Università degli studi di torino | Rating agencies and financial speculation | An analysis of the protagonists of the world market | | Elisa Valenti | Matricola 711323 |

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INDEX The protagonists of the world market | 2 | A particular source of power: rating agencies and country rating | 2 | Conflict of interest? | 4 | Other issues of concern * Barriers to entry and lack of competition * Transparency | 555 | The importance of reputation | 6 | What went wrong? | 7 | The need for regulation | 7 | Can we trust the rating agencies? * The Enron Case Study * The Parmalat Case Study | 889 | Are rating agencies guilty? | 12 | The sinister power of rating agencies | 13 | A world without rating agencies | 14 | Conclusions | 15 | References | 16 |

The protagonists of the world market

A rating agency is a private firm which publicly evaluates a company capacity to repay the debt issued. This capacity is classified using a scale that goes from a maximum of AAA and a minimum of DDD. Obviously the evaluation received influences the interests that a company has to pay to receive credit.
Today the rating market is controlled by three giants, the so called “three sisters”: Moody’s Investor Service, Standard & Poor’s and Fitch . Till the 70s rating agencies were not making high profits, but today they are extremely relevant such that in 1996 the New York Times was writing that there were just two powers in the world, the United States and Moody’s and often it was not clear which one was more powerful.
How could the relevance of rating agencies grow so much? First of all, in the 70s rating agencies were paid by investors to gain information. But this process became less convenient when technology allowed investors to copy and spread the information they got. So in the 70s the issuers started to pay rating agencies and the cost was then carried on the investors.
Soon a new problem emerged, that is the conflict of interests. To respond to how many worried about the reliability of rating agencies, organizations in charge of monitoring were instituted: the NRSROs (Nationally recognized statistical rating organizations). To become a NRSRO, a rating organization had to fulfill some requirements difficult to achieve. But regulations had also a side effect: not many agencies were able to fulfill the requirements and the number of rating agencies decreased consistently, creating a market very little competitive.

A particular source of power: rating agencies and country rating

Regarding their role vis-à-vis developing countries, the rating of country and sovereign is particularly important. As defined by Nagy "Country risk is the exposure to a loss in cross-border lending, caused by events in a particular country which are – at least to some extent – under the control of the government but definitely not under the control of a private enterprise or individual". Under this definition, all forms of cross-border lending in a country – whether to the government, a bank, a private enterprise or an individual – are included. Country risk is therefore a broader concept than sovereign risk. The latter is restricted to the risk of lending to the government of a sovereign nation. However, sovereign and country risks are highly correlated as the government is the major factor affecting both. Rare exceptions to the principle of the sovereign ceiling – that the debt rating of a company or bank based in a country cannot exceed the country’s sovereign rating – do occur.
The failure of big CRAs to predict the 1997–1998 Asian crisis and the recent bankruptcies of Enron, WorldCom and Parmalat has raised questions concerning the rating process and the accountability of CRAs and has prompted legislators to scrutinize rating agencies. Rating explained | | | Interpretation | Moody | Standard & Poor’s | Fitch | | Long term | Short term | Long term | Short term | Long term | Short term | Investment-grade ratings | | | | | | | Highest credit quality | Aaa | | AAA | | AAA | | High credit quality | Aa1Aa2Aa3 | Prime-1 | AA+AAAA- | A1+ | AA+AAAA | F1 | Strong payment capacity | A1A2A3 | Prime-2 | A+AA | A1 | A+AA | | Adequatepayment capacityLast rating in investment-grade | Baa1Baa2Baa3 | Prime-3 | BBB+BBBBBB | A2A3 | BBB+BBBBBB | F2F3 | Speculative-grade ratings | | | | | | | SpeculativeCredit risk developing,due to economic changes | Ba1Ba2Ba3 | | BB+BBBB- | B | BB+BBBB- | B | Highly speculative,credit risk present,with limited margin safety | B1B2B3 | Not prime | B+BB- | | B+BB- | | Highdefault risk,capacity depending on sustained,favourable conditions | Caa1Caa2Caa3 | | CCC+CCCCCC-CC | C | CC+CCCCCC-CC | C | Default,Although prospect of partial recover | Ca, C | | C, D | D | C, D | D |

Source: Based on Moody's, Standard and Poor's and Fitch.

Conflict of interest?

As said before, the rating agencies are paid by the same companies which they should evaluate.

This issuer-paid model creates the paradox for the rating agency of not compromising the relation with the issuer and at the same time to protect its reputation. This situation obviously reduce the value and credibility of rating, since this model creates the phenomena of rating shopping and the blackmailing tool of unsolicited rating.

Issuers seek for the rating agency giving the highest rating. This is a source of conflict of interest since a rating agency could actually indulge these requests, fearing to lose a customer. This phenomena is known as rating shopping.

As a result of this interdependence between rating agencies and companies, there is also the phenomena of unsolicited rating. In this case ratings are issued although a company did not ask for it. It is important to notice that unsolicited rating are usually lower than solicited rating and are issued just by using information publicly disclosed. This practice has actually been used to acquire new customers under the threat of giving lower rating and so generally the companies subjected to unsolicited rating become customers of the rating agency which issued the rating. Finally there is a third phenomenon that increases the problem of conflict of interests: the ancillary services: in exchange of an additional fee, rating agencies would give a rating taking into account even the effect of future actions such as acquisitions or sales of assets. Generally we can say that issuers may think that if they do not buy other services from the agency their rating could get worse and, at the same time, that if they buy ancillary services their rating may get higher.

Although unsolicited ratings raise potential conflict of interests, both Moody's and Standard and Poor's state that they reserve the right to rate and make public ratings for United States SEC registered corporate bonds, whether or not requested by an issuer. If the issuer does not request the rating, the rating will simply be based on publicly available information. If the issuer requests the rating, then it provides information to the rating agency and pays the fees.

Other issues of concern

Barriers to entry and lack of competition

In the United States, there are only 5 CRAs designated by the SEC as NRSROs: A.M. Best.; Dominion Bond Rating Service (DBRS); Fitch; Moody's Investors Service; and the Standard and Poor's Division of McGraw Hill. A.M. Best is a global agency which rates the debt only of insurance companies. DBRS is Canadian-based with a regional scope and the only non-US NRSRO designated agency. Thus, the number of global NRSROs providing a comprehensive service in the United States are three, of which two agencies, Moody’s and Standard and Poor's control over 80 per cent of the market. The mean number of CRAs recognized among the BCBS' member countries is around six and there are between 130–150 credit rating agencies in the world. However, only a small number of CRAs are recognized internationally and the number has not changed much since the 1970s (BCBS, 2000).

Transparency
Many market participants have expressed concern over the lack of transparency over Credit Rating Agencies’ ratings methodologies, procedures, practices and processes. The IOSCO Code (IOSCO is the International Organization of Securities Commission) to promote transparency and improve the ability of market participants and regulators to judge whether a Credit Rating Agency has satisfactorily implemented the Code Fundamentals: * Credit Rating Agencies should disclose how each provision of the Code Fundamentals is addressed in the Credit Rating Agencies’ own Code of Conduct; * Credit Rating Agencies should explain if and how their own Code of Conduct deviate from the Code Fundamentals and how such deviations nonetheless achieve the objectives laid out in the Code Fundamentals and the IOSCO-CRA principles.
This will permit market participants and regulators to draw their own conclusions about whether the Credit Rating Agencies has implemented the Code Fundamentals to their satisfaction, and to react accordingly.
IOSCO requires the Credit Rating Agencies s' methodologies to become public to enhance transparency in an industry which is very opaque in nature.

The importance of reputation

One of the main issues in the study of credit rating agencies is related to the reputation mechanism. The assumption behind it is that the rating would incorporate not only information about the creditworthiness of the issuer, but also the reputation of the agency that assigned the rating.

In other words, the quality of rating would depend significantly on the reputation and credibility that the rating agency acquired by working in the market since due to historical performances, the market would be perfectly capable of perceiving the reputation of the rating agency as a fundamental for the reliability of its evaluation.

Therefore the reputational capital has been considered for a long time the most valuable asset for those agencies since investors base their trust on it. For years, therefore, the motto was “reputation can be a substitute for regulation”. The mechanism of reputation was believed fully capable of ensuring the objectivity, independence and accuracy of ratings, at the extent that any form of regulation was pointless, since the loss of investor confidence would mean the elimination of the value of the product on the market that agencies sell.

Schematizing

* The need of a reputational capital would be a powerful incentive for investing in the collection of the information needed to provide accurate ratings. * Building reputation takes time and considerable investment, so the chance of losing it would prevent potential conflicts of interest, ensuring the objectivity and independence of their evaluations. * The virtuous system of incentives that the reputational mechanism triggers makes unnecessary and probably counterproductive to control rating agencies by public regulators, which would jeopardize competition in the acquisition of reputation capital, undermining the efficient operation of rating services market (so-called accountability paradox).

What went wrong?
To be underestimated was, first of all, the risk that, in a market without competition, once consolidated the reputation capital, the agencies would be tempted to cost cut on the collection and analysis of information , that is to reduce its costs below the optimal level corresponding to a particular reputation.

Secondly, and consequently, until the barriers to entry remain high and their liability remains low or nonexistent, the absence of market mechanisms and legal instruments to make them pay the cost of negligence creates the problem of conflicts of interest: agencies could consciously decide to sacrifice part of reputational capital to increase profits.

As said above, the first and most obvious conflict of interest comes from the fact that since the mid-seventies, the issuers have to pay for the ratings. The issuer-paid model creates a conservative tendency in agencies, squeezed between the need not to jeopardize the relationship with the issuer - for which a lower rating would mean an increase in the cost of raising financing in the market - and to protect its reputation, which could be affected by successive downward revisions of issuers initially rated as deserving of credit.

The need for regulation

Starting in 1975, the regulations favoring rated securities specified that the ratings at issue be obtained from a “nationally recognized statistical rating agency,” designated as such by the Security Exchange Commission. The Nationally Recognized Statistical Rating Organization (NRSRO) requirement was adopted in response to credit crises in the early 1970s. The result was to “freeze” the then existing rating agencies and “severely limit the possibilities for new entrants.” Since the NRSRO requirement went into effect in 1975, the Security Exchange Commission has designated only ten agencies as NRSROs.

The current U.S regulation is therefore addressed only to the agencies recognized as NRSRO and it is represented by the Credit Rating Agency Reform Act of 2006, integrated and implemented by different rules issued by the Security Exchange Commission in June 2007. The act has mainly two goals: defining the criteria to become NRSRO and how to keep such a status and it states a number of provisions designed to protect those who interact with NRSRO.

Here some of the provisions: it is forbidden for a NRSRO to rate a subject whom are derived from more than 10% of net revenues during the previous year, since it seems apparent that there is an influential relation between the NRSRO and the rated subject. As well, it is forbidden for a NRSRO to rate a subjects towards which there may be personal interests of different kinds.

Furthermore the Security Exchange Commission has issued new rules, pursuing the aim to increase transparency of NRSRO and solve conflict of interest. In 2004, the European Parliament adopted a resolution on rating agencies, requiring the European Commission to adopt some legislative measures.

One of the most important measures is the rule 1060 of December 2009. This rule aims to create a framework for the activities of credit rating agencies in order to protect investors and European financial markets from the risk of wrong practices: conditions of issuance of ratings are issued and rules relating to supervision of rating agencies. Can we trust the rating agencies?

The Enron Case Study

Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity companies, with claimed revenues of nearly $101 billion in 2000.

Enron collapsed suddenly in 2001. The event came totally unexpected since the company had a very rapid growth in the past ten years, ranking as the 7th major U.S. corporation. However within a very short time, Enron shares lost all their value, going from $ 86 to 26 cents.

What is surprising is that Enron shares had a AAA rating till the collapse happened.

Can rating agencies be considered responsible for the losses of thousands of consumers?

The Parmalat Case Study

Parmalat is the largest Italian food company and the fourth largest in Europe, controlling 50% of the Italian market in milk and milk-derivative products.

Suddenly, it was discovered that its claimed liquidity of 4 billion euro did not exist, and that 8 million euros in bonds of investors' money had evaporated as well.

Parmalat is the largest bankruptcy in European history, representing 1.5% of Italian GNP—proportionally larger than the combined ratio of the Enron and WorldCom bankruptcies to the U.S. GNP.

The Parmalat case after over ten years is involving new protagonists. The most emblematic one is Standard & Poor’s, the well-known rating agency , which was severely condemned by the Court of Milan

The fine that the rating agency received was the payment of 784.000 euros and the legal expenses, a considerable amount of money but definitely adequate to the events. In fact, the American company pays the price for assessing a wrong rating to the company of Collecchio since 2000 till few months before the bankruptcy, a mistake that turned to be quite expensive.

Parmalat itself, therefore, seeks to find also others responsible to blame for what happened.
As a consequence, Standard & Poor’s has to pay a fee equal to the fee that received for giving the rating (784.000 euros) but the litigation of Parmalat to make Standard & Poor’s pay over 4 billion euros to cover the default of the investors has not been successful.

History of emblematic mistakes by rating agencies

Organization | Date of Default | Rating | Lehman Brothers | September 2008 | A+ | Fannie Mae | September 2008 | AAA | Freddie Mac | September 2008 | AAA | Parmalat | December 2003 | BBB- | Enron | December 2001 | AAA | Argentinian Bonds | December 2000 | BB |

Sovereign ratings failure statistics, 1997–2002 1

Failure | Failed rating(and date) 2 | Corrected rating(and date) 2 | NotchesAdjusted 3 | Key factor | Standard & Poor’s | | | | | 1997: Thailand | A ( 3 Sep. 1997) | BBB- (8 Jan. 1998) | 4↓ (0.97) | Evaporation of reserves | 1997: Indonesia | BBB (10 Oct. 1997) | B- (11 Mar. 1998) | 7↓ (1.40) | Collapse of asset quality | 1997: Rep. of Korea | AA- (24 Oct. 1997) | B+ (22 Dec. 1997) | 10↓ (5.26) | Evaporation of reserves | 1997: Malaysia | A+ (23 Dec. 1997) | BBB- (15 Sep. 1998) | 5↓ (0.57) | Collapse of asset quality | 1998:Rep. of Korea | B+ (18 Feb. 1998) | BBB- (25 Jan. 1999) | 4↑ (0.36) | Reserves replenishment | 1998: Romania | BB- (20 May 1998) | B- (19 Oct. 1998) | 3↓ (0.61) | Evaporation of reserves | 1998: Russian Federation | BB- (9 June 1998) | B- (13 Aug. 1998) | 3↓ (1.43) | Evaporation of reserves | 2000: Argentina | BB (14 Nov. 2000) | B- (12 July 2001) | 4↓ (0.50) | Fiscal slippage | 2002. Uruguay | BBB- (14 Feb. 2002) | B (26 July 2002) | 5↓ (0.94) | Evaporation of reserves | Moody's | | | | | 1997: Thailand | A2 ( 8 Apr. 1997) | Ba1 (21 Dec. 1997) | 5↓ (0.68) | Evaporation of reserves | 1997: Indonesia | Baa3 (21 Dec. 1997) | B3 (20 Mar. 1998) | 6↓ (2.05) | Collapse of asset quality | 1997: Rep. of Korea | A1 (27 Nov. 1997) | Ba1 (21 Dec. 1997) | 6↓ (7.83) | Evaporation of reserves | 1997: Malaysia | A1 (21 Dec. 1997) | Baa2 (14 Sep. 1998) | 4↓ (0.46) | Collapse of asset quality | 1998: Romania | Ba3 (14 Sep. 1998) | B3 (6 Nov. 1998) | 3↓ (1.76) | Evaporation of reserves | 1998: Russian Federation | Ba2 (11 Mar. 1998) | B3 (21 Aug. 1998) | 4↓ (0,75) | Evaporation of reserves | 2000: Argentina | BB (14 Nov. 2000) | B- (12 July 2001) | 4↓ (0.50) | Fiscal slippage | 2002. Uruguay | Baa3 (03 May 2002) | B3 (31 July 2002) | 6↓ (2.07) | Evaporation of reserves |

Notes:
1. Ratings failure defined by successive downgrades or upgrades of a long-term foreign currency sovereign rating by three or more notches in aggregate during any rolling 12- month period, excluding downgrades or upgrades into, out of , within, or between the ratings categories from "CCC" or "Caa" downward. Based on ratings activity up to-end July 2002, coverage of failures from August 2001 on is therefore partial. 2. Refers to a long-term foreign currency sovereign rating.. 3. Notches of ratings downgrades (↓) or upgrades (↑). Figures in parentheses capture the speed of adjustment, in notches per month (notches of adjustment divided by the number of months from start to end of the corrective sequence)

Are rating agencies guilty?

The Procura di Trani (Bari) seized documents of the rating agencies Moody’s and Standard & Poor at their headquarters’ in Milano. This procedure has been done consistently with the investigation that has been running for months in which it is assumed the crime of market manipulation. According to Procura di Trani, rating agencies could have consciously contribute to cause turmoil in financial markets on bonds, equities and banks.
Furthermore the Procura di Trani acquired from Consob (Commissione Nazionale per le Società e la Borsa, that is the Italian National Commission for rated companies and stock market) the documentation of the authorization procedures that enable agencies to carry out ratings on financial markets.
The investigation in Italy started after the denunciations of Adusbef (Associazione difesa consumatori ed utenti bancari, finanziari ed assicurativi, Association to protect consumers and bank, financial and insurance users) and Federconsumatori (Italian Association to protect consumers). The two consumers associations required an investigation after the speculation that occurred on the stock markets and on the bonds market after the broadcast of the ratings on Italy.
Can we consider Credit Rating Agencies Guilty?
Credit Rating Agencies stress that their ratings constitute opinions. They are not a recommendation to buy, sell or hold a security and do not address the suitability of an investment for an investor. Ratings have an impact on issuers via various regulatory schemes by determining the conditions and the costs under which they access debt markets. Regulators have outsourced to CRAs much of the responsibility for assessing debt risk. For investors, ratings are a screening tool that influences the composition of their portfolios as well as their investment decisions.

The sinister power of rating agencies

As we have seen till now, rating agencies are the entities that ensured that Greek government bonds are now seen as "junk" and those from Portugal and Ireland are rated only slightly better.
Clearly, being saddled with such a low rating makes it far more difficult for these countries to take out additional loans and Standard & Poor’s has repeatedly downgraded Greece's credit rating over the past two years -- and each step down the rating ladder has escalated the European debt crisis.
It seems evident, therefore, that everything that rating agencies do have consequences for entire countries and even continents
Ever since the US government's AAA sovereign credit rating has been downgraded, shockwaves have been reverberating around the globe. Stock markets are plunging and politicians are dashing from one crisis summit to the next. When the rating agencies give the thumbs-down, the markets are obliged to follow. Indeed, most investors have no choice but to rely on the assessments of rating agencies. Their role is enshrined in countless statutes and regulations stating that institutions such as banks, insurance companies and pension funds may only invest in companies, financial securities and government bonds that are classified as practically risk-free. If the rating falls, they are forced to sell.
This gives enormous power to this tiny sector. The agencies' verdict decides whether, and at what price, a country can raise money on the capital markets and, therefore, if the crisis will continue to escalate. If a country is downgraded, this price rises, which exacerbates its plight (which could in turn lead to the next downgrading)
The governments of the euro zone, which are struggling to find a way out of the crisis, are forced to watch helplessly from the sidelines as the rating agencies make life more difficult for them. When they moved to have private-sector creditors shoulder part of the burden of a new aid package for Greece, the rating agencies threatened to give Greece a "default" rating, which would have caused renewed turmoil in the markets. It took intense negotiations to hammer out a compromise.
Again the dilemma is whether it is acceptable for so much power to be concentrated in private companies whose objective is not a stable financial system, but their own profit.
On the other side, one could state that this precisely what global public finances need: an independent oversight that forces governments to tighten their belts and keep their budgets in order.
But are rating agencies infallible?
When analysts decided to lower the long-term sovereign credit rating for the first time from AAA to AA+, the United States Treasury immediately sounded the alarm and contended that Standard & Poor’s had made a $2 trillion (€1.4 trillion) error in its calculations of the country's future debt. The agency asked for a few hours to think it over. It then confirmed the downgrade, but the reason had suddenly changed. Now, instead of highlighting its financial calculations, the agency cast doubt on the country's political leadership. The dilemma stays: can we trust rating agencies? This dilemma brought the conviction that more transparency is needed. Many people consider rating agencies one of the reasons of the crisis. Therefore in the last years it has been discussed about plans to establish a competing European agency. It must be said that in case an European rating agency should take place, there would be the risk to make it a political instrument and its rating would probably be considered as reliable as the ones assessed by independent and private institutions.
Till now a compromise between the private rating agencies run for profit and an European rating agency could be the disclosure of data and methods of the current rating agencies.
A world without rating
It is clear that rating agencies have been considered responsible for the global economic financial crisis.
Are rating agencies really indispensable for whom decide to invest his money in stocks or bonds?
Some economists believe that it is possible to evaluate the probability of default of the issuer and therefore understand the risk level of any bond, even if it has previously been assessed with high rating. This is possible thanks to some derivative instruments such as Credit Default Swaps*.
The sensational case of bankruptcy of Lehman Brothers has shown, that , if properly assessed and communicated, the so-called "probability of default" would have been, months in advance, the only effective indicator the riskiness of the bond.
So this case has proved a further argument in favor of theory that some market instruments (including the CDS in fact)would be able to effectively replace the judgments of rating.

*Credit Default Swaps are derivatives in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

*Credit Default Swaps are derivatives in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

Through this kind of tools it is possible to build an independent evaluation in real time and free from any inefficiency of the typical market rating. .
In short, the CDS quantifies the risk of default of the company. The operation is the same as that of ratings: AAA is the maximum degree of safety, in this case identified by a spread that varies between a range of 0 to 30 points. The CDS allows therefore to isolate and transfer the credit risk associated with a given issuer.
Moreover, the nature of "swap" of the CDS, ie exchange of cash flows between counterparties, makes the assessment of its price partially immune from changes in market interest rates.
Conclusions
The central role of that the three main rating agencies have played in the financial crisis has led to a considerable interest for this industry and its practices. This interest, however, should have occurred before and in that case the agencies would have felt a greater responsibility on their shoulders. Surely if they had suspended those ratings on which there was too much uncertainty, disastrous consequences would have been avoided and they would have maintained a greater credibility .
At this point it is good to trust rating agencies, but it is necessary to be aware of the speculations and the conflicts of interests present in those companies that can affect the global economy.
Although rating agencies are often targeted as responsible of financial crisis, it is important to keep in mind that the recent market crisis is the result of a variety of causes
Therefore, in such a delicate moment for the international economy, the authorities and economic policies should not point the finger at the agencies, in order to find a culprit, but instead they should analyze the problem deeply, without forgetting to look ahead in order to build a good system of incentives for these companies, so as to ensure that crisis of this magnitude will not recur in the future.

References
Hill C.A., 2003, Regulating the rating agencies, Business, Economics and Regulatory
Policy, Working Paper, n. 452022, Georgetown University Law Center.
IMF- International Monetary Fund www.imf.org
Standard & Poor’s www.standardandpoor.com
Moody’s www.moodys.com
Fitch www.fitchratings.com
Spiegel www.spiegel.de/international
La Repubblica www.repubblica.it
Financial Times www.ft.com