15 June 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
1) It’s not easy to find out anything substantive about them.
You’d be shocked how little comes up on a Google search.
but surprisingly few analytical articles about what they actually do from those same places.
There are, of course, the standard plethora of “wiki” web sources about this and related subjects,
but it’s disturbing to see how not just the same information, but the very same phrases re-appear from place to place.
Still, don’t take my word about how difficult it is to get clear information about credit rating agencies, or CRAs, as they’re known “in the business.”
Check this out, from one of the few “professional” sources I was able to find:
What exactly are credit rating agencies, and why do credit ratings exist?
In spite of the mounting interest and growing body of literature on CRAs, the answer to these two ostensibly simple questions is hard to find.
2) Despite that, you CAN find some interesting bits and pieces that help explain why these mysterious creatures are simultaneously so omnipresent in the financial world, yet whose function and operation is so hard to understand.
On a legal level, the credit rating system today works as a government sanctioned oligopoly.
In both Canada and the U.S., the ratings issued by these organizations are referenced in the regulations
as a basis for determining the acceptability of investments for certain investors
and for determining the eligibility for streamlined regulatory processes for certain issuers.
Both countries have government-led processes for qualifying ratings agencies.
You see what I mean about the usual impenetrability of academic or “professional” prose.
3) But this DOES say something important about CRAs:
“On a legal level, the credit rating system today works as a government sanctioned oligopoly.”
That is, it’s a LEGAL REQUIREMENT for any company, or country, that wants to offer a bond – that is, a promise to pay back debt – to be evaluated by these ratings agencies.
Now before I started researching them, I had NO idea that this was why credit rating agencies were so important, but I do now:
in order for the bond issue to go through, BY LAW, what they’re offering has to be evaluated by one of the existing credit rating agencies.
Gee, no wonder CRAs are so important.
4) Since so many of the bonds that are up for sale are –
as we have all recently learned to our combined horror and dismay –
being issued by individual nation-states themselves,
the ratings CANNOT be done by a public agency from a particular country,
but, in the twisted logic of the system that exists today, must be done by a PRIVATE, PROFIT-MAKING corporation
that receives its legitimation FROM a government agency, such as, in the US, the Securities & Exchange Commission,
or internationally, the International Organization of Security Commissions.
5) Now the assumption about the necessity of credit rating being done by a profit-making corporation does not seem at all self-evident to me.
We can somewhat see the necessity of a non-public agency,
since you wouldn’t want a ratings agency to become an instrument of any one country’s political or policy desires.
But it’s by no means clear to me why a NON-PROFIT corporation –
funded by tax payments from SEVERAL governments –
couldn’t do the EXACT same things that CRAs do now.
But for some reason, this thought hasn’t occurred to the financial powers-that-be –
or, rather, perhaps it HAS occurred to them, but then they ran away from it as quickly as possible.
Now, why would that be ???
6) Perhaps, it has to do with the sixth point, namely that CRAs are, as noted above, an oligopoly.
For those not familiar with the term, an oligopoly means an industry dominated by a few entities,
usually with high barriers to entry, meaning it’s hard for any NEW players to get into the game.
Oh, and there’s something else rather important about an oligopoly:
Because they are dominated by a few players, with high barriers for any new ones,
oligopolies are almost ALWAYS able to FIX PRICES.
That means, to put it bluntly, they can charge pretty much whatever they want, and whoever is paying has to pay what they ask.
7) Now here comes the SECOND killer:
CRAs are paid by the very entities, whether corporate or, in the lingo, “sovereign,” i.e., individual countries,
whose issuance of debt they want the CRAs to evaluate.
Anybody see a structural conflict of interest here ???
Well, in the aftermath of Black September 2008,
and the revelation in the invaluable Valukas report of Lehman Brothers’ consistent use of the now-infamous Repo 105,
apparently … NOW … a LOT of people see a conflict of interest in this cozy little system,
including the world’s favorite investor St. Warren of Buffett,
who, in testimony to a hearing of the “definitely NON-Pecora” like Financial Crisis Inquiry Commission,
in this excerpt from the New York Times, acknowledged all was not right in this section of the financial world:
Currently, the issuers of securities pay the rating agencies to analyze their creditworthiness.
The ratings are then made public so investors can judge whether to invest in those securities or not based on risk.
The issuer-pay model has come under fire as the financial crisis raised questions about potential conflicts of interest
in which rating agencies were pressured by issuers to give favorable ratings
in order to maintain their business relationships with large issuers.
“As chairman of Berkshire, I hate issuer-pay. We pay a lot of money and we have no negotiating power,”
Mr. Buffett told the Financial Crisis Inquiry Commission.
“It makes for a wonderful economic model for the business, but for a practical matter, I have no negotiating power.”
Mr. Buffett is speaking from both sides on this one.
On one hand, he dislikes the fact that the issuer-pay model is so restrictive as a business owner
[which is business “journalism” talk for the fact that
he has no choice but to pay what he is told to pay if any of his companies want to issue stocks or bonds.]
But it still benefits him as THE major investor in Moody’s, given its strong pricing power …
He did not mention any possible conflicts of interest.
What a surprise that he failed to mention this little matter of conflict of interest between the CRAs and their customers.
8) Guess who ARE the members of this little club of “security evaluators” ???
Well, as you might have guessed from the excerpt above, one of the major members is a company in which Buffett is the largest stockholder: Moody’s.
And Moody’s is one of the THREE largest CRAs in the world, the others being Standard & Poor’s and Fitch Ratings.
As Piero Cinqueprana, author of one of the few academic studies of the CRAs, puts it in the opening of his rather hard to get through tome:
The credit rating industry is a global business, with three leading players (Moody’s, Standard & Poor’s, and Fitch) controlling over 94% of the global market (European Commission 2008b).
Credit rating agencies (CRAs) sit at the centre of international capital markets.
Until recently CRAs were seen as neutral information providers, capable of objectively assessing the credit risk of a certain entity or debt security.
From the early 1990s on, however, CRAs have been increasingly criticised.
From the 1994 Mexican Tequila Crisis to the 1997-98 Asian Financial Crisis; from the 2001 Enron Scandal to the 2003 Parmalat bankruptcy,
CRAs have been blamed for failing to warn investors of imminent corporate or sovereign default.
The anger directed at these agencies indicates the degree of power CRAs enjoy in financial markets.
The role of CRAs in the subprime financial meltdown in exacerbating the financial crisis has become startlingly clear,
and yet investors and the financial press still discuss ratings widely.
As capital markets have become increasingly global, so has the dominance of the leading CRAs.
9) And despite his apparent frustration at having to pay what the market – in this case a company in which he is the largest shareholder – will bear, it’s not surprising why Buffett remains perfectly willing to go along with the present credit rating agency system:
Which means the global credit rating market is not just an olig-opoly,
it’s even more of a du-opoly, in which just two companies – Buffett’s Moodys, and Standard & Poors –
each control almost half of the total market of their industry, one which brings in approximately … ???
Despite the plethora of different, and unusually opaque, “wiki” sources I was eventually able to develop,
the one fact I was un-able to come up with was exactly how big the global credit rating agency market is …
Now maybe this speaks to my poor research skills, and one of our fabulously well-informed readers will have the answer at the tip of his or her hand, in which case, we naturally invite you to share it with us …
But even if this SHOULD turn out to be the case, it’s a bit disturbing that,
in an industry where transparency and accessibility of information are supposed to be watchwords,
it’s remarkably difficult to find out quickly and easily how big their OWN market actually is.
10)In conclusion, then, we hope to have shed some light on the mysterious world of the credit rating agencies, or CRAs, above all, why they are so important in determining the “credit-worthiness” of not just companies, but also countries – and hence are so crucial to the current “Euro-zone sovereign debt crisis”.
And it’s on the “credit-worthy” inter-relation of countries and companies that we’ll end.
Of all the bizarre aspects of this world of CRAs, perhaps the weirdest –
especially at the moment of the sovereign debt crisis laying waste to the Euro-zone –
is the so-called “country ceiling”:
the practice of not allowing the rating of individual companies within a country to be higher than the rating of the country itself.
The assumption HAS been that no company will be more capable of honoring its debts than the country in which it is located.
But apparently, if it has done nothing else, globalization is – finally – putting an end to this ludicrous assumption.
Admittedly, a lot of these companies are oriented towards exporting, and so are less dependent on their national economies.
But that it should have taken until now for this to be recognized says something not so very flattering about how the credit rating agencies – at least until now – have been doing their business.
No wonder the world is such a mess.
David Caploe PhD
Chief Political Economist
President / acalaha.com