Rating Agencies are Hoping to Redeem Their Reputations by Downgrading Countries

Location: London
Author: Shahin Shojai
Date: Wednesday, May 27, 2009
 

In recent weeks, the major rating agencies have become very courageous; they have started to hint at downgrading a number of major economies. They started with Japan, which was downgraded by Moody’s on May 18th, and moved swiftly onto the U.K., for whom S&P issued a downgrade outlook. The top executives at these firms must have thought they have sent shivers down the backs of these governments and that their decision to downgrade would have significant repercussions for them in the debt and currency markets.

Well, the reality was that nothing really major really happened to either’s borrowing spreads vis-à-vis U.S. t-bills since the announcements. The fact is that the best examples of just how the markets ignore the major rating agencies are those that relate to downgrades of major economies. Does anyone remember what happened to Italy when it was downgraded a few years back? What happened that time was the spreads actually narrowed post downgrade.

The fact of the matter is that the value of ratings used to come from their ability to give information about companies, issues, and markets that were difficult to assess. Having ratings about a large South Korean company back in the 1980s was very valuable, but there was nothing that S&P or Moody’s knew about the amount of Italian debt that the markets did not know already. The same goes for the U.K. Responding to a downgrade of U.K. debts would suggest that the analysts at S&P are better than those sitting in other banks, and we know that they certainly are not. The amount of debt that the U.K. has issued is well-known. What is different are the perspectives about how much impact the stimulus will have on the U.K. economy, how fast it would regain steam, and how soon can they afford to repay the debt and will actually do so. There are millions of economists out there who are significantly more qualified to make that assessment than the people at Moody’s or S&P.

In fact, even within emerging markets we see that their influence has waned. Gone are the days that a visit from a major ratings agency caused panics in national central banks and treasuries. Most governments are now well understood by the markets and there are now so emerging market desks that they are much more capable of assessing these countries that any of the major ratings agencies. One might then ask why do we need ratings agencies, if the markets choose to ignore them. The reality is that we really don’t. Does anyone really think that professional investors invested in CDOs because they thought that the ratings agencies knew what they were doing? Markets like to hear information that corroborates their positions and ignore ideas that oppose them. Rating agencies obviously knew that, which is why they gave so many great ratings for instruments that no one really understood, including those who developed the original models to price them. And the public announcements of those who raised concerns about these markets were obviously ignored by the markets.

In fact, if anything, the question is why has it taken the ratings agencies so long to downgrade Japan, or put U.K. under watch? The amounts of borrowings were well known months ago. They might wanted to make the announcement when the dust about the borrowing announcements had settled so that they could make a huge news splash. To announce that we are not in fact dead, but that we still matter to the world markets. Sadly for them it coincided with the huge news in the world press about the expenses claims of British members of parliament. So, few people actually took too much notice of their announcement.

Given that they have announced their intentions to assess the increasing risks of default of the world’s major economies many are now asking whether they might also downgrade the U.S. government. Would any of the top 3 ratings agencies really have the courage to downgrade the U.S.? If so, why are they putting the U.S. under watch now? In the past 30 years there have been ample opportunities to do so. Could it be because they wish to present a new assertiveness in their ratings, in response to their exceptional work on CDOs? If so, would they really have the courage to downgrade the borrowings of the same government that could open the floodgates of class action suits against them for the ratings they issued on the MBS and ABS markets, as well Lehman Brothers?

It would be an interesting test, but sadly it would be a lose-lose situation if they do. The world already has better information about the risk of the U.S. national debt than any of the ratings agencies, so they don’t really achieve much, as they found in the case of Japan and the U.K., as well as Italy, by downgrading the U.S. They can obviously face the wrath of the Congress and literally disappear under the weight of potential lawsuits. It is also impossible to rate the U.S. government debt. If ratings are about the likelihood of bankruptcy and not the success of future issuance, then the U.S. will certainly not default on debt issued in its own currency. Given that it is still the world’s major currency, risks of default simply don’t exist. The country has been issuing currency without adequate reserves for decades now, so what difference would it make now?

The fact of the matter is that as the world becomes smaller so will the remit of rating agencies. They simply do not have the tools to accurately determine the risks of highly complex financial instruments, since no one really does. And, when it comes to rating major global economies, the information they have is no more or less than the rest of the market, the only difference is that they can’t afford some of the top economists that say, Deutsche Bank can in someone like Norbert Walter.

Consequently, while the rating agencies might be tempted to use national downgrades as a way to salvage their reputations, they are focusing on the wrong end of the spectrum. All this action will do is make people question the whole purpose of their existence.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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