“If we really want to rub their faces in it, then the only way is to increase revenues and for every Greek to pay the taxes they are supposed to. If that happens, then we won’t need Moody’s or anybody else.” In his own inimitable style, Deputy Prime Minister Theodoros Pangalos’s blew open in Parliament on Friday an issue of public debate while displaying all the subtlety of a bulldozer trying to open a safe.
Although he was more forthright than others, the veteran PASOK politician was expressing an opinion that reflected the mood of many voters and MPs. His comments came just a few days after Moody’s, one of the three credit rating agencies that have been observing the Greek economy with the intensity a menacing stalker, downgraded Greece’s debt — already at junk status — by three notches, to B1 from Ba1 and suggested Athens would not be able to repay its debt without some form of restructuring. Moody’s also downgraded six Greek banks in the same week.
The feeling in Athens was that Moody’s provided a skewed assessment of Greece’s economic prospects and that the timing of its downgrade, just a day before Athens auctioned 1.6-billion euros’ worth of sovereign bonds and four days before a crucial eurozone leaders’ summit, was damaging. Finance Minister Giorgos Papaconstantinou provided a cutting response to Moody’s latest rating.
In a letter to the European Commission, the European Central Bank and the head of the Eurogroup, Jean-Claude Juncker, on March 10, he argued that Moody’s was only seeing the negatives in Greece and was making it much more difficult for Athens to access international markets and borrow at reasonable rates, thereby risking the creation of “self-fulfilling prophecies.”
“Ultimately, Moody’s downgrading of Greece’s debts reveals more about the misaligned incentives and the lack of accountability of credit rating agencies than the genuine state or prospects of the Greek economy,” Papaconstantinou said in his letter. “Having completely missed the buildup of risk that led to the global financial crisis in 2008, the rating agencies are now competing with each other to be the first to identify risks that will lead to the next crisis.”
Critics will say that the Greek finance minister’s response is just sour grapes from a politician who knows his country is struggling to get out of a deep hole but does not want to admit it publicly. In fact, even the most patriotic of Greeks would find it hard to disagree with much of Moody’s assessment. The ratings agency acknowledges the country has made “very significant progress” in reducing its deficit but that the “task facing officials and managers remains enormous.” It highlights the government’s problems in collecting tax revenues and indicates that the uncertainty over the EU’s permanent bailout fund increases the likelihood that Greece will have trouble paying off its debt.
While Moody’s judgment seems fairly sound, the structure that supports it is less so. It is the institutional role of credit rating agencies that should be called into question, rather than just their expertise. The system for providing credit ratings has been around since the 19th century and was created to give investors information about bonds. Gradually through the 20th century, insurance companies, pension funds and hedge funds looked to rating agencies for insight into the quality of investment products. The advent of securitization in the 1980s, when a number of assets were pooled together for investment purposes, meant that Moody’s, Fitch and Standard & Poor’s became the sherpas that would guide investors through this complex terrain. However, in recent years, the credit raters’ judgment has been proved wrong, their methodology suspect, their ethics questionable and their effect on markets devastating. It is for these reasons that concerns about the part credit rating agencies play in the international financial system, especially when it comes to giving opinions that could affect millions of people if bond yields balloon, should be aired and acted upon.
“I would recommend quite simply dismissing US rating agencies and not taking their recommendations seriously,” Hans Martens, chief executive of Brussels-based independent think tank the European Policy Centre, told Kathimerini English Edition. “They failed miserably during the crisis and the US Congress hearings last year disclosed irresponsible behavior in many ways. Furthermore, they are closed and not transparent at all about their methodologies — if they have any.”
In fact, the 18-month congressional inquiry into the role of the credit raters during the financial crisis exposed some very embarrassing facts about the way the agencies worked. The most serious of these was that they did not provide independent judgments but instead were heavily influenced by their relationships with the financial institutions that were paying them to grade their bonds. Banks often shopped around to find the rating agency that would give their securities the best possible rating so they could attract investors. Confiscated e-mails and testimonies from employees stripped bare the facade of these exalted agencies and revealed that their independence and reliability was compromised. Their credibility was further dented when it was revealed that some investors were also shareholders in the rating agencies. The US’s most famous billionaire investor, Warren Buffett, was called to answer questions in his role as chairman and chief executive of Berkshire Hathaway, Moody’s largest shareholder. Democrat Senator Al Franken said there had been “a staggering conflict of interest.”
It was this incestuous relationship that, as Papaconstantinou suggested in his letter last week, blinded the credit raters to the toxicity of some of the products they were grading. Congress’s investigation revealed that between 2004 and 2007, Moody’s and Standard & Poor’s knew the risk of giving generously high ratings to investments backed by risky mortgages but failed to take any corrective action. So when widespread mortgage fraud, lax underwriting standards and an unsustainable housing bubble led to millions of US homeowners defaulting on their mortgages, the rating agencies downgraded billions of dollars of investments at once, firing up the financial crisis. The inquiry also revealed that the agencies, which were making healthy profits (Standard & Poor’s reported a net income of more than $1 billion in 2005), committed no extra resources to ensure that new products were properly graded and that previous ratings were accurate. In a highly competitive industry, it seems that the key players were not interested in the quality of their analysis but were content to muddle along. Testimony suggests that some analysts were actually discouraged about asking too many questions.
There are some people who believe that the rating agencies did not have suspect motives but that they just got carried away. “They were stupid rather than venal,” as former merchant banker Martin Hutchinson put it in an article on the Money Morning website. He points out that the system the credit raters used was flawed because they did not properly understand securitization credit risk and relied on methods of analysis that were inappropriate for these types of complex products.
Whether it was foolishness or greed, the fact is that the rating agencies failed on a massive scale. Their main defense has been that they just give opinions, which can, sometimes, be wrong. In fact, they have repeatedly defended themselves both from prosecution and closer oversight by relying on the US Constitution’s First Amendment, which protects free speech. Their lawyers have fended off stricter supervision from Congress for the past two decades by successfully arguing that their ratings are protected by the right to free speech, much like newspaper editorials. But in the wake of their failings over the past few years, this hardly seems an adequate defense. “They should first of all be very open and declare on what grounds they rate,” says Martens. “They are considered as giving investors advice but they have failed miserably to give good advice and opinions.”
However, if we were to take the credit raters on their word and accept that their public recommendations are just opinions, then we would have to question whey these expressions of sentiment from analysts should gain such prominence and influence. For example, an opinion piece by a journalist would never be the main story in a newspaper or the top item on a TV news bulletin, yet the opinions of Moody’s, Fitch and Standard & Poor’s often dominate the agenda. A politician’s opinion may gain equal or more coverage but they are elected officials, or in the case of EU officials, they represent institutions that have been approved by national parliaments. The credit raters, however, do not represent anyone but themselves and are accountable only to their paying customers.
The simple answer to why the opinion of credit rating agencies matters and consequently why they gain such wide coverage is that they have a discernible impact on the market — rather than tracing its outline, they shape its constantly changing form. “There is no reason for us to keep paying attention to what credit rating agencies have to say but the only problem is that most people in financial markets do listen to them,” says Martens. “They have an impact because you will always fear that the others will react and, therefore, that you will have to do the same.”
Investors, it seems, cannot break the habit. Many rely heavily on the agencies to guide their hands when it comes to deciding where to place their money. Although this relationship has reached a dangerous level of dependency with too much power ending up in the laps of analysts who have proved gravely fallible, it is only natural that investors should seek expert opinions. It is this demand for information, coupled with greater transparency that Chinese rating agencies are trying to satisfy. Spearheaded by Dagong Global Credit Rating, which published its first sovereign credit ranking last July, the Chinese credit raters are aiming to be more reliable than their Western counterparts.
“The Western rating agencies are politicized and highly ideological and they do not adhere to objective standards,” Dagong’s chairman Guan Jianzhong told the Financial Times last year. He said his company’s methodology provides for a more objective assessment of a government’s fiscal position, ability to govern, economic power, foreign reserves, debt burden and ability to create wealth in the future. Critics have questioned Dagong’s transparency and laughed off its decision to assign a higher rating to Chinese bonds than ones issued by the US. The Securities and Exchange Commission in the US has also rejected an application by the Chinese agency to become officially recognized as a credit rater in the US. Ironically, the watchdog claimed that it could not ensure an adequate level of oversight.
However, others regard the emergence of new ratings agencies to challenge the established order as a positive development. “The fact that the Americans are trying all they can to keep the Chinese out indicates they might be a serious new factor,” says Martens. “I like the Chinese way because they are very open about their methodologies and because they are more forward-looking in the measurements, for example by looking into the future earnings potential when they look at the quality of the debt.
“The most important fact here for the future is that if the Chinese investors are listening to them, they will have effect, because this is where the serious money for investment is to be found.”
A new ratings landscape may be emerging from the turmoil caused by the financial crisis but the fog has not yet lifted. Despite the challenge from China, Fitch, Moody’s and Standard & Poor’s appear to still be omnipresent and omnipotent and like moths to the flame, the media, politicians and markets are drawn to their pronouncements, thereby only strengthening their influence, while apparently forgetting the unforgivable mistakes they have made in recent years. “As long as you give them attention, they have an impact,” says Martens. “I think for a while they should have a lot of coverage, so everyone can be told about their performance in recent years.”
While Pangalos would like to “rub their faces in it,” the truth is that it will take Greece quite a while to reach the stage where it can convince the agencies and other pessimists that it can pull through on its own. But this is not about retribution, it is about restoring balance. It is about calming things down, not fanning the flames. What the situation demands is balanced opinions that can be trusted and, just like some politicians, credit raters have proved that they are not always able to provide them. So the next time one of the big three issues a rating for Greece, maybe the best course of action would be to do exactly what they have done with Greek sovereign bonds: cast it onto the nearest pile of junk.
This commentary was written by Nick Malkoutzis and was published in Kathimerini English Edition on March 15, 2011.