28.09.11 - What rating for the rating agencies?

On 5 August, the US rating agency Standard&Poor’s downgraded the US credit rating from AAA to AA+. While this move was expected, it was nevertheless historic as the US had benefited from the top grade since ratings were adopted 90 years ago. So who are these rating agencies, powerful enough to give grades to nations? And what exactly is the extent of their influence?

From rating railroads to ranking nations
The role of rating agencies is to provide investors with objective analyses and independent assessments of companies and countries that issue debt obligations and fixed-income securities. Standard&Poor’s, Fitch Ratings and Moody’s are the three major agencies, all created at the time of the rush to build railways across the American continent. Investors were looking for information to help them to profit without taking too much risk, and the agencies’ Manuals did just that by rating railroad companies. H.V. Poor started his business (which later became Standard&Poor’s) in the late 19th century, while J. Moody first published his manual in 1900. Finally, J.K. Fitch created his own rating agency in 1913 and adopted the famous grades, from AAA to D.
After the 1929 crisis and the Great Depression, rating agencies gained in power. In contrast to banks who were fiercely criticised, their perceived lack of conflict of interest was a major factor in bringing them to the forefront of a new regulatory regime. Back then indeed, rating firms only earned revenues from selling their Manuals. Over the years, however, they continued to spread their sphere of influence and by the 1990s market boom, some significant issues had come up. Mainly, their independence was increasingly put in doubt as, by then, they were paid by the very firms that sold the debt to investors. Also, during the boom years, they overvalued their ratings with more than 90% of positive grades, misleading investors, and they were not able to foresee some previous crises or business scandals (Enron, Worldcom).

Responsible for the 2007-2009 credit crisis?
But the real problems arose as they started to rate structured products and not only the main issuers, such as countries (sovereign), supra-nationals, and corporate issuers. Indeed, the securities at the heart of the recent credit crisis, such as mortgage-backed securities (MBS) or collateralized debt obligations (CDO) could not have been marketed and sold without their seal of approval. Their ratings helped the market soar and their subsequent severe downgrades (averaging 5-6 notches) through 2007 and 2008 brought chaos to markets and firms. They lost a lot of credibility as they overlooked the subprime exposure that was embedded in some complex but widely distributed products.

A historic move
Following the crisis, rating agencies worked much less on products but they recently received a lot of publicity for their sovereign ratings, especially on European countries – Greece, Portugal, Spain. Nations being a unique economic agent, sovereign rating is a very complex process, which always involves a political dimension – for instance, for historical reasons, emerging countries tend to be under-rated while developed economies can remain over-rated. In search of renewed credibility, rating agencies have become extremely strict and the historic downgrade of the US rating is part of this recent trend. It took place just days after Congress and the Senate approved a rise of the US debt ceiling and a disappointing last-minute compromise on a public deficit cutting plan. The downgrade mainly reflects the view that the faith in American political institutions has weakened in a context of fiscal and economic challenges. However, it was hardly a surprise as investors had known for a while that US Treasuries were no longer true AAAs. Interestingly enough both Fitch Ratings and Moody’s have so far kept the triple A grade on the US, Moody’s with a Negative watch.

Our views on the US
In a world where most OECD countries have excessive public debt, the notion of AAA might have to be redefined, or even that of rating nations altogether. So, short of giving it a grade, how do we assess the US economy today? We believe it is in a ‘stall speed’ regime (where the potential for growth is lower) with a rising risk of recession; the private and public sectors need to deleverage further whereas fiscal spending has limited flexibility to implement counter-cyclical policies. All eyes will continue to be on the US Federal Reserve (Fed) hoping that it is able to restart monetary transmission channels. However, although previous unorthodox monetary tools, such as Quantitative Easing (QE) and QE2 have helped to contain deflationary risk, they’ve only had a limited impact on the real economy; a new round of QE will likely just have a temporary effect on the wealth channel and could even have a negative feedback on the income
channel. The Fed seems nevertheless ready to pump further liquidity into the system in order to avoid a ‘Japanese scenario’, (low growth and deflation) and favour low growth and inflation (also called stagflation); the latter, coupled with regulation and targeted long-yields, would push real yields into low or negative territory and help to reduce both private and public debt. In the current environment, we have had to revise downward our earnings expectations and growth outlook. We are becoming increasingly cautious on the US equity market, due to the longerterm issues, such as the underlying weakness of the US economy, the government’s credit downgrade, and the political challenges regarding fiscal tightening. On the contrary, we are presently positive on US debt due to the poor economic outlook, the increased pressure for fiscal consolidation, and the very loose monetary policy, which will likely continue until 2013. We expect positive - but very low - yields on long-dated US Treasuries and do not believe any large sell-off of Treasuries will take place this year, on the contrary. Demand will not abate as there is no good alternative – except gold.

Room for improvement
Rating agencies currently operate with various drawbacks: their independence is questionable, according to US laws they cannot be held responsible for their recommendations, the three ‘Majors’ rule the field with almost no competition and some believe they are US biased, and the reliability of ratings is inconsistent. Moreover, many countries also want to tighten the oversight of the rating agencies. In order to have a more balanced situation, the European Union is considering creating its own rating agencies, while China already has Dagong Global Credit Rating, which currently gives the US an A while China is triple A. The Chinese agency has been gaining recognition and some experts already believe that, for OECD countries, Dagong is more accurate than the three US agencies. Using the lessons of the past, the rating system could thus quickly evolve, with more competition and responsibility. Although ratings are an ‘easy reading’ and many investors rely on them to make an investment decision, they remain no more than a small part of very large pool of information available to professional investors. One must remember that they are merely an incomplete reflection of a much more complex reality and that better information may lie in the price of assets. Furthermore, our experts run their own independent and thorough research, and are at your service to provide professional advice on a wide range of securities.