The make-or-break power of ratings agencies

Moody's, Fitch and S&P can shake up the markets and change a country's fortunes – but is it time to curb their influence, asks Nikhil Kumar

Back in 1996, the American commentator Thomas Friedman quipped that there were two superpowers in the world: the United States and Moody's. The US, he observed, could destroy you by dropping bombs and Moody's could destroy you by downgrading your bonds. Much has changed in the intervening years, but America's arsenal can still wreak havoc on the world and Moody's, Fitch and Standard and Poor's (S&P), the three giant credit-ratings agencies, can still rattle markets with nothing more than a change of heart.

Just ask the Greeks. The other week, S&P slashed Greece's ratings to junk, indicating a high risk of default and prompting investors to demand eye-popping premiums to hold the country's debt. Lisbon was next: S&P lowered Portugal's ratings by two notches. Though Lisbon maintained its investment-grade status, indicating a relatively high level of creditworthiness, the move sparked fears of contagion.

Spain's ratings soon faced the axe, with S&P slicing them by a notch, though keeping them above Portugal's, shortly before the London market closed on 28 April. The FTSE 100, which had been on its way to end in the black, swiftly veered to a loss and the euro struck a fresh low against the US dollar. In Britain, with the election campaign in full swing, would-be chancellors sought to present themselves as prospective guardians of the UK's AAA standing, the highest available.

European leaders waded in, taking aim at the agencies. The EU's internal markets commissioner, Michel Barnier, said: "The power of these agencies is quite considerable, not only for companies but also for states," and the French President, Nicolas Sarkozy, and German Chancellor, Angela Merkel, called for a review of the sector. It also emerged on Friday that the US Securities and Exchange Commission (SEC) has told Moody's that it may face action for allegedly misleading regulators in a 2007 application to remain an officially recognised ratings firm.

The agencies aren't new to controversy. While now they're being criticised for downgrading government debt, in the past they've been attacked for their failure to recognise the subprime bubble by affixing favourable ratings on mortgage-related securities. In 2007, Pimco's Bill Gross chided the agencies, saying: "Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr Moody's and Mr Poor's, by the make-up, those 6-inch hooker heels and a 'tramp stamp'."

Last week, as southern Europe's debt woes shook markets, he revisited his view, saying that "a tramp stamp and hooker heels" did not begin to describe what he termed "the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the sub-prime craze". At the time of the Enron collapse, it emerged that the major agencies had maintained an investment-grade rating on the energy giant's debt until five days before it filed for bankruptcy, while Lehman Brothers' debt was rated investment grade on the day it sunk.

The agencies weren't responsible for Lehman's investment decisions, nor did they pile all this debt on Greece's balance sheet. But how is it that despite being criticised in the recent past, a piece of research from one of their ilk triggers such worry in both dealing rooms and the corridors of power? The answer, many argue, is that the agencies are often backed up by the same governments they can unsettle by shuffling their ratings. In the US, New York University professor Lawrence White traces the rise of the agencies from John Moody's ratings of railroad bonds at the turn of the last century. His firm was joined by Poor's publishing company in 1916, and then the Fitch publishing company in 1924, the precursors of today's giants, with the three selling their views in thick ratings manuals.

The mid-1930s were a key marker. The US Office of the Comptroller of the Currency prohibited banks from putting money in "speculative investment securities" as determined by "recognised ratings manuals". This effectively endowed ratings with the force of law, according to Professor White. Other regulators followed suit and in the 1970s the SEC came up with a new category of nationally recognised statistical rating organisations, or NRSROs. From then on, NRSRO ratings were used to work out the capital requirements of broker-dealers, thereby entrenching the role of the agencies in the financial system.

These and other moves – in Europe today, for instance, ratings play a role within the Basel II framework of calculating capital requirements for banks – put the agencies on a "pedestal", according to Professor White. The key to curbing their influence is less, not more regulation, he says, arguing for the elimination of regulatory reliance on ratings.

The political imperative seems to be moving in the opposite direction, however. In Europe, the push is towards more rules, as opposed to removing the agencies from the regulatory system. "That is a broader debate, which we should probably have but like a lot of things, is not being pursued at the moment," says Patrick Buckingham, a regulatory partner at the law firm Herbert Smith.

S&P says that if regulators and other authorities are to continue referencing ratings in their rules or criteria, "they should use other measures, too", otherwise "there is a risk of encouraging undue investor reliance on credit ratings". A Moody's spokesperson said the agency had "long supported the removal of ratings from regulation".

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Mortgage Administrator

£20000 - £25000 per annum: Recruitment Genius: We are a vibrant and establishe...

Recruitment Genius: Payments Advisor

£15000 - £20000 per annum: Recruitment Genius: An experienced Repayments Advis...

Recruitment Genius: Investment Analyst

£25000 - £30000 per annum: Recruitment Genius: This leading provider of financ...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: Are you looking to take your ...

Day In a Page

Migrant crisis: UN official Philippe Douste-Blazy reveals the harrowing sights he encountered among refugees arriving on Lampedusa

‘Can we really just turn away?’

Dead bodies, men drowning, women miscarrying – a senior UN figure on the horrors he has witnessed among migrants arriving on Lampedusa, and urges politicians not to underestimate our caring nature
Nine of Syria and Iraq's 10 world heritage sites are in danger as Isis ravages centuries of history

Nine of Syria and Iraq's 10 world heritage sites are in danger...

... and not just because of Isis vandalism
Girl on a Plane: An exclusive extract of the novelisation inspired by the 1970 Palestinian fighters hijack

Girl on a Plane

An exclusive extract of the novelisation inspired by the 1970 Palestinian fighters hijack
Why Frederick Forsyth's spying days could spell disaster for today's journalists

Why Frederick Forsyth's spying days could spell disaster for today's journalists

The author of 'The Day of the Jackal' has revealed he spied for MI6 while a foreign correspondent
Markus Persson: If being that rich is so bad, why not just give it all away?

That's a bit rich

The billionaire inventor of computer game Minecraft says he is bored, lonely and isolated by his vast wealth. If it’s that bad, says Simon Kelner, why not just give it all away?
Euro 2016: Chris Coleman on course to end half a century of hurt for Wales

Coleman on course to end half a century of hurt for Wales

Wales last qualified for major tournament in 1958 but after several near misses the current crop can book place at Euro 2016 and end all the indifference
Rugby World Cup 2015: The tournament's forgotten XV

Forgotten XV of the rugby World Cup

Now the squads are out, Chris Hewett picks a side of stars who missed the cut
A groundbreaking study of 'Britain's Atlantis' long buried at the bottom of the North Sea could revolutionise how we see our prehistoric past

Britain's Atlantis

Scientific study beneath North Sea could revolutionise how we see the past
The Queen has 'done and said nothing that anybody will remember,' says Starkey

The Queen has 'done and said nothing that anybody will remember'

David Starkey's assessment
Oliver Sacks said his life has been 'an enormous privilege and adventure'

'An enormous privilege and adventure'

Oliver Sacks writing about his life
'Gibraltar is British, and it is going to stay British forever'

'Gibraltar is British, and it is going to stay British forever'

The Rock's Chief Minister hits back at Spanish government's 'lies'
Britain is still addicted to 'dirty coal'

Britain still addicted to 'dirty' coal

Biggest energy suppliers are more dependent on fossil fuel than a decade ago
Orthorexia nervosa: How becoming obsessed with healthy eating can lead to malnutrition

Orthorexia nervosa

How becoming obsessed with healthy eating can lead to malnutrition
Lady Chatterley is not obscene, says TV director

Lady Chatterley’s Lover

Director Jed Mercurio on why DH Lawrence's novel 'is not an obscene story'
Farmers in tropical forests are training ants to kill off bigger pests

Set a pest to catch a pest

Farmers in tropical forests are training ants to kill off bigger pests