Ratings fiasco

After stocks and the euro took a tumble this week on the announcement that credit rating agency Standard and Poor's was downgrading Greece's credit rating to junk status, new calls have gone out for ratings agencies to act "responsibly" and for the creation of an independent European rating agency.

But responsibility is not a word that has been associated with credit ratings agencies much in the wake of the global financial crisis, especially after it emerged that the business practices of the big three US ratings firms - Standard and Poor's, Moody's and Fitch - played a central role in helping bring about the economic meltdown.

"We should not make the welfare of Europe dependent on ratings agencies," Peter Bofinger, a member of the German government's independent economic advisory panel, told the newspaper Die Welt.

German Foreign Minister Guido Westerwelle, who called for a European credit rating agency, said rating agencies must not develop, sell and rate financial products at the same time.

"Conflicts of interest are guaranteed," he said.

A matter of accuracy

A top International Monetary Fund official questioned the agencies' accuracy, arguing that that their assessments reflect mainly investors' perceptions of a nation's financial health.

"That's why you shouldn't believe too much in what they say," IMF managing director Dominique Strauss-Kahn said last week.

But according to Manfred Jäger-Ambrozewicz of the Cologne Institute of Business Research, government regulators and governments themselves, who also depend on ratings agencies analysis, have played a role in the increase of the agencies' influence.

"It's kind of ridiculous that they've turned on them now," he told Deutsche Welle. "They are the ones who have largely given them so much power."

He added that the creation of a new European ratings agency would be possible, but that agencies are built on their reputations, and it would take some time for a brand-new ratings entity to become credible.

"But if in addition to the private rating we had something from a semi-state agency or a rating by a body like the IMF or the European Central Bank, that could be helpful," Jäger-Ambrozewicz said.

Later this year, new EU rules which were hammered out last year will apply some regulation on already-existing agencies that operate in Europe.

The rules, which go into effect in December, will oblige the agencies to disclose information about the models and methods on which their ratings are based and require adherence to new corporate governance standards meant to guard against potential conflicts of interest.

Risk assessment

Credit ratings agencies began their lives as market researchers, analyzing corporate debt for people or groups considering whether or not to purchase that debt. Potential buyers depend on ratings to determine the credit risk involved.

For most of their existence, rating agencies answered a simple, but critical question: if I loan somebody money by buying one of their bonds, am I going to get that money back?

The agencies developed a grading system to indicate the sureness of the investment. Companies, cities and countries get rated. Standard and Poor's gives IBM its top rating, meaning there is very low risk. Argentina, on the other hand, gets the equivalent of a B-.

For investors, ratings agencies are supposed to provide independent measurements of credit risk, which in turn increases market efficiency, and adds to the supply of risk capital in the market, which can lead to stronger growth.

Mission creep

Starting in the 1970s, credit rating agencies began to get more powerful and these days, a significant bond issuance must have at least one rating from a respected ratings agency to be successful.

By the early 1980s, a different kind of bond appeared on the scene: so-called structured finance instruments such as mortgage-backed securities and collateralized debt obligations. Those are the now infamous complex financial creations made up of thousands of loans and mortgages bundled together and then sold as bonds. In effect, they became almost too complex for ratings agencies to get a handle on, but they rated them anyway, usually positively.

"Mixing cocktails of risk, you really want to know what is the percentage of alcohol in the drinks," said Irwin Collier, a professor of finance at Berlin's Free University. "Financial innovation is a good thing, but what is bad is when the information gets falsified."

Initial success

It was the rise and initial success of those complex financial instruments that led the three big rating agencies down a path of great financial gain for themselves, but disaster for economy as a whole. They began looking for ways to give their seal of approval to bonds, even working directly with the bond issuer. And that, critics say, drove a stake in the heart of their neutrality.

Ratings agencies make their money by charging fees to those they rated, creating an inherent conflict of interest.

Furthermore, if Moody's, for example, indicated to a bond issuer that it was not willing to give it a good rating, the issuer could simply go over to Standard and Poor's or Fitch, whichever would be willing to provide the AAA imprimatur.

It was in the agencies' own financial interest to work with bond issuers to find a way to give out these top ratings. And agencies' pursued that interest aggressively. Between 2002 and 2007, the firms tripled their revenues.

"It's like the parties in court paying the judge's salary," said US Senator Carl Levin at a hearing last week in Washington that looked into whether the agencies failed to provide honest assessments of securities to investors.

Poor performance, poor oversight

The credit agencies' track record is not very impressive. According to The New York Times, of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent have been downgraded to junk status. They failed to foresee the collapse of the US housing market.

The agencies are not overseen by the US Securities and Exchange commission, and they have escaped any legal liability by claiming that their ratings are just opinions, protected by the American First Amendment right to free speech.

While the credibility of the big agencies has been hit, they are still the only game in town and have tremendous power, as the reaction to the Greek debt rating and subsequent ratings about Portugal and Spain have shown.

"The markets are still listening, that's clear," Collier said.

Author: Kyle James

Editor: Toma Tasovac