Rating agencies and their excessive power:
Why are they so powerful?

By Nadezhda Peneva
American University in Bulgaria, EMBA, Cohort 13
NIP147@aubg.bg

March 21, 2014

Abstract
The paper is set out to find out the influence of credit rating agencies on the business and the national policies as well as to elaborate on how powerful are they for the society and why. Over 100 years rating agencies demonstrate excessive power, but is this just an assumption or it could be a strong conclusion? In the paper the role and power of the rating agencies like Standard and Poor’s, Moody’s and Fitch would be defined and assessed.

1. Introduction Credit Rating Agencies (CRAs) could be generally defined as „providers of opinions about the creditworthiness of companies and countries which have become very important players in financial markets due to growth in Capital Markets, Credit Derivative Markets, Globalisation of Capital Markets; and an increase in Regulatory Use of Ratings” (Ryan, 2012). Here comes the question: Why actually they have become very important players globally? CRAs are companies who assign credit ratings for the debt of public and private companies who are issuers of certain types of debt obligations and also CRAs assign credit ratings for debt instruments themselves. Usually the issuers of securities are companies, governments, NGOs and entities with special purposes or national governments issuing bonds that can be traded on a secondary market. The main important thing is that depending on the given credit rating, CRAs in fact affect the interest rate applied to a particular issued security, because it is perceived that CRAs take into consideration the issuer's ability to pay back debt/loan. Who needs these entire credit ratings one would ask… – they are used by investors, issuers, investment banks, insurance companies, pension funds, broker-dealers and even the governments. Dealing with so many stakeholders next question should be raised: Can we assess the power of the CRAs and who gave them the power?

2. Power of the Credit Rating Agencies

2.1. Power by Definition On the official website of Standard and Poor’s (S&P), the biggest rating agency, there is an announce to the readers saying “With offices in 23 countries and a history that dates back more than 150 years, Standard & Poor's Ratings Services provides high-quality market intelligence in the form of credit ratings, research, and thought leadership” (http://www.standardandpoors.com). Later on, when a reader goes to the Ratings Definition there is a very strong statement which says: “The analyses, including ratings, of Standard & Poor's and its affiliates (together, Standard & Poor's) are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or make any investment decisions. Standard & Poor's assumes no obligation to update any information following publication. Users of ratings or other analyses should not rely on them in making any investment decision...” (http://www.standardandpoors.com) Considering this can we be sure that CRAs may be simply defined as specialists in providing information regarding the creditworthiness of a company, security or obligation, where creditworthiness is “the likelihood that an issuer will default on the interest or principal due on its bonds” (http://www.economist.com, 2005) or we should just know that they are not at all an absolute predictor of whether a debtor will default on a particular obligation and they are just opinion makers with their subjective views, so called credit ratings? It seems that CRAs by definition professionally apply the rights given by the First Amendment of US Constitution.

2.2. Power by the Market Credit rating organizations have served investors and the markets more than 100 years as they provide individual and institutional investors with information and assessments as well as they enable companies and governments to access capital markets as issuers of securities. Globalization in the financial and investment markets and diversification and complexity of the issued securities as types and quantities are really challenging to institutional and individual investors who must analyze risks for domestic or foreign investments. Usually investors are lack of resources and/or skills so here is the role of the CRAs as an important part of the financial markets. Even if considered subjective, or sometimes misleading, CRAs are invaluable information resource for investors. In 1909 John Moody published the first publicly available analytical information "Moody's Analyses of Railroad Investments", mostly concerning value of railroad securities. Expanding this idea led to the 1914 creation of Moody's Investors Service[1], which 10 years later provided ratings for nearly all of the government bond markets at that stage. At the same time Standard Statistics was formed in 1906, later on the Standard Statistics Company (in 1922)[2] which published corporate bond, sovereign debt and municipal bond ratings. And Fitch Publishing Company in 1924[3] followed the first two publishing financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual”. At that time these firms sold their bond ratings to investors as mentioned above in rating “manuals”, so they followed the business model known as “the Subscriber-Fee Model, in which certain investors such as hedge funds and financial companies would contract and pay for ratings reports and receive them on a non-public, proprietary basis” (www.globalcreditportal.com). Thus CRAs were paid by investors and they play the important and critical role to determine the credit quality of debt securities which without CRAs should be made by the investors themselves. Since 1970s CRAs adopted a different business model „The Issuer-Fee Model, in which the issuer organizations pay fees to a rating firm as part of the process of issuing a security in the marketplace” (www.globalcreditportal.com). In practice rating agencies collects fees from issuers they rate, rather than the end users of credit ratings such as investors, as their principal source of revenues. Thus they enable issuers to access the capital markets whit ready investors as they provide to them ratings lasting for several years and thus helping them to reduce cost of funds compared to standard bank loans. And now a big question could be asked about the source of revenue of all leading CRAs and concerns may arise on their distorted incentives to issue inflated ratings as a way to promote business with their clients. Such concerns were heightened in the wake of high-profile bankruptcies such as Enron (2001), WorldCom (2002) and Parlamat (2003). The major rating agencies' failure to predict distress at those companies, and their large-scale downgrades on structured financial products (e.g. CDOs) in the more recent sub-prime financial crisis in 2008 have motivated a series of investigations and subsequent regulatory proposals to promote transparency and integrity in the rating industry (Xia, 2010). Current investigations and lawsuits even underline more and more questions about the business model of the CRAs, but at the end even if doubtful for many the model is a profitable one for the CRAs which additionally strengthen their power in the global world.

2.3. Power by the Regulations There are so many regulations which give strong power to the CRAs and actually during the recent decades the regulators have even increased the let’s say obligatory usage of credit ratings aiming to support monitoring of the risk of investments made by regulated entities such as banks, insurance companies, pension funds and etc. and in order to provide some disclosure framework for securities of differing risks. In 1975, the US Securities and Exchange Commission (SEC) for the first time formulated the so called risk-weighted capital adequacy requirements for banks and broker-dealers which depend on the safety of the assets held by them (recently requirements are well known as such for Risk weighted assets, RWAs). To clarify these rules SEC decided to use credit ratings as the measures of risk of securities and then recognized S&P, Moody’s, and Fitch as so called Nationally Recognized Statistical Rating Organisations (NRSROs), thus only their ratings could be used to assess whether the financial companies were satisfying the regulatory requirements. Currently bank capital requirements continue to depend on ratings of the NRSROs and so do the requirements of other private institutions, such as pension, insurance, money market and mutual funds which also follow specific restrictions for their investments based on credit ratings (typically excluding those rated below BBB, labelled as „junk”). Other investors follow internal rules such as not buying more than five to ten percent of unrated debt and etc. Positioned as globally uniform benchmark for credit risk Bank for International Settlements (BIS) decided to use them in Basel II to calculate banks’ regulatory risk capital adequacy (currently Basel III, obligatory to be introduced until March 31, 2018, covering capital adequacy, stress-testing and market liquidity risk). Considering all mentioned above, everybody could imagine what power had given SEC in the hands of the NRSROs. Recently the UK’s Financial Services Authority’s (FSA) Chief Executive, Hector Sants commented that credit ratings “have become very deeply embedded Background in the regulatory architecture, so when they change they have knock-on effects across the board in terms of the way companies can fund themselves” (House of Commons, 2009). There is a big question if the times come for new regulations, for example in the Turner Report, the FSA made clear its conviction that “regulation can and should address issues relating to the proper governance and conduct of rating agencies and the management of conflict of interest” (Financial Services Authority, 2009). In many articles and documents it is stated that actions have been taken forward in the wider international community, but still let’s wait and see.

2.4. Power by the Oligopoly The valuable property rights that come with NRSRO membership is very well described by Frank Partnoy, Professor of Law and Finance at the University of San Diego School of Law, who explained that „These regulatory benefits – which I call “regulatory licenses” – generate economic rents for NRSROs that persist even when they perform poorly and otherwise would lose reputational capital. Until recently, there were only three NRSROs: Moody’s, Standard & Poor’s, and Fitch” (Partnoy). Agencies have come and gone from the NRSRO list and there are currently ten, but the big three still account for the lion’s share of the market. S&P and Moody’s each control majority of the market. Third-ranked Fitch Ratings, which has the smaller but still significant percent market share, sometimes is used as an alternative to one of the other majors. Thus rating industry is known as an oligopoly. Besides the SEC regulations for NRSROs, which are limiting entry for the new entrants, also limiting factor for new agencies to enter the market is the fact that credit ratings’ market is strongly reputation based and in reality it is really difficult for new companies with less experience to enter this field and to gain market share and clients. This is confirmed by the economics theory, which assumes that in oligopoly market the participants have big market power over the price, even there is mutual interdependence between the participants, and it is not easy to enter or exit the market. Of course, everybody would suppose that no one of The Big Three wants to exit such market, even though they have been in the eye of the storm and under many attacks because of failures to predict some defaults or because of suspicious rating’s inflation/deflation.

2.5. Power by the Public Here, the first question to ask and try to answer is whether there is a need to have independent third-party valuation such as credit ratings. The answer is probably yes. For many reasons, neither the buyer nor the seller can be credible valuing a security. And actually it seems the buyer is just as conflicted as the seller. Probably only people who do not understand finance at all could believe that buyers are „innocent” people who have been swindled by the „evil” investment bankers and have been mislead by the rating agencies let’s say. Only after one realizes that an independent assessment is needed, who, how or what shall provide it becomes important. And then the valuation method can be different, but as long as there is a reliance on the rating agencies they will continue to „provide their opinion” and even to get more and more power in the global market. Still, one should be sure that smaller “mom and pop” investors may put more weight on CRA opinions than do large, sophisticated investment companies and banks which often conduct their own credit analysis separately. You and I may have no choice but to consider the CRA designation of AAA+ or “junk status” when buying, or not buying, a security. But does Goldman Sachs make its investment decisions based on the opinions of S&P, Moody’s or Fitch?

2.6. Power by the Failures The globalization processes accompanied by increase of volatility of financial markets that have been going on for the past 25 years extended the CRAs’ power far beyond credit ratings designations. During the Asian financial crisis in late 1990’s the big CRAs were too slow to respond to the processes so they directly affected Thailand, Indonesia and South Korea, as they maintained their investment ratings until the end of 1997, i.e. 6 months after the beginning of the crisis. During the subsequent response the reduction of ratings was too great in view of the economic conditions. This led to significant increase of the price of external financing and additionally deepened the economic crisis in those countries (G. Ferri, 2003). So, big power of the CRAs over those countries, although there were reasons, such as that CRAs have assessed the Asian issuers for a relatively short period of time, thus the accumulated historical data was not sufficient to make a reliable rating and also the quality of financial reports of the companies was considerably lower than the one of the developed nations. Other powerful failures, as mentioned previously, are the ratings decision related to several big corporations, which have bankrupted. The first such case was Enron in 2001. The company had an investment rating by the CRAs of (BBB-) 4 days before the official bankruptcy despite the fact that the information about problems had been available months in advance. In 2002, the CRAs gave Worldcom an investment rating two months before bankruptcy and in 2003 Parmalat was assigned the same rating 18 days before bankruptcy. One could state an argument that in all three cases there was fraud and that the information submitted by the companies was false. In contrast to the auditors CRAs have no powers to examine the correctness of data and entirely rely on issuer’s good faith. Save for these popular cases, in that period, as a whole, they responded slowly to the considerable fluctuations of the financial markets. Many researches and analysis show that the CRAs increased or reduced the rating not only once but at small steps over time. The argument of the agencies is that by doing so they follow a policy of “through-the-cycle rating,” where ratings remain stable in the course of the economic cycle. For that purpose CRAs state that they do not change their assessments of debtor’s creditability if only temporary changes have occurred in his financial condition. Thus the rating reflects not the current assessment of the probability of bankruptcy, but the one in the long run, which better meets the investors’ interests. But in times of great changes of the market conditions the ratings “lag behind” the actual situation and in some more extreme cases such as before mentioned they can be not exactly adequate but powerful and influential over the investors’ profitability, economic stability and etc. While in the case of the Asian financial crisis and the concussions in 2001–2003 there might be some objective reasons for CRAs wrong decisions the past years demonstrated that the inaccuracy of the credit ratings could “push the button” of a financial crisis globally. Here I refer to the cases dealing with bankruptcy of big corporations. In September 2008, Lehman Brothers went bankrupt while the investment bank’s rating was an investment one (А-). The insurance company AIG had the same rating (A-), when it was bailed out by the state’s financial aid and in both cases no fraud and no submission of false information has been found, the companies were public and operated on the most developed financial market, with the highest standards of transparency and the deterioration of their financial condition was not temporary but permanent. The most significant failure of CRA is, however, the assessment of the risk mortgage-backed securities and mostly of CDOs. In the middle of 2007, S&P and Moody’s reduced the rating of structured financial instruments to the amount of USD 27 billion issued in 2006. Some of them had a rating of triple A, and a great part of the remaining ones had an investment rating. Until the end of the year the agencies reduced the ratings of securities for another USD 69 billion and placed instruments amounting to USD 105 billion under monitoring. By the development of the crisis the reduction of the ratings globally affected issues amounting to USD 3 trillion. But here the failure is intensified by the fact that most structured financial instruments were issued with the advice of the rating agencies so that they have permanent rating (mostly investment one). Still no one can deny that right or wrong, correct or not, with their rating assignments CRAs really influenced not only the financial markets globally but many countries’ policies and their future developments as well.

3. Real impacts of the CRAs’ Power in the Real world „It must not be easy being a rating agency. Where corporate debt is concerned, the major CRAs are said to be too slow and lagging the market. When the topic is structured finance, the agencies are said to inflate ratings to attract business. And when the subject is European sovereign debt, those same agencies are said to be suddenly too conservative, issuing aggressive downgrades that destabilize the market and precipitate a crisis which otherwise would not have happened.” (Abrantes-Metz, 2014) Slow or fast in designating rating decisions, being inflating or conservative, in reality, CRAs have big impact, especially when it comes to sovereign credit ratings’ downgrades. Although negative ratings decisions are often made after the previous deterioration of the market-based credit indicators and thus the ratings can be considered as lagging indicators which often show only information already known by the market, when one of the Big Three talks about the outlook for the creditworthiness of the governments, people listen, even if they don’t always agree.

3.1. Impact on governments and national policies Usually, when there is a sovereign credit rating downgrade, it is associated with yield increases. An exception is the downgrade of the rating of USA in August 2011 S&P downgraded the USA rating form triple A to AA+ with negative outlook, which was associated with a general decrease in risk appetite and lower yields on US bonds because of their relatively safe status. Different influence had the S&P downgrading of the public debt of Greece, Portugal and Spain to a junk level – it induced “cliffs effect” on the markets: the euro and share prices have fallen; the price of each of the three nation’s government bonds has dropped and etc. And the recent downgrade of the ratings of France, Austria and UK to AA+ had almost no influence on their sovereign policies, which might be because of less reliance on CRAs opinion nowadays or simply because of the fact that this are countries with comparatively stable economic and proven track record of the governments’ bonds historically. This question is addressed by many economists, including Moody’s ones, who made an „event study” on the difference between bond yields and Credit Default Swaps (CDS) spreads (which measure the price of insurance against default by an underlying issuer) in a window of time surrounding a rating action to see if there is a statistically robust response pattern. They studied a data set from 2005 through early 2012, and examines the response of the CDS market to sovereign credit announcements, upgrades and downgrades, of the three major rating agencies Moody’s, S&P, and Fitch. As CDS spreads represent the direct prices of credit risk and therefore, if a rating action causes changes in the market perception of credit risk, direct evidence in the CDS market should be seen. The study founded that for EU 12 countries there is a small portion percent of negative credit events associated with CDS excess returns, consistent which put a question mark on the impact of negative sovereign rating actions. Similar results are found when sovereign rating actions are positive. The study also finds that sovereign rating actions have an effect on returns of smaller and/or lesser developed countries, and only if the rating action is credit negative. So it might be concluded, that for the big stable sovereigns with proven record such as core US and EU sovereigns, ratings do not seem to impact market credit perceptions beyond what would be randomly expected, but for developing countries CRAs still have a big power to influence the business and national policies.

3.2. Impact on companies and business It is important to be mentioned that sovereign downgrades and especially sovereign ceiling policies used by rating agencies affects relatively more the companies, because firms generally cannot have ratings above the country rating. Following a sovereign rating downgrade, some companies could be downgraded not because of deterioration of their financials and business, but simply because of the sovereign ceiling policy. A decline of company’s credit rating can negatively affect the capital supply and cost due to: • Limited access to the bond and stock markets because of regulations on institutional investors. As mentioned before the pension and money market funds often follow restriction for investments. • Credit ratings affect the capital requirements that banks and insurance companies should apply when take a decision for taking loans and making investments. • Credit ratings can convey information to the market about a company’s credit quality and can trigger events such as securities issues – violations, increases in rates or loan interest rates, and forced bond repurchases • Ratings also can impact customers, employees and business relationships – for example questions could be raised for the ability of the company to enter or maintain long-term supply and financial contracts. • Also big decisions for merger and acquisitions deals can be affected by the ratings. This list for sure could be even longer and probably in the future different impact could be seen as long as during the last years the investors and business behaviour is changing and the reliance on the ratings is heavily questioning.

3.3. Impact on consumers I believe there is no need to discuss in details the impact of CRAs over consumers considering their powerful influence over the sovereigns and companies. Governments’ policy are changed because of rating downgrades, usually macroeconomic changes are also seen in many countries, microeconomic climate is impacted as well and as a result for example there is an unemployment rate increase end etc. In addition access to financing could be limited and more difficult for the customers in countries with non investment grades due to parent’s banks restrictions such as lower possible mortgages (higher loan to value requirements), limitations for maximum unsecured loans, which directly impacts demand, pricing and household consumption and living standard.

4. Conclusion At the end the questions is “Are there any more powerful and feared institutions in the world than CRAs?” The answer is that The Big Three have been endowed with enormous authority and power by governments, central banks and regulators, and by the public also. They are and act like “gods of the credit markets”, so one can conclude that they have excessive power and it is not just an assumption. The rating agencies' assessment of the quality of bonds or tradable debt issued by public sector and private sector is, officially, the last word on the subject – and has been since 1970s, when the SEC in the US started using their ratings to assess the strength of securities firms’ balance sheets. One is probably wondering if these are surely the same rating agencies which gave triple A ratings to many billions of dollars of tranches of CDOs and issues of residential mortgage backed securities that turned out to be a very bad joke. Actually these triple A CDOs weren't the solid gold that the AAA badge implied? So, many would say that the CRAs played an important role in somehow provoking the biggest finance crisis since the 1930s. What is curious is the fact that almost nothing has been done by governments, or central banks or regulators to break the oligopoly (one would say de facto monopoly) of S&P, Moody’s and Fitch in the business of rating bonds. There has been a lot of thought and talks about reforming the way they are remunerated, to address the apparent conflict of interest arising from the convention that they are paid by issuers and borrowers who want the highest possible rating for their credit. I might sound not optimistic, but one can question if this model is indeed sustainable considering that the fate of nations and companies – and actually the perceived strength of the financial system – rests on the rating decisions of these powerful Big Three CRAs.

Endnotes

(n.d.). Retrieved March 13, 2014, from http://www.standardandpoors.com: http://www.standardandpoors.com/en_EU/web/guest/home

(n.d.). Retrieved March 13, 2014, from http://www.standardandpoors.com: https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1019442&SctArtId=147045&from=CM&nsl_code=LIME

(n.d.). Retrieved March 15, 2014, from www.globalcreditportal.com: https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=891445&SctArtId=217745&from=CM&nsl_code=LIME

(n.d.). Retrieved March 15, 2014, from www.globalcreditportal.com: https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=891445&SctArtId=217745&from=CM&nsl_code=LIME

(2005, March 23). Retrieved March 13, 2014, from http://www.economist.com: http://www.economist.com/node/3786551, The Economist, “Special Report: Who Rates the Raters?”

Abrantes-Metz, R. M. (2014, January). Retrieved February 18, 2014, from www.competitionpolicyinternational.com: https://www.competitionpolicyinternational.com/file/view/7078, “Did Credit Rating Agencies Cause the European Sovereign Debt Crisis?”

Financial Services Authority, T. T. (2009, March). Retrieved March 15, 2014, from http://www.fsa.gov.uk: http://www.fsa.gov.uk/pubs/other/turner_review.pdf, “A regulatory response to the global banking crisis”

G. Ferri, L.-G. L. (2003, December 2). Retrieved February 18, 2014, from http://onlinelibrary.wiley.com: http://onlinelibrary.wiley.com/doi/10.1111/1468-0300.00016/abstract, ‘The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis”

House of Commons, T. S. (2009, May 12). Retrieved March 15, 2014, from http://www.publications.parliament.u: http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/519/519.pdf, “Banking Crisis: reforming corporate governance and pay in the City”

Partnoy, F. (n.d.). Retrieved March 16, 2014, from http://finance.eller.arizona.edu/lam/fixi/creditmod/Portnoy.pdf, “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers”

Ryan, J. (2012, January 01). Retrieved February 28, 2014, from http://www.swp-berlin.org: http://www.swp-berlin.org/fileadmin/contents/products/arbeitspapiere/, The_Negative_Impact_of_Credit_Rating_Agencies_KS.pdf

Xia, H. (2010, November 16). http://www.business.uconn.edu. Retrieved March 15, 2014, from http://www.business.uconn.edu/finance/seminars/papers/JMP_HanXia.pdf, ‘The Issuer-Pay Rating Model and Rating Ination: Evidence from Corporate Credit Ratings”
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[1] Dun & Bradstreet bought Moody's firm in 1962; subsequently, in 2000, Dun & Bradstreet spun off Moody's as a free-standing corporation.
[2] Poor's and Standard merged in 1941 to form S&P; S&P was absorbed by McGraw-Hill in 1966.
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cã5?B*[pic]phhžah¯wà5?B*[pic]phhžahåCU0J5?B*[pic]ph' Fitch merged with IBCA (a British firm that was owned by French business services conglomerate FIMILAC) in 1997.