By Michael Park
They've been called "executioners" by the CEO of Vivendi Universal, Jean-Rene Fourtou, and "pyromaniac firemen" by the head of another French company, Alcatel. Michel Bon, former chief executive of France Telecom, has said Moody's downgrade eventually lost him his job.
But hostility to the major credit rating agencies cannot be ascribed just to French resentment of Anglo-American capitalism. From Japan to the UK, Iran to Brazil, disgruntled companies and sovereign nations are objecting to "unjustified" downgrades by Moody's Investor Services, Standard & Poor's (S&P) and Fitch.
The depth of hostility towards them is strikingly at odds with how the rating agencies (RAs) see themselves. They are just good citizens, they claim, quietly labouring to impart timely information on credit risk. "We try to be as objective as possible," said a spokesman for Moody's. "It is up to the markets to decide how much weight they are going to put on our opinion."
Given the enormous and growing influence the RAs wield, he was a mite disingenuous. Together, S&P and Moody's control almost 80 percent of the global market ratings for companies and economies, while Fitch enjoys 14 percent. Moody's alone rates 85,000 securities worth at least $30,000 billion and comments on the creditworthiness of 100 countries.
Capital markets have no real alternative and, until last year's collapse of Enron, whose status both S&P and Moody's described as "investment grade", few seriously entertained the thought. But now the RAs are coming under fierce scrutiny. They are being attacked as complacent and monopolistic and the Securities & Exchange Commission (SEC) is investigating their future structure under the Sarbanes-Oxley Act passed earlier this year. The SEC will deliver its report to President Bush and congress by 26 January.
Moody's and S&P have a long history of dominating the credit ratings market. In 1907, John Moody published an analysis of the railroads and their outstanding securities and ever since his company has been opining on creditworthiness. Last year, its revenues were UKpound 797 million. S&P, which turned over $870 million last year, was formed in 1941, after the merger of the Standard Statistics Bureau and Poor's Publishing. In 1966, it was acquired by McGraw-Hill.
Fitch Ratings is fully owned by Fimalac of Paris, so French accusations of US bias don't wholly stand up. After purchasing Duff & Phelps and Thomson Bankwatch in 2000, Fitch is now the world's third-largest rating agency.
The RAs' importance has increased in line with the rising numbers of issuers, the birth of the euro and the advent of new, complex financial products, such as asset-backed securities and credit derivatives, in the 1990s. The agencies' influence was largely confined in the first half of the 20th century to the US, but globalisation has vastly expanded their role. The fact that a corporation's or country's obligations have a rating from a RA is often enough to attract investors.
Today, credit ratings affect securities markets in a number of important ways, including an issuer's access to and cost of capital, the structure of financial transactions and the ability of fiduciaries and others to make particular investments.
The RAs' main customers are investors, but issuers are their principal source of income -- Moody's, for example, charges between $25,000 and $125,000 for rating corporate bonds. The
potential conflict of interest here has drawn much criticism from other credit research firms, which the agencies dismiss -- in an echo of comments made by the accounting industry before the Arthur Andersen scandal -- by saying that their reputation depends on maintaining their independence.
Sovereign ratings are determined by reference to often subjective variables, including per capita income, GDP growth, inflation, fiscal balance, external balance and debt and governmental stability. For corporations, the process generally involves a discussion with management (except when the ratings are unsolicited), in-depth examination of the company books and its projections, and any public records available.
When sufficient information has been gathered to evaluate the risk to investors who might own or buy the security, a conclusion is usually arrived at in committee. The rating agency then continues to monitor the company and assess the rating.
There are native rating organisations in many countries, but they tend to be small and confine their activity to assessing consumer credit. Critics in these countries say this is because the three major agencies are too powerful. But in the US, too, many are questioning their role.
The RAs are among the few significant financial players still largely unregulated. Now US politicians are calling for controls, which could include government audits of their performance.
The criticism is that the agencies effectively operate a closed shop in the US because they are protected by the SEC's designation of "nationally recognised statistical rating organisations" (NRSROs). This status of credibility is much coveted by smaller companies, whose attempts to compete with the three giants have often foundered on regulators' refusal to accept that they, too, are "nationally recognised".
Moody's says it's not worried by competition and the markets will ultimately decide: "There were three major ratings agencies active in the marketplace before the SEC designated NRSRO status in 1975 -- and there are three rating agencies now after consolidation."
In Europe, it points out, where there is no NRSRO designation, there are still only the three major RAs, and adds: "It may be that this number is the result of what the market itself has determined is sufficient to meet its needs."
Issuers and investors also complain about the quality and transparency of the agencies' analysis. There is a widely-held conviction that numbers are fed into a "black box" and a simple rating produced, as if by magic. Some believe that, because the agencies are private companies, there is no real appeal if they get it wrong. But both Moody's and S&P publish annual reports showing the relationship of ratings to defaults, which, it's generally acknowledged, are accurate.
"Why should there be an appeal, given the quality of information and length of dialogue that went into coming up with the rating in the first place?" S&P protests.
Records show that the agencies are usually prescient in their ratings, sometimes by allocating declining ratings on debt up to five years before the issuer eventually defaults. But they can miss the mark and when they do their excuse is that they are not auditors and lack privileged access to issuer information.
S&P told the SEC it believed Enron was providing it with "complete, timely and reliable information". But congressional investigators ask why the RAs did not downgrade Enron's debt to below investment grade until days before it sought bankruptcy protection on 2 December 2001. They also want to know whether the agencies were pressured by Wall Street investment bankers, worried that a downgrade would jeopardise their loans to Enron.
Senator Joseph Lieberman, the Connecticut Democrat who is chairman of the senate governmental affairs committee, has said: "They [the rating agencies] see themselves as private, but they're playing at least a quasi-governmental role in this unusual system that has built up, where the laws give them the authority to decide where literally trillions of dollars can be invested or borrowed, depending on whether they say this company is okay or not. And we hold them to no accountability."
The RAs now recruit specialists in accounting, off-balance sheet financing and corporate governance, the three areas with the greatest potential for abuse. Moody's has also hired a European corporate credit officer "to ensure consistency of the rating process and the way we communicate to the financial markets". Yet questions about their business practices refuse to go away.
Partly, the criticism is cultural. The agencies have disseminated US business methods throughout the world, but these were found wanting during the Asian currency crisis of 1997 and the sovereign rating processes in Japan, South Korea, Thailand and Malaysia. Downgrading of sovereign debt, followed by a swift upgrading, left the impression that the agencies' analyses were neither accurate nor appropriate.
Japan has several times borne the brunt of agency downgrades. In November 1998, its finance minister responded to Moody's downgrading of its government bonds by threatening to "re-rate the rating agencies". Earlier this year, when Moody's did it again, the talk was of "flawed logic".
In the earlier case, Moody's critics observed that Japan's gold and foreign currency reserves ($220 billion) eclipsed those of any other G7 member and that it had almost enough external credits to finance the external liabilities of the US. The IMF, in September 1999, asserted that the rapid downgrading of South Korea and Thailand had accelerated the dramatic outflow of capital from these countries and made a bad situation worse.
The downgrading of Japan was undeniably controversial, not least because the rating was unsolicited and some observers think unsolicited ratings are a business tactic adopted to win requests for ratings -- that RAs release unsolicited ratings and low-ball them as a pressure sales pitch. "They may be considered a kind of intimidation," says one. For the past three years, Moody's has not assigned unsolicited ratings and says it doesn't intend to because the "concept has often been misunderstood".
At bottom, a credit rating represents only an opinion on a specific date about the creditworthiness of the issuer of an obligation or the financial obligation itself. It is not investment advice and does not speak to the market price of the securities. But there is a growing belief that the provision of a rating is moving beyond the simple contribution of an opinion; and, in particular, that the discussions known as the Basle II Accord, which form the basis for proposed EU regulations, could lead to the agencies becoming an international arbiter of capital liquidity.
The Basle committee on banking supervision suggested in June 1999 that national regulators should use the ratings generated by the RAs to decide how much capital banks should be obliged