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Are the ratings agencies credit worthy?

By Kevin Voigt, CNN

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Rating the credit raters
  • The 'Big Three' credit ratings agencies are facing increasing criticism on both side of the Atlantic
  • The ratings agencies are deeply embedded in global regulations, catalyzing market reaction
  • Critics say the fee structure for agencies, who are paid by bond issuers, creates a conflict

(CNN) -- Their decisions on Greece, Spain and Portugal sparked a market freefall last week and spurred a $145 billion bailout plan. A powerful U.S. congressman characterizes them as the triggermen of the 2008 global financial crisis.

And yet a spokesperson for the European Union seemed to be speaking for much of the world when he asked at an April 28 press conference, "Who is Standard & Poor's by the way?"

On both sides of the Atlantic, rancor is growing against the triumvirate of companies -- Standard & Poor's, Moody's Investor Service and Fitch Ratings -- that make independent decisions on credit worthiness of government bonds, businesses and financial products.

"Regulators and investors are addicted to credit ratings like heroin," said Frank Portnoy, author and director of the Center on Corporate and Securities Law at the University of San Diego. "The only problem with them is they are false. Every academic study shows they substantially lag the market. So why is everyone on the edge of their seats with these ratings announcements?"

The slow rolling Greek debt crisis quickly sped downhill last week after Standard & Poor's downgraded Greek bonds to junk status. The threat of a debt contagion across Europe was heightened when Standard & Poor's also downgraded the investment grade of Portugal and Spain.

Who are the credit ratings agencies?

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Credit ratings agencies had a starring role in the financial crisis, after the firms blessed mortgage-backed securities with AAA ratings -- the safest rating possible -- and fed the global mania for these risky investments. A report released two weeks ago by a U.S. congressional committee showed that the ratings agencies knew their risk model was flawed in 2006, but didn't act until July 2007 when it downgraded billions worth of subprime securities.

U.S. Sen. Carl Levin, chairman of the Senate committee investigating the crisis, characterized the mass downgrade as "the trigger" that sparked the financial crisis.

Frustration with the ratings agencies is palpable in Brussels, where the Greek debt crisis is threatening the foundations of the European monetary union: "We of course expect that credit rating agencies, like other financial players, and in particular during this difficult and sensitive period, act in a responsible and rigorous way," said Chantal Hughes, a spokesperson for the EU Commissioner for internal market, at a press conference last week.

What Greece's debt rating downgrade means

And yet the big three credit ratings agencies are so tightly woven into fabric of global business, attempts to rein in the industry in the U.S. and Europe are fraught with difficulties.

"Ratings are now very much embedded into regulations," said Patricia Langohr, professor of economics at ESSEC Business School in France and co-author of "The Rating Agencies and their Credit Ratings."

Since 1975, regulations in U.S. require bond issuers to use either Standard & Poor's, Moody's or Fitch to rate the credit worthiness of the investments; internationally, the Basel II accord regarding the capital banks must have on hand are also impacted by ratings from the credit agencies. "Hence, if you, as an issuer want your debt to be widely accepted and bought by the market, you will have it rated by a suitable credit rating agency," Langohr said.

The 'Big Three' are valued for judging investments by the same yardstick -- with ratings ranging from AAA for safest investments and D for the worst -- across international markets. But the fact that the ratings agencies are paid by the issuers of the bonds creates an inherent conflict, critics say. "It's like you're paying your professor to give you a grade," Langohr said.

The downgrades of mortgage-backed securities in 2007 and the sovereign debt of Greece last week to junk status both created ripple affects that quickly sped across the globe -- in part because many governments prohibit institutional investors, such as pension funds, from investing in low-rated bonds.

Regulators and investors are addicted to credit ratings like heroin
--Frank Portnoy, author and securities attorney

"The problem is that as soon as a rating drops to junk level, then many investors for regulatory purposes have to sell," Langohr said. "The ratings have so much power, they become a self-fulfilling prophecy."

The credit ratings agencies walk a tightrope between the demands of issuers and investors who both crave high and stable ratings.

"It's sort of like the Italian scientist who got sued because he forecast an earthquake and it happened," said Alan Laubsch, founding member of RiskMetrics Group and a former vice president for JPMorgan. "You want to be very, very sure before you make a call. You may be detecting a lot of red flags in the market, but you may trigger a panic."

On the other hand, "if you wait until the last minute when it's obvious, you trigger this mad rush ... it's as if you're saying `this boat doesn't float so well' while it's already sinking," Laubsch said. As seen by the rapid-fire events after Greece was downgraded, "you cause an even more crowded rush to the exit, because any reaction under stress is going to be more severe," he adds.

The tendency of credit ratings agencies to act conservatively means that they often fail to predict when firms and governments are in trouble, Portnoy said. "You saw that not just with Lehman Brothers and Bear Stearns, but with Enron, with Orange County (California, which went bankrupt in 1994), with AIG -- they all had AAA ratings before they went bust," Portnoy said.

Fact Box
Country ratings: How they stack up
Here is a list of the credit worthiness of a sampling of nations as listed by Standard & Poor's.

Australia, Austria, Canada, Denmark, Finland, France, Germany, Netherlands, Luxembourg, the Netherlands, Norway, Singapore, Sweden, Switzerland, UK, USA
Belgium, Hong Kong, New Zealand
Abu Dhabi, Ireland, Japan, Slovenia, Spain
Kuwait, Qatar, Saudi Arabia, Taiwan
Chile, China, Cyprus, Italy, Slovak Republic
Bahrain, Czech Republic, Israel, South Korea, Malta, Oman, Trinidad and Tobago
Aruba, Botswana, Estonia, Malaysia, Poland, Portugal
Bahamas, South Africa, Thailand
Bulgaria, Croatia, Lithuania, Russia, Mexico
Brazil, Hungary, Iceland, India, Kazakhstan, Morocco, Peru
BB+ (Junk status) Considered highest speculative grade by market
BB+ participants
Azerbaijan, Colombia, Egypt, Greece, Panama, Romania

Martin Winn, vice president of communications for Standard & Poor's in Europe, disagrees that the ratings agency acts too slow.

"We actually started downgrading Greece in 2004 and have always rated it lower than other Eurozone markets, even when markets for many years treated Greek debt as broadly equivalent with its AAA-rated peers," Winn said in an e-mail. "What we have seen in recent months is the market catching up with our long held view that there is real divergence of sovereign credit risk in the Eurozone."

Regarding criticism within the EU that Standard & Poor's should have waited until after EU-IMF bailout before judging Greece's credit worthiness, he said the agency does expect the bailout to give Greece some "breathing space in the short term.

"However, our focus is on the longer term economic and fiscal challenges that Greece faces. In particular, we have revised our economic assumptions for Greece and now expect nominal GDP not to regain its 2008 level until 2017," Winn said. "In our view, that will make its task in achieving fiscal consolidation even tougher."

For the ratings imbroglio over mortgage-backed securities in the U.S., the fee structure wasn't the problem, Winn said. "The real issue here is that the regrettable performance of our ratings of US residential mortgage securities from 2005-07 resulted from the fact that S&P, like other market participants, took into account a possible decline in US housing but not of the severity and speed that occurred," he said. "We have drawn lessons from this and made important changes to the transparency, criteria, governance and quality of our ratings."

Critics say that is not enough. They want to see restrictions in the U.S. requiring credit ratings from the 'Big Three' eliminated to introduce more market competition. Langohr wants to see investor associations "rate the raters" for their transparency, accuracy and timeliness.

Late last year, the European Union modified rules governing ratings agencies that require more disclosure, forbids side businesses in "advisory services" and forbids agencies from rating financial products without adequate information on the investments. But all eyes are now on U.S. legislators as they debate the Wall Street reform and its impact on credit agencies.

Critics also want the U.S. to revisit rules that protect credit ratings agencies from being sued. The credit ratings agencies say their opinions are protected by the First Amendment as form of free speech.

"Unlike the other so-called gatekeepers -- investors, issuers, auditors and others -- who are potentially liable if there is a false statement in registration -- credit ratings agencies are not," Portnoy said.