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RATING AGENCIES:Are they Credible?

Moody’s, the grade-setter for credit default risks, announced an upgrade for Mauritius last week. Good. Does it make sophisticated investors as opposed to quick profit-seekers like speculators bounce around like corn in a popper? Let’s have a contrarian look at rating agencies.
Rating agencies are one of capitalism’s strangest hybrids. They are profit-making companies performing what is essentially a regulatory role. The public, particularly investors, expect them to affix their imprimatur on securities that are unquestionably safe, nothing less than safe. The agencies also serve their shareholders by making profits on selling their imprimatur on securities – safe or not. For more than thirty years, financial institutions and other issuers of debt have paid rating agencies to appraise securities. To put it graphically, it’s akin to a restaurant paying a critic to review its cuisine only if the verdict is highly favorable. Who should regulate the regulator is an intense debate that the US and the Eurozone has never conclusively agreed upon. Recent credit scandals have reminded investors that a system where raters are paid by the issuers of debt instruments cannot be trusted.
Not many months before the onset of the latest financial crisis rating agencies had come under attack from researchers and academics. After the crisis the attacks intensified from all sides. An editorial in the Financial Times said: Triple A does not in fact always mean Triple A. Rightly, so. The incisive Avinash Persaud puts it bluntly that there is a crucial difference between rating agencies and analysts: rating agencies do not have the business model of star analysts. The US Fed came up with findings that confirm investors’ misgivings about ratings. Michael Gibson of the Fed had presented in May 2007 at a Conference in Dallas a fascinating and important paper illustrating how the rating process is rife with what may be dubbed as “anomalies”. The research backing of this argument is complex but the implication is clear: investors should view rating with a degree of wariness.
Amongst others, Lehman brothers, Bear Sterns and Meryl Lynch held triple A rating until the last day when they had dropped dead. For five troublesome years the Eurozone is trapped in a banking crisis the intensity of which is intimately known to insiders. The already discredited rating agencies did not find anything wrong with the seriously undercapitalized banks until recently. Only in the last ten days or so they downgraded banks in Spain etc. But Moody’s was fast and furious with MCB in 2003 when the MCB/NPF irregularities were announced and acted swiftly although MCB’s balance sheet did remain very sound and very strong. Notwithstanding, MCB’s maintained its impressive performance and proved Moody’s, whose chief business is to measure default risks on debt, dead wrong.    
Rating agencies’ rating exercise is not based on the kind of dynamic general equilibrium analysis that takes into account comprehensive view of an economy. Not every aspect of an economy is captured in the rating process. A very simple illustration proves a point. Just a few months ago, the IMF stress-tested our Government finance and rightly recommended that the Government should bring down its debt/GDP ratio to 50 per cent in the next few years. This recommendation was based on a realistic assumption that our GDP is not likely to pick up given the inhospitable world economic outlook and the unfriendly growth policies being pursued. Government was best advised to lower the ratio. And here comes Moody’s upgrade implying, in a stunning display of logic, that Government is blessed with an almost unimpeachable creditworthiness. In other words, the risk of default is much lower should government decide to borrow more. Who is right? The IMF or Moody’s?  No wonder sophisticated investors routinely ignore the ratings.
No investor should ever think of initiating a lawsuit against rating agencies for misleading ratings. They reject both regulation and liability claiming the same US constitutional protection of free speech as the media does. Their ratings are not oracular utterances but simply “opinions” – the same kind of opinions expressed by external auditors of banks. Haven’t we seen enough of those kinds of “opinions” being expressed by external auditors until the day the banks have dropped dead – in Mauritius, too? The funeral lists of financial institutions with laudatory grades are long and littered in financial literature. They certainly aren’t felicitous of the “opinions” of rating agencies. It’s nevertheless a necessity to have them as a reference metric system in the world debt markets despite their shortcomings – sort of a needed meteorological enterprise even if it perpetually comes up with the wrong forecasts.
Anyone who has blind faith in the Big Three rivals, Moody’s, Standard & Poor’s and Fitch are well advised to have a look at the names of their major shareholders and their interests in businesses worldwide. Those who have spent years in the business of regulation and supervision of financial institutions and are gifted with a highly sensitive feel of things in the area of economics and finance must have seen how certain kinds of games are played out superbly in the marketplace. Suffice it to say, a very recent study reveals that the 30 largest US Corporations spend more on lobbying than they pay as Federal taxes. No wonder China has its own rating agency. In a retaliatory move, the Dagong Global Credit Rating Co had stripped the US, Britain, Germany and France of their AAA rating in July 2010. The paradox is that rating agencies themselves recognize the need for an institutional reform.
Consequent to the downgrade of local banks in July 2009, the Governor of the BoM had made a vitriolic sortie against Moody’s. He had accused Moody’s of playing Russian Roulette. He was dead right then. The Governor’s comment “What they know that we don’t know?” had reverberated. Without being cynical, let me update the question in a whispered voice: “What do we know that they don’t know?” John Maynard Keynes is often quoted as having said, “When the facts change, I change my mind. What do you do, Sir?” Let’s not fool ourselves. Old rule: Be careful what you ask for. You may receive it. Begin with good faith.

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