A recent decision by S&P is the latest to have the markets wondering if agencies are objective enough.
Rating agency credibility is under fire again. Not since the Asian and
Mexican crises has the market so fiercely questioned the agencies’
ability to make tough calls.
But Standard & Poor’s decision last month to delay the launch of
credit ratings for Germany’s Landesbanken ahead of when they lose their
state guarantees in 2005 only compounded worries over the agencies’
response to Ford Motor Company, whose downgrade narrowly escaped junk
status and which regained a stable outlook.
Predictive ability
In the Asian crisis of 1997-1998, rating agencies were criticised for
failing to anticipate sovereign risk and then downgrading highly rated
countries, such as South Korea, to almost junk status overnight,
deepening the crisis still further. The markets argued that agency
actions should be predictive, not reactive. But one of the problems
then was that, when rating sovereigns, the agencies had little
advantage over other market participants: ratings are largely based on
publicly available information such as foreign debt reserves or
political and fiscal constraints, which is as easily available to
investors. Thus the agencies have little opportunity to acquire advance
or superior knowledge on matters that affect that risk.
The root cause of the latest hullabaloo is speculation that market
pressure was brought to bear on the agencies. In the Ford decision,
anecdotal evidence suggests that market participants were vociferous in
their argument that downgrading Ford to junk, or even combining the one
notch slip with a negative outlook, could have unbalanced the entire
bond market. In Germany, pressure is said to have been exerted by the
finance ministry, the Bundesbank and powerful banking associations, not
to re-rate the Landesbanken yet. S&P – which previously stated
plainly the importance of investors being made aware that debt issued
before 2005 but expiring after 2015 would be deemed “unguaranteed”–
appeared to change its mind.
Under scrutiny
There is no evidence that S&P did respond to pressures in
arriving at its decision in either the Ford or Landesbanken case. But
the result is that the rating agency role is coming under scrutiny once
more.
Rating agencies fiercely defend their objectivity and their
methodologies, but many observers wonder whether it is possible for
them to achieve what markets want them to. Some argue that a fee
structure based on the borrowers paying is incompatible with the
requirement to rate negatively when necessary. Maybe it’s time to look
at this issue again.