Rating agencies – a sector dominated by the Americans Moody's, S&P's and Fitch – have always been the cross and delight of the financial markets. On the one hand, they guide investors' choices, on the other they help issuers reach investors according to their risk profile. This makes them a central hub of the financial system.
Ratings summarize a series of information in a simple alphanumeric index (from AAA to CCC or D), an overall judgment on the solidity and solvency of the issuer of securities. If it is easy to understand the scale of ratings, this is not true for their attribution, i.e. what influences the financial soundness of a company or a country. Not to forget the biggest problem: often the rating does not correspond to the true state of health of the issuer.
Punctually, with every financial storm, the agencies end up in the dock. Is this also the case in the current public debt crisis in Europe? And how much responsibility do they actually have?1
Too often, in the opinion of most, the agencies have revised downwards the ratings of important issuers too late and then they have perhaps overplayed their hand – remember for all the case of the Asian crisis in 1997-1998 – thus aggravating the pro-cyclicality of investments and the flight to quality. And the Italians remember well that, in the torrid summer of 1992, the agencies downgraded our public debt only after the Amato Government had undertaken the first serious measure (of 90.000 billion lire) of fiscal stabilization, thus contributing to the lira crisis.
There has also been much criticism of inflated ratings assigned to private entities, where agencies have been accused of carelessness, if not connivance with issuers, induced by conflicts of interest due to the fact that issuers pay rating fees. Such cases emerged prominently in the 2001-2002 season of corporate mega-bankruptcies (Enron, WorldCom and many others in the US, Parmalat in Italy, Vivendi in France). And it was the perception of their involvement in placing so-called "toxic securities" linked to subprime mortgages on a global scale that brought the rating agencies back into the eye of the storm, in the crisis that culminated with the bankruptcy of Lehman Brothers in September 2008, where the agencies had first issued rather high ratings on those securities and then, with the outbreak of the crisis, had downgraded them en masse by various levels. In fact, in many structured finance issues the agencies had succumbed to a major conflict of interest by performing both the advisory and rating assignment functions (several observers thus explain how from an average B+ quality portfolio it was possible to obtain around 70 % of CDO tranches rated AAA2 and embarrassing emails exchanged between agency analysts have emerged).
After the debacle of structured finance, governments have seriously considered the need to regulate rating agencies in order to induce them to behave more responsibly. The new regulation is coming into effect in Europe.
Returning to the role of rating agencies in the current European public debt crisis, it is useful to recall how the international perspective has changed rapidly in the past three years. In the autumn of 2008, many said "nothing will ever be as before" when, in the eye of the storm of the worst financial crisis of the last sixty years, even the giants of Wall Street showed feet of clay. Governments around the world were then being solicited to the bedside of dying investment banks. One by one the most beautiful names – Bear Stearns, Lehman, Merrill Lynch, JP Morgan and Goldman Sachs – fell from riches to rags in a frenzied dance, like dervishes dazed by their own reckless gyrations. At the time, national public debts seemed the least of the problems. Finance had to be saved from its speculative excesses. We had to hurry. Except for Lehman, which was unexpectedly left bankrupt, all those finance blazons were bailed out with public money.
Today, many of those governments that were praised – think of Ireland – for the speed with which they moved to rescue their banks are under attack for the alleged unsustainability of their public debts. The so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) ended up in the dock.
Therefore, perhaps it is not true that "nothing is as before". The Economist, Cassandra Liberal, has returned to warn of financial bubbles around the world. But in the meantime, speculation has been unleashed on European public debts and from public debts it is even percolating towards the solidity of the old continent's banks and private companies.
Naturally, rating agencies cannot ignore the values of public debt securities or even private issuers when the markets put them under stress. But, you have to wonder if you haven't actually entered a self-perpetuating loop.
Anyone looking at the accounts of Euroland as a whole would see that in substance there is no external imbalance (the deficits of some member countries - especially the countries of Southern Europe - are offset by the surpluses with the outside of the area of other member countries - especially Germany). Therefore, from this point of view, the situation of the USA, which has not adjusted its external imbalance, is weaker: and it is perhaps no coincidence that the main rating agencies have recently put the AAA to the USA under observation, after the Chinese rating agency Dagong had already downgraded the US since last autumn.
The European debt crisis is mainly fueled by political uncertainties and tug-of-wars, it is not due to an external imbalance in the area. While waiting for European leaders to come to their senses, one really has to wonder whether ratings have gotten out of hand and, instead of being part of the solution, are becoming part of the problem. In other words, the great utility of ratings in normal times has another face in times of crisis: it can become an element that contributes to destabilization. Maybe someone should start thinking that it's better to temporarily dispense with ratings when the systems are screwing up on themselves.
After all, Chuck Prince, the CEO of Citibank, apologized for having compromised his bank in structured finance by saying that "as long as there is music, we must dance." Maybe it's time someone turned down the volume to prevent the sirtaki, fado, Gaelic ballad, flamenco and tarantella dancers from getting seriously hurt.
* Professor of Political Economy at the University of Bari, former Bank of Italy and World Bank manager
1 For a discussion of the role and problems, see G. Ferri and P. Lacitignola (2009), The rating agencies between the crisis and the relaunch of global finance, Bologna, il Mulino.
2 See Benmelech, E. and Dlugosz, J. (2009), “The Alchemy of CDO Credit Ratings”, Journal of Monetary Economics, Carnegie-Rochester Conference, vol. 56, no. 5.
