Who Needs a Financial Rating and How to Use It Correctly

The recent worsening of relations between rating agencies and the governments of the world’s leading countries has again brought to the fore the debate about the role of ratings and their “producers” in the modern financial system.

The practice of “calculating” a borrower’s reliability rating by specialized companies emerged at the beginning of the last century. The business idea was multi-parameter analysis of a borrower’s condition by independent analysts in order to assess its ability to meet its debt obligations (the idea belongs to the American John Moody, who also developed the first assessment methodology in 1900). In effect, this led to a ranking of borrowers according to the calculated probability of their default (see Table 1).

Over time this practice became very widespread. Today both large investment companies and individual investors, when building a portfolio of debt obligations (and sometimes of shares), look first of all at the issuer’s rating. Moreover, financial institutions everywhere formalize investment practice depending on the rating. Usually, the higher the rating, the larger the relative volume of permissible investment in the issuer’s debt obligations. That is why a high rating has become the key to a broader investor base and, as a consequence, to cheaper financing. In other words, a high rating has become the dream of every borrower. This encourages issuers, on the one hand, to genuinely maintain financial discipline and, on the other, to pay well for the services of rating agencies.

As a result, the rating business has turned into an extremely profitable industry, and the leading rating companies (today these are three American agencies: Moody’s Investor Service, Standard & Poor’s and Fitch Ratings) have become large, high-earning corporations.

Up to the financial crisis of 2007-2009, the established practice of using credit ratings did not attract much criticism. There were, of course, isolated scandals, such as the bankruptcies of issuers with the highest ratings (Enron in 2001, Parmalat in 2003). From time to time there were also facts pointing to possible “corruption” and “political bias” on the part of respected agencies. But in the overwhelming majority of cases ratings did reflect the borrower’s reliability, helping investors find their way in the vast ocean of debt obligations that the world had become.

However, as early as the end of the last century, discrepancies between the market yield of bonds and the issuer’s rating began to be seen more and more often. That is, between the assessment of a debtor’s reliability by the market and by the rating agencies.

On the one hand, this was due to the acceleration of the processes affecting issuers’ condition, and the agencies simply began to lag behind with their assessments. On the other hand, the market that had gained strength (read: speculators) increasingly began to push prices first one way and then the other, not always in line with the borrower’s fundamentals.

But the first truly serious complaints about the work of the rating agencies arose after the recent global financial crisis. Recall that the financial crisis of 2007-2009, which nearly brought down the entire global financial system, began with problems in the American subprime mortgage market. The point is that low-quality American mortgage debts had been packaged into bonds that, for some reason, received high ratings from the leading rating agencies. With good ratings, these securities were successfully sold all over the world and, in large volumes (in line with the rating), ended up in the assets of leading banks. After the price bubble on the American real estate market burst, these securities fell sharply in price, which led to the first significant losses in the system. Subsequently, a chain reaction of forced sales brought the global financial system to a full-scale crisis that nearly ended in its complete collapse.

When, after the crisis ended, people began to look for those responsible, it was impossible to ignore the role of the rating agencies. Opinions on the share of their responsibility differed, up to the extreme view voiced by Henry Waxman, chairman of the US Congress Committee on Oversight and Government Reform: “The activities of the leading US credit rating agencies became one of the main causes of the financial crisis.” The agencies themselves also partly acknowledged their fault, admitting afterwards that “there was little basis for giving the highest rating to thousands of mortgage securities.”

The second round of tension in relations with the rating “producers” occurred against the background of the debt crisis in the eurozone. At first the leading rating agencies failed to keep pace with the situation and began to lower the ratings of the troubled eurozone countries long after prices in the market had already fallen significantly.

But then, despite the assistance programmes adopted by international bodies, the agencies began to cut the ratings of the PIGS countries relentlessly. They did so without taking into account that these programmes really did improve borrowers’ solvency. It can be said that such actions by the rating agencies contributed to the growth of the crisis. Moreover, after the adoption of the second rescue plan for Greece, which included a voluntary write-off by investors of a small part of the debt, two of the three agencies threatened to assign Greece a rating of D (default).

All this caused extreme irritation among the leaders of the leading EU countries. The American agencies were accused of taking political decisions with the aim of creating conditions for unfair competition. And now the idea of creating alternative, European structures is being seriously discussed in Europe.

But soon the leading rating agencies also fell out of favour with the American authorities. In April 2011 S&P, followed in July by Moody’s, lowered the outlook on the US sovereign rating, and Fitch threatened to do the same in the near future. This caused undisguised irritation in the American establishment.

And the decision taken by S&P on 5 August 2011 to downgrade the US rating from AAA to AA+ became a real scandal and had the effect of an exploding bomb.

How sensitive the system is to such formal decisions was shown by the subsequent collapse of prices on the world’s leading stock exchanges, which created a threat of a repetition of the global financial crisis.

And the fairness of this decision is far from obvious. The fact that S&P’s decision may have had a political undertone is also indicated by the fact that it provoked extremely sharp criticism from the Republicans but moderate criticism from the head of the White House. This is because the agency justified its action not only by the increased volume of government debt but also by the “insufficiency of the adopted plan to reduce budget deficits to stabilize the dynamics of public debt in the medium term.”

This refers to a substantial concession by Obama to the Republicans on the issue of raising taxes. As a result of these concessions, Obama’s plan to reduce deficits by $4 trillion over 12 years was replaced by a far more modest plan to reduce them by $2.4 trillion over 10 years.

The American state’s indebtedness itself is also not so simple. Gross US government debt did indeed reach 100% of GDP in August 2011, and there are no countries in the world with such a ratio and the highest rating (see Table 2).

But US government debt (like that of Japan) has a specific feature not characteristic of most developed countries. Up to 35% of American government debt is held by government bodies (including, admittedly, the “not entirely” governmental Fed), and the “net” government debt is estimated at only 74% of GDP. That is less than in the leading eurozone countries (including Germany at 83%, France at 82% and the UK at 80% — data for 2010), which retain the highest rating from S&P.

Note also that the two other leading agencies found no weighty reasons for the current downgrade of the US rating, confirming it in August at the top level of AAA.

Incidentally, the increasingly frequent cases in which the leading agencies assign borrowers different ratings (during the eurozone debt crisis sometimes differing by as much as 3 notches) are also a cause for concern. Which rating should one then use, and which of them reflects the situation more accurately? Exploiting this collision, the European Central Bank has already stated that it will continue to accept Greek bonds as collateral as long as at least one of the three agencies does not lower their rating to default (now all that remains is to persuade at least one agency).

In other words, today there is an extremely serious crisis both in the system of assigning credit ratings and in the practice of using them. How to get out of it is not yet clear. In theory, one could abandon the use of rating agencies’ services altogether. In the equity market, similar analytical work, without being singled out as a separate business, is carried out by the analysts of banks and investment companies and even by some private investors. With the current development of technology and the prompt disclosure of information by the issuer, this work is not all that transcendental.

There is one more argument. If the growing armada of speculators in the market is not stopped, the importance of fundamental assessments of issuers will diminish.

And if there is no difference, why pay more?

Table 1. Moody’s estimate of a borrower’s probability of default depending on the assigned rating.

Source: Moody’s Investor Service

Table 2. Ratings of countries with a government debt to GDP ratio above 100%