ANALYSIS:Credit rating agencies exacerbate the tendency of financial markets to move like panicked herds. Not enough has been done to stop this, writes DAN O'BRIEN
ANOTHER DAY, another rating agency blunder. Late on Tuesday night, at a time of heightened tensions in the government bond market, Standard and Poor’s (S&P) announced it was downgrading Irish government debt.
The result was predictable: a further flight from Irish government bonds yesterday, and the high likelihood that the issuance of new debt this morning will cost taxpayers even more than it would otherwise have done.
S&P is in the business of trying to assess the riskiness of all kinds of financial instruments, from government bonds to company stocks to the most complicated, new-fangled derivative instruments.
The folk at S&P are not very good at their job. Their competitors – Moody’s Investor Services and Fitch – are no better.
In the pre-financial crisis era, when financiers were inventing new and ever more complex financial instruments almost by the day, these credit rating agencies made hay. They did so because in order to market these instruments, their inventors needed the supposedly independent rating agencies to assess the products and give them a stamp of approval.
Many of these instruments were not only collateralised against dodgy US mortgage packages and other junk, but they were so intricate that the rating agencies did not have the resources to assess them properly.
Worse still, it was not the buyers of these products who paid the agencies to rate them, but their creators. This “issuer-pays” business model has glaring weaknesses. Any agency that scrutinised these new inventions too closely risked losing business – the financial wizards would take their custom to another agency where their creations would be given a triple-A rating, with fewer questions asked.
If you want a definition of conflict of interest, the issuer-pays model is it.
When it comes to government bonds, the failings of the rating agencies were less fundamental, if no less serious. They misjudged the risk of countries going bust. Their defence is that everyone else did too, including investors and assorted analysts in both public and private sectors.
The collective delusion that Italy was at little more risk than Germany of not paying its creditors was blown away by the financial crisis. All involved swung from delusional optimism to panic-stricken fear. Alas, that is where we stand today.
Much of this is plain old human nature. When hubris and avarice combine, bubbles form. When panic and fear come together, bubbles burst. Having gone from the highest of highs to the lowest of lows, we are more aware of this than most, as our property frenzy has turned to depression.
But if herd-like human behaviour – from fashion to finance – will always be with us, its damaging effects need not be amplified.
This is what rating agencies have done too often, Tuesday included. These agencies claim to be above market panic, but the timing of their downgrade announcements often appears driven by it. The downgrades, in turn, add to panic.
Rating agencies have frequently amplified volatility, misjudged risk and been swayed in the judgments by perverse incentives.
What should happen to fix this system?
Three big agencies dominate the world of ratings. This is a global oligopoly. Individual countries can do little to sort out the mess.
For Ireland, the action is taking place in Europe. The European Commission President, Jose Manuel Barroso, in an effort to grab control of the post-crisis reform agenda, set up a committee in October 2008 to make proposals.
He appointed one of those super-bureaucrats that only France produces – Jacques de Larosière – to chair it. Along with a handful of other European grandees, he produced a comprehensive report on the failings of finance and what should be done about them. Published within months, the de Larosière report was clear in its analysis and relatively radical in its proposals for the reform of finance, including rating agencies. Some of its recommendations have been put in place, some are being discussed and some have gone nowhere.
So far, European countries have agreed to supervise the rating agencies, and it is likely this will be done by a single EU regulator. This is sensible, as one big stick-carrier will be more likely to keep manners on the agencies than many small national ones.
They have also committed to looking again at their national laws, which oblige many investors, such as pension funds, only to hold assets to which the agencies give good ratings (too often the result has been fund managers not scrutinising their asset purchases closely enough and lazily relying on their triple-A labels).
In the “nothing done” list of recommendations is the ending of the “issuer-pays” model. To ban agencies from making their money this way was considered a step too far, although that issue is to re-examined next year.
Nor has the idea of setting up a European rating agency taken off. This was designed to make the ratings market more competitive, and lessen reliance on the incumbents who have made such big misjudgments.
This is probably no bad thing – the risk, or perceived risk, of governments interfering in a public body would probably hobble it from birth.
The issue most affecting Ireland now – poorly timed downgrades – was not addressed by de Larosièr. It has, however, been on the agenda since the eruption of the sovereign debt crisis earlier in the year, and is likely to be one of the issues any new regulator takes up with the agencies.
Despite this, S&P did not appear to hesitate on Tuesday. The agencies are unlikely to do so in the immediate future. With Spain teetering on the brink of downgrade, brace for lots more rating agency-induced turbulence, and possibly worse.
Dan O'Brien is economics editor of The Irish Times