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.

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