The reputation of the ratings agencies is now so thoroughly trashed that their continued usefulness might seem in doubt. But reform proposals from both Washington and Brussels amount to little more than tinkering. Why is that?
Indeed, we can pose a starker question. If the agencies – Standard & Poor’s, Moody’s and the rest – were to vanish, would it matter?
The conventional answer is that the regulatory system depends on them. Many investing institutions can only hold investment-grade securities, as defined by the agencies. The Basel II rules on bank capital rely on agency ratings for the risk-weighting of assets.
Whether that is sensible, given the mess the agencies have made of things lately, is debatable. But if it is, the next key question was raised some years ago by Richard Sylla, the US academic.
If, he asked, ratings are to be a regulatory requirement, why is it not the business of the regulators to supply those ratings? And if it isn’t, why should they not outsource other regulatory functions, such as bank examinations?
To raise the question is to spot the answer. Regulators would have to pay for a system that is now – absurdly – funded by the bond issuers. And even if they were free from that particular conflict of interest, they would still make occasional mistakes – and would no longer have the agencies to blame.
Leaving that aside for the moment, consider what the agencies have to offer the investment community. They claim to have privileged access to companies’ books. It is unclear how far that is still true – and whether such a practice is legitimate in today’s supposedly transparent markets.
More to the point, academic work strongly suggests that the agencies bring nothing to the party. They tend to follow the credit markets rather than lead.
And if they do move the market, it is generally because they are flipping the on-off switch between investment and non-investment grade. So again, their power rests on regulation rather than market demand.
A little history is in order here. The first agency, Moody’s, set out its stall exactly a century ago. By then, it appears, the US corporate bond market had become too complex and diverse for the financial press and the investment banks to track – for the time being, anyway.
In 1931, ratings became an explicit part of bank regulation. Despite that, though, by the 1960s the agencies were in decline, since the US bond market was by now well enough understood by investors. But when the market went international in the 1970s, the agencies went into overdrive.
Today, it seems pretty clear that investors have again caught up, thus rendering the agencies redundant for other than regulatory purposes. A clear pointer is that until the credit crisis, equity analysts and investors were often unaware of the ratings of the companies they covered or invested in.
This was in spite of the fact that if a company’s bonds went into default, the equity would already be wiped out. But equity investors reckoned they could figure that out for themselves.
Today, it seems, that has changed. Analysts will probe companies on what level of rating they are comfortable with – the point being that in these desperate times, companies will cut the dividend or capital spending to preserve access to the bond market.
But again, that does not mean the ratings are new information. More likely, bond investors are so shell-shocked that they need the ratings as justification should their purchases go wrong.
Another argument for the agencies’ existence is that without them, the market would be unable to analyse complex structured products. But it is now abundantly clear that the agencies could not analyse them either. The answer is to scrap the products.
Indeed, that whole episode is central. At the peak, structured products – today’s toxic assets – amounted to almost half the business of some agencies.
And the record is gruesome. By one industry estimate, 60 per cent of structured issues were rated triple A against 1 per cent of corporates. Many of the former are now bust. And extraordinarily, it now appears that on some the recovery rate – the amount retrieved after default – has been just 5 per cent.
It is of course argued that this was an unfortunate aberration, and that the ability of the agencies to rate conventional bonds is unaffected. But corporate defaults are only getting started this time round, so we shall see about that.
The answer to all this is for the regulatory tie to be severed, and for investors to pay for ratings as they please – and from whoever they please, rather than from a sanctioned handful. I very much doubt that will happen. But these are revolutionary times. If the authorities want to sort the whole sorry mess out, they will never have a better opportunity.