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Little gained from berating the raters

In a July 2007 email exchange cited in the US government’s current case accusing Standard & Poor’s of defrauding investors with its CDO ratings, a recently hired analyst told an investment banking contact about the view among many employees that senior management at S&P had prevented downgrades to avoid alienating clients.

The unnamed investment banker replied with a view that was widely shared both inside and outside Wall Street as it became obvious how much damage would be caused by inflated ratings for structured finance deals.

“This might shake out a completely different way of doing biz in the industry,” the banker emailed. “I mean come on, we pay you to rate our deals and the better the rating the more money we make?!?! What’s up with that? How are you possibly supposed to be impartial????”

It was trenchant analysis, but almost six years later not only has a completely different way of doing business failed to emerge, but there has been no perceptible change in the dominant role played by the big three credit rating agencies.

Moody’s, S&P and Fitch still supply over 90% of bond ratings and retain an effective oligopoly in credit rating provision.

One reason for this stasis is economic. A shift from a system where debt issuers pay for ratings to one where investors pay was never likely to happen because of buy-side reluctance to shell out money without seeing clear value. Debt investors from hedge funds to pension managers have ramped up their spending on in-house analysis since the 2008 crash and are more aggressive in sourcing credit research from their bankers, but they have shown no interest in paying for the broad-based rating services traditionally provided to them for free by the big-three agencies.

Governments across the world have considered various ways to force change on the industry, but some potential shifts have such obvious pitfalls they have been rejected.

The approach by different regimes across the world has varied in refreshingly stereotypical ways. In Europe the first impulse was to proceed by fiat. Member states of the European Union have been particularly infuriated by sovereign downgrades in recent years. This has led them to consider banning the dissemination of this type of rating change because of its potentially destabilizing effect. It is the same impulse that has placed Germany in the vanguard of various actual and proposed bans on short-selling, and comes from a similarly confused idea of how markets work.

A more practical version of this fix for the rating industry has emerged recently in the calmer atmosphere that prevails now that European Central Bank president Mario Draghi has convinced the markets that the ECB cash spigots can and will be opened as needed.

European officials are pushing the main agencies towards adoption of sovereign rating announcement timetables, to at least avoid the likelihood of nasty surprises at awkward times, such as when people of substance are on vacation in August. This approach will work best when only a few agencies need to be pressed into line, so the recent emergence of a couple of new German-based rating firms is unlikely to have much effect on the status quo in Europe.

In the US, reform proposals have become mired in the Byzantine conflicts that accompany any potential loss of influence for existing regulatory bodies or their Congressional oversight committees. Senator Al Franken proposed a bill that would enforce random rotation of agencies and managed to insert the provision in an early version of the Dodd-Frank bill that overhauled Wall Street regulation. The final language of the law watered down this change to a mandate for a study of the change by the SEC, however. The SEC proved to be unenthusiastic and Franken is trying to pick a fight with recently appointed SEC head Mary Jo White to push her into adopting his proposal.

As is so often the case in the US, it might take litigation to get anything done. The Justice Department’s case against S&P for fraudulently inflating CDO ratings looks far from solid. But if S&P – and possibly Moody’s afterwards – were to lose a fraud case led by the government, then either or both firms might face a sudden loss of new business, which would prompt the emergence of new contenders for oligopoly status.

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