Feeling moody about downgrades
While the effects of the downgrade of Ireland’s credit rating to junk status by Moody’s are still being felt, Paul Walsh examines the motivation behind the decision, and asks how the credit ratings agencies have so much influence on the global financial markets.
On 12 July the credit rating agency Moody’s downgraded Ireland’s bond rating from Baa3 to BA1 with a negative outlook. In layman’s terms that means the nation’s credit rating was cut to junk status. What does this mean for Ireland, and, given their record, should we trust a credit rating from Moody’s or any of the other major credit rating agencies (CRAs)?
According to their report the reason for this decision was their expectation that Ireland will require further IMF/EU funding and will not be able to return to the private bond markets at the end of 2013, when the present package finishes. To be fair to Moody’s they are not the only analyst to predict a second bailout for Ireland. Minister for Transport Leo Varadkar got a slap down from the Kenny/Noonan axis when he dared to voice such a possibility in May of this year. Luckily for Ireland the international financial world does not hang on the every word of Mr. Varadkar. By contrast, Moody’s influence is far-reaching and their influence can be devastating to a nation’s international reputation.
The power of CRAs
Rating agencies assess the risk of default on debt products traded in financial markets. The higher the risk of default, as calculated by the agencies, the higher the interest rate governments and companies have to pay to service their debt. The agencies also have an influence over who can invest in what – for example, institutional investors such as pension funds may be legally obliged to only invest in securities rated above a certain level. Ratings from CRAs also help determine capital adequacy requirements – or the amount of capital a bank needs to hold as a ratio of its assets – for financial institutions. Three agencies – Moody’s, Standard and Poor’s and Fitch Ratings – enjoy what one commentator has called a ‘cosy oligolpoly’ in the credit ratings industry. All three were heavily implicated in the financial crisis for failing to adequately estimate the risk that the issuers of more complicated financial instruments (such as collaterised debt obligations or CDOs) might not repay their debts.
Wielding the knife
Former Canadian Prime Minister Paul Martin can testify to the power that Moody’s Investors Service can wield. In February 1995, when Mr. Martin was Canada’s finance minister, Moody’s mooted a possible downgrade of Canada’s debt. Just the threat of a downgrade resulted in an interest rate rise and $300 million being added to payments on its bonds. As Alec Klein wrote in the Washington Post in 2004: “The warning – not even the downgrade itself, which came later – was enough to roil financial markets and send a major sovereign nation scurrying to restore order.”
In April 1995 Moody’s officially downgraded Canada’s debt rating to “Aa1” (oh how Ireland would kill for that rating now). It took Canada seven years to get the coveted AAA rating back, and at great cost to the nation state.
In more recent times Moody’s downgrading of Portugal’s debt to junk status led to serious repercussions rippling throughout the Eurozone and prompted an attack on the agencies by the Portuguese president of the European Commission, Jose Manual Barroso. According to Barroso, “It's quite strange that the market is dominated by only three players [Moody’s, Standard & Poor’s and Fitch Ratings]. It shows that there might be bias in the market when it comes to evaluation [of Europe].”
The developing world
If the major Western economies cannot control or tame the CRAs what chance do developing nations have? CRAs have the power to influence the flow of capital and they also have the power in the developing world to exclude these nations from the capitalist investment merry-go-round. A 2007 World Bank report pointed out that at the end of 2006 “only 86 developing countries have been rated by the rating agencies. Of these 15 countries had not been rated since 2004. Nearly 70 developing countries had never been rated”. As Oscar Wilde once said “the only thing worse than being talked about is not being talked about”.
On top of this, a sovereign’s rating can have an influence on the rating offered to a company indigenous to a state. Poor or non-existent ratings for developing countries can mean that companies in those countries struggle to raise funds through capital markets.
So while Barroso may fume at the insolence of Moody’s, the third world finds it hard to raise international finance due to the failure of Moody’s and Co to acknowledge there may be another side of the planet worth investing in.
The Irish downgrade
The effect on Ireland of the Moody’s downgrade was immediate, with yields on Irish 10 year government bonds reaching record highs. Despite the IMF and EU giving us gold stars for economic subservience and A1s for not rocking the boat lest contagion come aboard, the gatekeepers of international finance had decided to punish us. According to Alan McQuaid, Chief Economist with Bloxham Stockbrokers, Moody’s have their own agenda: “The timing was very suspect. They knew the IMF/EU/ECB was going to come out with very positive thumbs up for Ireland two days following. So why did they want to cause this amount of damage? If they waited till afterwards they would have looked a bit silly, it’s become like a game”. He goes on: “You have to ask yourself is there something sinister or something more behind all this. Do they want to bring the Euro down?” Surely this can’t be the case. As an international credit rating agency the assumption is that Moody’s have a reputation of independence and consistency through boom and bust and their analysis, while not welcome, must be taken seriously.
One only needs to look at Moody’s report on Anglo Irish Bank from May 2008 to cast doubt on that idea. This report gave the bank a credit assessment of A2 due to “the bank’s stable market position and solid track record as a secured lender to medium-sized corporates, professional property investors and high net worth individuals.” And the punchline? “The bank had undergone substantial loan growth in recent years, however, the apparently aggressive growth rates need to be assessed in the context of the economic expansion experienced in the Republic of Ireland and the bank’s conservative underwriting policies. We expect this growth to fall back somewhat due to the slowing Irish economy and the global ‘credit crunch’.” [Emphasis added.] By January 2009 the bank had been nationalised as the markets were drip fed revelations about incompetence and deceit. As the billions tot up and the former Anglo debt gets attached to generations of Irish taxpayers that Moody’s rating seems to be just a tad off the mark.
CRAs and the financial crisis
So what is the explanation for Moody’s inexplicable decision to award Anglo Irish bank a positive rating seven months before the bank had to be nationalised? It dates back to the 1970s when Moody’s and the other credit rating agencies started charging bond issuers as well as investors for credit ratings. The rating agencies then had to compete to give investment banks the rating they wanted or fear losing the business. This development lead to a huge conflict of interest for Moody’s which only deepened, according to Bloomberg, in the first decade of the this century.
The emergence of the collateralized debt obligation (CDO), a financial product so complicated, and in the end devastating, was facilitated by Moody’s and the other big credit rating agencies Standard and Poor’s and Fitch. CDOs wreaked havoc across the world the big three credit rating agencies had a hand in this havoc not just through their blessing of CDOs that were chock full of risky debt with AAA ratings, but also in their creation in the first place. Charles Calomiris told Bloomberg in 2007 that CRAs were in the “financial engineering business” and not engaged simply in “a passive process of rating corporate debt”.
Having been burned in the wake of the financial crisis in 2008, and publicly excoriated for their failure to spot massive risk, the rating agencies have, suggests Alan McQuaid, retrenched, and gone too far the other way: “They haven’t exactly covered themselves in glory and now they are trying to make up for it by going the other way, far too extreme in my view.”
An accidental or deliberate failure of oversight?
So did the credit rating agencies see the abyss coming or would they, like our former Taoiseach Bertie Ahern, “have loved if somebody somewhere had told me what was going on”? Well some employees did, and their reward for their prudence was a P45 as the companies rewarded the risk takers and gamblers. Mark Froeba, who joined Moody’s in 1997, told McClatchy: “[There] was a systematic and aggressive strategy [from 2000 on] to replace a culture that was very conservative, an accuracy-and-quality oriented (culture), a getting-the-rating-right kind of culture, with a culture that was supposed to be 'business-friendly,' but was consistently less likely to assign a rating that was tougher than our competitors."
Froeba and his fellow critics were ‘downsized’ when they voiced their concerns; their less risk-averse colleagues received promotions.
It’s not personal, it’s just business
The same cut-throat attitude – and questionable approach to supposedly ‘objective’ ratings practices – was demonstrated by Moody’s in 1998 when it took on Hannover Re. They started grading the company – one of the biggest insurance companies in Germany – that year, without an instruction or payment from the company. They wrote a letter to Hannover Re telling them that although they had started rating them for free they looked forward to payment for this service in the future. The implied threat of this “horses head in the bed” letter panicked the management of Hannover but they stood firm. They already employed two credit rating agencies and told Moody’s that they had no need for a third. However, the agency was not keen to take no for an answer so they made Hannover an offer they couldn’t refuse. They continuously downgraded its rating, culminating in a downgrade to junk status in 2003. Investors rushed to dump stock, and the company lost $175 million in market value within hours. To paraphrase Michael Corleone, it was nothing personal, just business.
Despite their key role in the global economic crisis, and a track record that bespeaks not just failures of independence, consistency or objective but a rank abuse of power, when Moody’s downgrades Ireland’s debt the world takes notice and Ireland’s future economic prospects suffer. The EU has attempted to introduce stronger legislation governing credit agencies. New rules suggested by MEPs include making credit agencies liable in civil law for their ratings (introduced in the United States under the Dodd-Frank financial reform) and creating a European credit rating agency. There may never be a better time to take on the power of three big credit rating agencies.
While EU has recently been talking tough, is there the political will to enact real change and claim back power for the sovereign state from financial institutions? Alan McQuaid thinks that comments emanating from the powerbrokers in Europe reveal how things will progress. “Looking at the comments from the EU officials it looks like it could be two or three years before they can do anything about it. I think the will is there. I think they have learned their lesson. Unfortunately, like everything else in Europe it will take years to come to fruition.”
This financial crisis has become a battle for control and survival. The single currency project has powerful political supporters that want their European vision to succeed at all costs. So if the credit rating agencies are seen as an impediment to its survival the gloves may well be off in this fight.