Ratings agencies: catalyst or bystander in company – or country – demise?
Experts clash over the role of ratings agencies, after the demise of MF Global, and with proposals to allow the EU to suspend the rating of sovereigns
Experts disagree on the role of the ratings agency, after the European Securities and Markets Authority (ESMA) approved the four largest ratings agencies to continue to issue ratings on countries within the European Union, having initially proposed to prohibit them from rating sovereign countries if they were in the middle of negotiating a bailout.
The question over how helpful or detrimental the role of ratings agencies has been exacerbated after MF Global collapsed and filed for bankruptcy after the slew of downgrades on its sovereign debt.
On Thursday, the shares of securities and investment banking group Jefferies were halted, after a 20% decline in its stock price, after receiving a downgrade from the smaller yet well-respected ratings agency Egan-Jones. The agency had concerns about the firm’s sovereign debt exposure, which amounts to 77% of equity, despite saying it had no “meaningful exposure to sovereign debt”.
Some market participants have blamed rating agencies for catalysing the demise of MF Global, while others say that now, more than ever, transparency is needed to gauge the risk of its books.
Only two days ago, Jefferies released a statement saying that “in response to questions from investors and analysts, it currently has no meaningful exposure to the sovereign debt of the nations of Portugal, Italy, Ireland, Greece, and Spain”.
“To the extent Jefferies from time to time takes positions in such debt, they are short term in nature, are recorded in the trading book of Jefferies' regulated UK broker-dealer, are marked to market daily, and fluctuate depending upon customer demand, auction activity and opportunities in the market place,” continues a statement. “Jefferies does not have any repo-to-maturity activity or related off-balance-sheet derivative activity,” the statement adds.
Ever since the 2008 crisis, ratings agencies have fallen under closer and more scrutiny, as experts partly blamed the systemic global financial crisis on the fact that market participants were being fed data and information that was deemed not fully reflective of the risk in financial instruments, institutions and countries.
With regulators seeking to ensure that the markets do not see a repeat of the perceived lax ratings that contributed to the crisis, experts are divided as to how best to proceed.
“It isn’t the role of the agencies to soften the blow to a failing institution,” says Fred Ponzo, managing partner at independent capital markets consultancy GreySpark Partners. “Rating risk is something that companies should manage; it should be factored into risk models.”
The initial proposal that has caused most of the controversy was that ESMA should be able to suspend the rating of sovereigns that are going through a bailout.
The theory is that when a country is in such a fragile position, news of it being downgraded may be the final straw in crushing investor confidence, leaving the sovereign’s position untenable.
The ratings agencies’ ability to sound the death knell for financial institutions was displayed this week, with downgrades of MF Global by Fitch and Moody’s being seen as hastening the decline of the brokerage.
However, some experts have criticised the EU’s proposal as sending out mixed messages about the ratings agencies. Given that the agencies were roundly criticised for not rating financial institutions strictly enough in 2008, it seems contradictory to prevent them giving negative ratings to struggling sovereigns.
“It’s astonishing that the EU is looking to prevent the ratings agencies from being able to rate sovereigns in a crisis,” says Jacqui Hatfield, partner at law firm Reed Smith. “The agencies suffered a lot of fair criticism over their role in the 2008 crisis, and now they’re being pilloried for downgrading sovereigns.”
The cynical take on the issue is that the same sovereigns that berated the agencies post-2008 have found themselves victim to the demands that they made of the agencies.
“The rating agencies lost a lot of credibility after 2008, but it’s a different situation now,” says Ponzo. “Some governments are now a hostage of the ratings agencies. They control the rate at which the governments can borrow, and the ratings have a direct effect on the banks, since they must hold the bulk of their capital cushions in AAA-rated securities. This in turn hurts the credit worthiness of the government, potentially triggering a downgrade of the sovereign debt, and so on.”
However, the efficacy of this proposed rule in preserving confidence in sovereigns undergoing a bailout is somewhat doubtful. Ultimately, it is suggested, any entity undergoing a bailout is going to be perceived as a risky target for investment whether they were rated at junk or just not rated at all.
“Suspending ratings won’t make any difference: you wouldn’t be able to tap the markets whether you were rated as junk or if you were suspended,” says Ponzo. “It would be pointless.”
The second controversial proposal stemming from ESMA is that issuers of financial products should have to regularly change the agency that rates their issuances, and that ratings from at least two agencies should be obtained.
“The credit ratings agency engaged should not be in place for more than three years or for more than a year if it rates more than 10 consecutive rated debt instruments of the issuer,” states a draft proposal from the European Commission.
Ponzo is upbeat about this proposal, suggesting it would introduce a degree of competition that has so far been lacking – with the system being largely dominated by a small number of large agencies.
“Requiring a minimum of two agencies will allow the smaller agencies to have access; it would break the cartel and balance out the power,” he says. “The main problem with the agencies is that there is a small oligopoly. This would introduce viable competition.”
But as ESMA’s role in the system is to standardise the ratings being given by the agencies, it seems odd that issuers would need to switch agencies – in theory, they should be giving the same ratings.
“The ESMA rules are meant to ensure that the ratings given by the agencies are standardised, so you’re left wondering why it would be desirable for issuers to have to switch agencies regularly,” says Hatfield.
A distinction needs to be drawn here between standardising the ratings given, and the way that they reach those ratings. Two agencies could reach the same conclusion through different methods, giving prospective investors an increased level of information on which to make their decisions.
“Even if there is convergence in ratings, the methods may be different, and different processes can be valuable in themselves,” says Ponzo.