It is easy to point the finger at rating agencies – but are they really the ones at fault?

WITH SOVEREIGN debt concerns dominating global markets in 2011, it is little surprise that credit rating agencies have been in the line of fire of irate policymakers.

In December alone, Moody’s downgraded France’s three biggest banks, warned that euro zone countries were facing possible downgrades and cautioned the UK regarding its AAA rating. Standard and Poor’s and Fitch have been equally downbeat, with the latter warning that six euro zone countries – including Ireland – faced downgrades as a “comprehensive solution” to the debt crisis was now “beyond reach”.

European politicians, irked by rising interest rates, have accused the agencies of wild exaggeration and of being politically motivated, as did US policymakers after SP stripped the country of its AAA rating in August.

The “how dare they?” attitude is not confined to politicians. French intellectual Bernard-Henri Lévy this month protested that rating agencies, “with the careless batting of an eye, can bring down entire economies”, and decried the “dictatorship they impose upon the markets”.

Like Lévy, EU commissioner for the internal market Michel Barnier wants to rein in the rating agencies. He has proposed that investors be allowed to take legal action in the event of flawed downgrades and has even suggested a temporary ban on ratings for countries involved in a bailout programme.

It is certainly easy to fault the agencies’ historical record. They missed the Asian financial crisis in 1997; Enron had an investment grade rating just days before filing for bankruptcy in 2001; Lehman Brothers, AIG and Fannie Mae all received strong ratings in 2008.

Indeed, the US financial crisis inquiry commission dubbed them “key enablers of the financial meltdown” due to the AAA ratings ludicrously ascribed to subprime securities. Rating agencies are paid by the issuer of bonds, creating an obvious conflict of interest.

Nor did they cover themselves in glory in their more recent European analyses. Rock-bottom interest rates allowed Greece to load up on debt throughout the last decade, and ratings remained strong even after the government admitted in 2004 that it had lied about its deficits. Moody’s allowed Greece to retain its strong A rating throughout 2009, saying in December of that year that investor fears were “misplaced”. Within six months, Greek debt had been reduced to junk status.

Rapid downgrades rock markets. An International Monetary Fund report last year said Greece’s ratings collapse represented a “failure” of the rating agencies.

Still, it is ironic that the policymakers who lashed rating agencies for their kid-gloves approach to past crises now demand that they tread softly. Bill Gross of Pimco, the world’s biggest bond fund, said SP “finally got it right” when it removed the US government’s AAA rating for the first time in its history in August. “They are enforcing some discipline,” he said. “My hat is off to them.”

Others assert that the agencies are overcompensating for past sins. The data does not bear this out, however. France, like Germany, is still rated AAA, even though the yield on its 10-year bonds is 1.25 per cent higher. Research group Exotix found that the ratings of peripheral European states are six notches higher than equally healthy emerging economies.

Far from agencies exercising a “dictatorship” over the markets, the biggest investment firms conduct their own proprietary research. If looking for guidance, they increasingly find it by analysing the credit default swap market, which measures investor opinion regarding the likelihood of debt default.

The contention that rating agencies are overreaching themselves by jumping into politics may also be simplistic. Political wrangling drove the US to the brink of default in August, and it is hard to blame SP for being concerned about this political dysfunction. In Europe, too, the debt crisis has rumbled on as much for political reasons as economic ones.

Still, while the influence of rating agencies may be exaggerated, nor is it negligible. An IMF study that examined 71 ratings announcements found that downgrades had statistically and economically significant spillover effects, suggesting their decisions could catalyse financial instability.

A recent Bank of England paper also found that ratings calls had potentially systemic implications.

The problem is partly that credit ratings are so hardwired into financial regulation. The Basel II recommendations adopted in 2005 forced banks (including the European Central Bank) to rely on assessments by Moody’s and SP when attempting to gauge a firm’s financial solvency. A similar situation has prevailed in the US since 1975.

Former IMF chief economist Simon Johnson says many investors cannot disregard the rating agencies as they are “guided by rules – either self-imposed or created by regulators – that tie investment decisions, and thus these investors’ holdings, to ratings”. He adds that the system “has long outlived its usefulness and should be discontinued”.

In the US, the 2010 Dodd-Frank Act has attempted to reduce regulatory reliance on credit ratings. Law and finance professor Frank Partnoy has suggested that investors buy bonds with low swap spreads rather than being instructed to invest in AAA securities. European policymakers are also determined to enact substantial change.

Throughout the debt crisis, however, European politicos have tended to shoot the messenger, whether it be short sellers, the credit default swaps market or rating agencies. Few commentators deny the need for reform, but emasculating rating agencies will not suddenly liberate governments from the demands of sceptical bond investors.