POLITICS AND THE SOVEREIGN RATING
By Michael Shari
The debate rages on as to whether recent sovereign downgrades were politically motivated, or whether the ratings agencies were simply slow to act on decisions made long before. Stakeholders worldwide are calling for a new ratings model, but a new model could affect the cost of funds for corporates.
This winter's downgrades to the sovereign ratings of numerous eurozone countries occurred at a delicate moment: The EU was locked in intricate negotiations to restructure the debt burden of peripheral European nations and cushion the blow for banks in countries that were exposed to them.
Numerous European countries, including France, Austria, Italy, Portugal, Spain and Belgium, were downgraded by Standard & Poor's, Moody's Investors Service and Fitch Ratings between mid-January and early March this year. The timing struck many Europeans as a premeditated Wall Street conspiracy to topple their governments. What shocked them most was that several of the affected governments had already begun reducing debts and decreasing deficits—which were viewed as problematic by certain analysts and policymakers—before the downgrades.
Heuser: Sovereign ratings have become high explosives
The issue has been slowly building political steam. Last August, Italian police raided the credit agencies' offices in Milan, seizing documents and email. And European authorities were not the only ones to find fault with the ratings agencies. The US Securities and Exchange Commission, which confers ratings agencies with the status of Nationally Recognized Statistical Rating Agencies (NRSRO) that qualifies them to rate bonds for large institutional investors in the US, asked S&P last August to disclose the names of employees who had known of its decision to downgrade the US sovereign rating a week earlier—reportedly as part of an investigation into potential insider trading. At the same time, the Senate Banking Committee launched a review of the downgrade.
The move by the SEC dumbfounded many fixed-income investors, who saw it as an attempt to punish the agencies after the downgrade. Unlike in Europe, the US sovereign downgrade had no real impact, they noted: The best investment last year was in US Treasuries, which had their strongest year since 2008. Plus, Fitch and Moody's were not investigated even though they had taken ratings actions that were just as significant as a downgrade by affirming their ratings on US sovereign credit.
Nearly a year earlier, the SEC denied an application for NRSRO status from Dagong Global Credit Rating, China's ratings agency, in September 2010 on grounds that it could not be fully transparent as Chinese law prohibited "the disclosure of documents containing 'state secrets or [information of] vital interest to relevant securities companies.'"
White: Expect more of the same for the foreseeable future
A more blatant message could hardly have been sent on either side of the Atlantic: Governments reserve the right to apply leverage over financial research firms that wield the power to determine their cost of funds. And therein lies a classic conflict of interest in the current ratings agency model—a ratings firms cannot be trusted to rate a government honestly if it is afraid of the government.
The role of ratings agencies in judging the ability of a country to honor its debt strikes directly at the heart of national pride. A ratings agency's independence is key to its authority, and that independence has been called into question.
"The fact that the largest sovereign debt market in the world—that of the US—is not independently rated because the ratings agencies are subject to political pressure from the people they regulate is really problematic for the long-term stability of our financial markets," says Mark Calabria, director of financial regulation studies at the Cato Institute in Washington. Treasury rates are the universal benchmark for US corporate bond rates. "If you get your benchmark wrong, everything else is wrong."
A NEW MODEL
Several academic institutions have even begun to reexamine the business model that the handful of US-registered agencies that dominate the global ratings landscape have used for decades. (While S&P and Moody's are both headquartered a couple of blocks from New York's Wall Street, Fitch is a majority-owned subsidiary of Fimalac, which is headquartered in Paris.) The legacy model has been vilified by US congressmen as rife with conflicts of interest because corporate issuers pay ratings agencies to rate their bonds. (Many sovereign issuers get rated for free.)
But whatever business model raters ultimately adopt—or reject—the regulatory scrutiny that they have been subjected to in recent months can be expected to get passed down to bond issuers. Ultimately, ratings agencies will get tougher in rating corporate bonds, which could lead to lower ratings. Because a lower rating implies a higher level of risk, corporate issuers can expect their cost of funds to rise accordingly. "The single most important thing for any issuer who wants to go to the market and is looking for a rating is that the ratings agencies are going to be more stringent for the next three or four years," says Calabria.
No one has done an empirical study of what the impact will be in dollar terms. But an off-the-cuff estimate would be an increase in interest rates on corporate bonds of 30 to 40 basis points above current spreads over Treasuries, Calabria notes. He expects the increase to be "incremental" and points out that it would be barely noticeable at today's historically low interest rates.
MANY POSSIBLE TEMPLATES
Numerous proposals have been presented for scrutiny by stakeholders—from policymakers to investors to analysts to public companies themselves. Here are a few:
• Abolish the government's NRSRO process of licensing ratings agencies. Then governments will not have any leverage over them. They will then be able to to rate the government of the country where they are based without worrying about potential repercussions.
• If ratings agencies are to be regulated, do not let them rate bonds in the countries where they are based. Let them rate only other countries' bonds. So ratings agencies in Europe would rate bonds issued in the US, and agencies based in the US would rate bonds in Europe—free of harassment from national regulators.
• Abolish rules that require major institutional investors to use external ratings agencies to rate bonds in their portfolios. Instead, let them hire independent financial research firms to rate bonds internally or build up internal teams of analysts to rate bonds. In December, the three federal bank regulatory agencies took a step in this direction by proposing that references to NRSROs be removed from their market risk capital rules—and be replaced by alternative standards of credit-worthiness.
• Abolish the issuer-pays model. Make all ratings free. Make ratings agencies nonprofit organizations. To finance their operations, set up foundations that issuers and investors alike would contribute to.
• Allow ratings agencies to remain as profit-making companies but change the compensation model to one in which investors—instead of issuers—pay for ratings. This model, which actually predates the issuer-pays model, has been embraced by Egan-Jones, which received NRSRO status in December 2007.
• Pay for the ratings with advertising. This could be lucrative if ratings agencies were to publish their ratings on a website in real time and the ads were online, notes Lawrence White, an economics professor at the NYU Stern School of Business.
• Set up a board that would hire ratings agencies to rate bonds, staffed by experts appointed by the SEC or another regulator. Issuers would pay the board. The board would publish the ratings online for everyone to see immediately. This would eliminate the problem of corporate issuers "shopping" for better rates (which is possible only if there is a delay in issuing a rating). This idea has been floated by White and, separately, by two other groups of economists.
• Set up a 'supranational' ratings agency that would be financed with multilateral funds like a UN agency. It would be above the authority of any single government and would not rate corporate bonds, allowing it to focus on rating sovereign issuers, which are "a different ball game," says Annette Heuser, executive director in Washington of Bertelsmann Stiftung, a European nonprofit think tank.
Apart from the investor-pays model, which boutique US ratings agency Egan-Jones uses, no one has come up with a working revenue model that would put these proposals into practical use.
A proposal resembling White's idea for a board that would hire ratings agencies to rate bonds has appeared in the wording of the Franken Amendment of the Dodd-Frank Act, but the law only recommends that it be studied further by the SEC—and only for use in structured finance products. The treatment of structured finance products by ratings agencies merited such attention in US legislation because agencies had been pilloried in congressional hearings for their slowness to downgrade CDOs and other asset-backed securities during the credit crunch of 2007.
A vigorous debate rages between academics over which model would work best for ratings agencies, and there is no consensus in sight. In some cases the counterarguments are so persuasive that some of the strongest proponents of a new model are starting to ponder whether the current model might not be the least-bad system anyone has yet proposed.
"Any model for receiving payment has potential conflicts of interest, whether it is an 'issuer pay' model, an 'investor pay' model or, if you thought of it in online terms, an 'advertiser pay' model," says NYU Stern's White.
For example, the investor-pays model is open to potential abuse by institutional investors who could threaten to stop paying ratings agencies if they didn't like the ratings on bonds that they hold in their portfolio. They might want to see a high rating on a bond if they have a long position, or a low rating if they have a short position, explains Douglas Peterson, president of Standard & Poor's. In the advertiser-pays model, advertisers—who would be issuers or institutional investors—could threaten to pull their ads if they were not happy with the ratings on the bonds they had issued or owned.
As for the board proposal, if the members of the board were political appointees, they could be expected to be beholden to the vested interests behind those who had appointed them. To hear White tell it, civil servants can be "sluggish" and thus unlikely to judge ratings agencies on the merits of, say, changes in procedure or advancements in technology.
Even if anyone could devise a model that would replace issuer-pays, the chances of it getting written into regulations by the SEC, much less into law by Congress, are slim at best. There is no surplus of political will in Washington to go up against the lobbying forces of publicly listed corporations that profit from the status quo. S&P is the cash cow of McGraw-Hill, the world's largest publicly listed publishing company, and Moody's is a publicly traded company in which billionaire investor Warren Buffett owns a substantial stake.
S&P's Peterson does not expect the issuer-pays model to die off, and he considers it the most viable. "The business model is one where the analysts have access to the issuers," says Peterson. "I believe that is made more powerful by having a contract between the issuer and the agency." Calabria and White both agree that it will be "more of the same" for the foreseeable future.
EUROPE’S NEXT WAR
Nowhere are concerns over conflicts of interest between ratings agencies and issuers more evident than in Europe. The January 13 downgrade by Standard & Poor’s of nine countries in the eurozone and subsequent downgrades by Moody’s and Fitch “have been perceived as a fiscal declaration of war,” says Annette Heuser, executive director in Washington for Bertelsmann Stiftung, a European nonprofit think tank. “The sovereign ratings that the Big Three have issued for Europe have become high explosives.”
At the heart of a debate that is rapidly coming to a boil in the European parliament is whether or not the European Union should start a new ratings agency that would be solely under its own influence—not that of the SEC or the US Congress. Also under debate is a new regulatory process for ratings agencies dubbed CRA III, which US financial institutions have greeted as something that “would not be conducive to free capital flows, market access and market information,” says Douglas Peterson, president of Standard & Poor’s in New York.
The idea of a European Union–generated ratings agency is also being greeted with skepticism in the US. “If this entity is perceived by the debt markets as being the handmaiden of European governments who want it to tell everyone, ‘Oh, everything is just hunky-dory, don’t worry,’ then the credit markets will not pay a lot of attention,” says Lawrence White, an economics professor at the NYU Stern School of Business.
There is far more at stake in the ratings game for sovereign issuers—and financial institutions—in Europe than there is in the US. Countries like Greece that are in the midst of restructuring hundreds of billions of dollars of their sovereign debt with myriad creditors are naturally obsessed with every single basis point that gets added to their cost of funds. Before Europe’s sovereign debt crisis broke out last year, debt formed a larger component of the capital markets in Europe than it does in the US—about 80% in Europe versus 50% in the US, says S&P’s Peterson. There has also been a marked preference in corporate finance for bank loans as opposed to bond issuance historically.
There is, as yet, no obvious recipe for ratings agency reform in Europe. But that has not stopped one entrepreneurial player from taking European parliamentarians up on their pitch for a new ratings agency. In early March, Roland Berger Strategy Consultants, a management consulting firm from Munich, went on a roadshow “to get roughly 30 investors on board who are willing to contribute approximately €300 million to establish a ratings agency,” says Claudia Russo, a spokesperson for the firm. The plan is to set up a nonprofit consortium that would run the agency.