibility of the rating firms, which remains badly bruised following their role in the financial crisis. Though they’re supposed to protect investors by gauging risk in the marketplace, during the housing boom, for example, the three major firms — Fitch Ratings, Moody’s and Standard & Poor’s — awarded their highest ratings to billions of dollars worth of assets that would later be deemed worthless.
Today, that means the firms are much more sensitive to being seen as playing catch up, said Morris Goldstein, a senior fellow at the Peterson Institute for International Economics.
“Since they’ve been accused of being so late in the past … they try and make sure that they’re not going to be late in the future,” Goldstein said. “So if they see things weakening at major financial institutions, knock them down. They see debt problems in the U.S., they drop the credit rating.”
Nonetheless, that lingering skepticism is worrying, says Dennis Kelleher, the president and CEO of the Wall Street watchdog firm Better Markets. If anything, last week’s downgrade should have been read as a warning that even the biggest banks in the country are just “marginally solvent.” Instead, he said, the market is ignoring the announcement and “counting on the Fed bailing every one out again.”
The Dodd-Frank financial overhaul expanded oversight of ratings firms by establishing an Office of Credit Ratings within the Securities and Exchange Commission. The new office will centralize oversight of the firms and issue annual reports on their performance.
Still, regulators continue to struggle with implementing several major components of reform, including breaking the compensation model that allows companies to pay the very firms that are rating them.
Take Morgan Stanley, for example, which in February was warned by Moody’s that it was in danger of receiving a three-notch downgrade by the firm. Bank officials responded by meeting with Moody’s analysts to convince them that their assessment of Morgan Stanley was too pessimistic, The New York Times reported.
“These meetings often resembled a monologue with Morgan Stanley talking and Moody’s listening,” one anonymous attendee told The Times.
On Thursday, when Moody’s listed Morgan Stanley among the banks it was downgrading, it only cut the firm’s rating by two notches.
“That raises the whole question which is how much did Morgan Stanley beat up the raters so that they didn’t go down three notches,” Kelleher said.
A separate issue facing regulators is removing barriers to entry into the marketplace for other ratings firms. One relative newcomer, Kroll Bond Ratings Agency Inc., has been seeking to compete with the three dominant firms by offering clients what it describes as a more forensic approach to ratings. The challenge for upstarts like Kroll, however, is that many regulatory filings and investment contracts require a rating from one of the three major firms.
Nonetheless, increased competition may be an antidote to the industry’s compensation model, according to at least one recent study that found that companies are more favorably rated when fewer analysts are studying them.
In the meantime, the SEC continues to study seven alternative models proposed by the Government Accountability Office to correct the compensation structure of the ratings industry to avoid conflicts of interest. One plan under review is a random selection model, whereby issuers would continue to pay for ratings, but rather than pay the credit agencies directly, they pay a government board which would then randomly assign the rating to Fitch, Moody’s or S&P.
Breaking the current model is key, say critics like Kelleher.
“If you’re in the business of making money and how you make your money is by the number of people who hire you to rate their securities — and of course they want their securities rated as high as possible — it’s just almost impossible to ask an organization under those circumstances to act against its own economic interest and do the right,” Kelleher said.