Credit Rating Agencies: the EU Targets the Messengers

The Wall Street Journal reported on P. A11 of its October 21, 2011 edition that the European Commission, the executive and administrative arm of the European Union, may ban credit ratings for the sovereign debt of EU member nations that are in bailout negotiations or receiving bailouts. In other words, the credit reporting agencies would not be allowed to issue ratings for EU sovereign debt that investors would really want to have rated.

Information is the lifeblood of the financial markets. Without adequate information, there is no rational way to price a financial instrument. The value of information is well-evidenced by the flurry of recent insider trading cases brought by the SEC and the U.S. Department of Justice. Information can be so valuable that some people will break the law to get it.

Now, the EU proposes to have investors plunk their money down for the debt of dodgy nations without knowing a crucially important piece of information--the credit rating. The credit rating agencies attained their prominent role because the financial markets are too complex, arcane and obscure for even many intelligent and diligent investors to comprehend. While these agencies have hardly covered themselves with glory in recent years, their assessments are held by many to be important (as well as being pertinent to those institutional investors that by law can hold only investments with certain ratings).

Shushing up the credit reporting agencies will have precisely the opposite effect intended by the EC. If deprived of important information, investors will become less confident, and their interest in buying or holding non-rated debt will diminish. The price of non-rated debt will likely plummet, and only vulture funds will profit. Other institutional investors and banks will take more losses than they've already sustained. The ability of the weak members of the EU to access private capital markets will evaporate, and Europe's taxpayers will be presented with more chits to pay.

That the EU wants to muzzle the messengers confirms the profound difficulties of its situation and the diminishing chances of successful resolution. Such blatant acknowledgement when the EU's leadership still claims it can wrassle this debt gator tells you that panic has set in among EU insiders. And where there's panic, bad things are likely to follow.

European Debt: Are the Rating Agencies Making Good Use of This Crisis?

Never let a good crisis go to waste, it is said. One senses that the credit rating agencies may be viewing the European debt crisis as an opportunity. They've questioned whether the "voluntary" or even voluntary reinvestment by banks and other holders of Greek debt in new long term bonds as a way of sharing losses with northern European taxpayers isn't a default. After all, it delays recovery of a good portion of the principal the bondholders would otherwise expect, and Creece's long term creditworthiness isn't self-evidently golden.

Today, Moody's downgraded Portugal's debt to junk status, finding that its chances of needing a second bailout are rising. This isn't a derivatives market domino effect. It results from an analytical process.

The credit rating agencies lost a lot of credibility during the 2007-08 financial crisis, amid allegations ranging from stupidity to blindness to conflict of interest from the fact that they are paid by issuers of securities. They've been dragged into court by angry investors, thus far surviving but hardly covering themselves with glory.

Reform of the regulation of credit rating agencies remains a work in progress. Particularly thorny are the problems of conflicts of interest and regulatory reliance on credit ratings. Resolution of these issues appears to be proceeding with all deliberate speed.

In the meantime, the agencies themselves may have figured out that demonstrating a little backbone would probably do them more good than squabbling in court or lobbying in Washington. Integrity is the scarcest thing in the financial markets--far scarcer than inside information, judging from recent government cases. Integrity's very scarcity makes it extremely valuable. The credit rating agencies' best chance for survival would come from providing accurate information and candid opinions in a timely manner. They would make themselves relevant and valuable to investors. And, at a time when virtually all high ranking governmental officials in Europe want to put new clothes on the sovereign's debt and kick the can farther down the road, the rating agencies would help move the crisis toward true resolution.

Reforming the Credit Rating Process

Recent news accounts report that employees at certain credit rating agencies sometimes knew that some of the deals they were evaluating were pigs without lipstick, and questioned the wisdom of rating them. The fact that the credit rating agencies are typically compensated by the issuers of the debt they are rating, instead of by investors, fuels concerns over potential conflicts of interest. Since many mortgage-backed securities that initially received AAA-quality ratings have since been downgraded for reasons that may have been foreseeable, the integrity of the credit rating process has become intensely important. This is particularly so since many institutional investors are required by law to rely on credit ratings with respect to some of the investments they can make.

Probably the greatest concern is the way the credit rating agencies are compensated. When you're paid by the person you're evaluating, how objective can you be? No matter how many rules and procedures are in place, will the credit rating agencies ever be willing to bite the hand that feeds them?

It would be much cleaner to have the rating agency funded by investors. There is a large community of institutional investors--mutual fund management companies, pension funds, university endowments, and so on--that has a powerful interest in disinterested and objective ratings. They also have the money to fund a nonprofit rating organization, and the market power to demand that issuers of debt agree to ratings by nonprofit rating agency.

An investor funded credit rating agency isn't as far fetched as it may sound. The credit rating process began with investors paying the fees, and it can return to that. In the consumer products arena, an independent nonprofit, Consumer Reports, stands as the most credible evaluator. Consumer Reports does not accept advertising from the companies whose products its evaluates, and it buys those products rather take free samples. By maintaining independence from manufacturers, its credibility is enhanced. If you want to find out how much pizazz a car has, you can read an ordinary car magazine. But if you want to find out the hard facts about how reliable a car is, you're better off reading Consumer Reports.

The established credit rating agencies are for profit organizations. Don't look for them to convert into nonprofit do-gooders. The buyside community (i.e., investors) will have to take the initiative to establish a new rating agency. Doing so may seem to involve a lot of work and expense. But, perhaps institutional investors could tally up their losses in the past couple of years from rated securities, and then they might see what's been truly expensive.