Insight: When ratings agencies judge the world
WASHINGTON/LONDON (Reuters) - The man who holds in his hands the fate of U.S. credit, and with it potentially the global economy, favors small tie knots, sports a bushy mustache and smokes his fair share of cigarettes.
Beyond that, he is a mystery, like the work he does.
You may have never heard of David Beers but every finance minister in the world knows of him. A Wall Street veteran, a graduate of London School of Economics where he has endowed a scholarship in his name, he is the global head of sovereign credit ratings for Standard & Poor's.
It is on his say-so and the committee he oversees that financial markets have been rocked over the last 18 months. They now await his judgment upon the U.S. debt deal on which will turn borrowing costs all around the world.
Behind all too many of market moves in government debt of late has been a report from one of the major credit ratings agencies. S&P is the biggest and arguably the most influential, fast followed by Moody's Investor Service and then their smaller rival, Fitch Ratings. In national capitals, they are alternately vilified by politicians or held out as just arbiters for denouncing government profligacy.
Yet there is an overwhelming irony in their new-found prominence. These are the same firms that many blame as prime instigators of the 2007-2008 credit crisis for freely giving out top ratings to ultimately worthless structured mortgage products, allowing the credit bubble to form. Now they sit in judgment of the countries that had to ruin their public balance sheets to prevent financial collapse by saving the banks shattered by those bad instruments once blessed by the agencies.
"The ratings agencies failed the world economy in spades in the past," said Lord Peter Levene, chairman of the Lloyd's of London insurance market and a former senior adviser to the British finance ministry.
"Their track record has not exactly been stellar."
Today they have Washington in their thrall. S&P and Moody's both have threatened to cut the top-notch credit rating of the United States' sovereign debt for the first time in its history, a move that could have deep ramifications for financial markets, pushing up the cost of credit world wide for many years.
They cite the $14.3 trillion U.S. debt, almost equal to the size of U.S. annual economic output and growing. They warn this is unsustainable and failure to break political gridlock to agree on a credible medium-term plan to reduce the debt pile -- at least by $4 trillion -- will trigger a downgrade.
In Europe, the agencies already have downgraded three euro zone countries for similar debt problems.
For many people their power and relevance is a mystery. Few understand why these companies have the authority to rock the global economy. Put simply, their role is little different from a credit bureau that hands out scores to individual and households. A bad credit rating denotes higher risk and lenders will push up the interest rate charged borrowers to protect themselves against chances they will not be repaid.
The credit score for the United States has outsized import. Its $14.7 trillion economy is the largest in the world and its track record of debt repayment is stellar, hence its Triple A rating from Standard & Poors, Moody's and Fitch.
U.S. government debt since World War Two has become the gold standard, the global benchmark off which all other credits worldwide -- government and corporate -- is judged. Lower the U.S. credit score and interest rates not only in the United States but worldwide will climb.
The ripple effects could be dramatic, from lower corporate profits to weakened consumer spending, as everything from mortgage rates, credit cards and car loans are costlier. At worst it could be enough to tip a shaky U.S. recovery back into recession and seriously dent world growth.
The credit ratings agencies have a secondary source of power of no less magnitude. They are embedded in the regulatory structures that dictate operations of banks and many pension and mutual funds, giving them a central role in the world financial system.
Much of this stems from the unwieldy acronym NRSRO. A "national recognized statistical rating organization" is an entity that, in the view of the U.S. Securities and Exchange Commission, is qualified to rate companies and their various financial obligations.
Governments and financial institutions around the world have required that any credit investment be officially rated by such an organization. In other words, an NRSRO has to say a bond is investment worthy before many banks, mutual funds and national treasuries can buy it.
Bank rules adopted in 2004 further cemented their role. Crafted by global finance officials in the Swiss border town of Basel, the Basel II rules put credit ratings at the heart of evaluating how much capital a bank must set aside in reserves against potential losses -- but with a twist. Sovereign debt was considered risk free under Basel II, a decision coming back to haunt bank regulators.
As sovereign nations face downgrade and even default, it further weakens banks whose capital reserves are filled with once risk-free sovereign debt.
For years Moody's, S&P and Fitch were the only recognized credit ratings organizations. After a series of reforms, there are now 10. Most people haven't heard of the other seven, though, and their ratings carry far less perceived weight.
The responsibility they bear is so huge that even people who wield it think it is too much. They say it distorts the financial system by encouraging bondholders to substitute the judgment of a handful of ratings agencies for their own in-depth credit analysis. It stacks the deck when a handful do the homework for hundreds of thousands of private investors, banks and funds.
"The big agencies have been given this power through the regulatory framework, and given this power by the markets that have relied on them in some cases blindly for decades," said James Gellert, chief executive of Rapid Ratings, a small agency that favors more competition.
"I definitely think that the ratings agencies have too much power. I don't think it was sought but it just sort of happened that way," said one former managing director of an agency. "I think there should be less regulatory reliance on them and much more responsibility placed on the investors to do their homework."
Further complicating the issue is that the major agencies make money by charging private issuers for a rating. They are paid by those they judge. Critics say this created perverse incentives such that at the height of the credit boom in 2005 to 2007, the agencies recklessly awarded Triple A ratings to complex exotic structured instruments that they scarcely understood.
They have profited handsomely. In the three-year period ending in 2007, the height of the credit boom, S&P's operating profit rose 73 percent to $3.58 billion compared to the three-year period ending in 2004. The comparable gain for Moody's over the same period was 68 percent to $3.33 billion.
In an April report to the U.S. Congress, Senators Carl Levin, a Democrat, and Tom Coburn, a Republican, said the agencies "weakened their standards as each competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom."
There is no such incentive for sovereign ratings, which are provided free of charge to the country. But this creates potential for a different type of conflict or at best a lively political tension where raters judge those who regulate them.
"Four years ago, the rating agencies were rating everyone AAA. They had a clear conflict of interest and they missed the crisis," said Sam Geduldig, a former aide to House of Representatives Speaker John Boehner and now a lobbyist with Clark Lytle & Geduldig.
"Now they're seeing the world with clearer vision. The irony isn't lost on anyone in either party," said Geduldig.
To be sure, there is nothing to suggest they have abused their power to determine the financial fate of nations. And during the intensive lobbying in Washington when armies of trade groups descended on the city in the spring and summer of 2010 to influence debate on new financial rules that eventually were enshrined in the Dodd-Frank financial reform bill after the credit crisis, ratings agencies were scarcely to be found.
At the time, a financial lobbyist said privately he did not want their business. An official at one of the big three agencies complained that "no one was on their side."
Lawmakers in the United States have written laws giving investors an easier way to sue them if they "recklessly" failed to review information in developing a rating, and to reduce reliance on their verdicts, federal agencies must remove references to ratings in their rules.
"The positive is that this will be the U.S.'s answer to diminishing the reliance on traditional rating agencies because there will no longer be a regulatory and legal structure that forces people to use them," said Gellert.
Over the past 18 months, the ratings agencies have trained their sights on Western governments, where the deepest recession since the 1930s has ravaged budgets. Most vulnerable are countries that face the triple whammy of falling tax revenues, soaring social welfare costs and the multi-billion dollar cost of bailing out economies and banks crippled in the credit crisis.
In Ireland, beset by huge bank bailouts, its government liabilities have risen to 70 percent of GDP this year from 1.5 percent in 2006, according to the OECD. In the United States, the level is 74.8 percent of GDP, against 41.7 percent five years ago.
Right now, Washington is the bull's-eye. The changed status of ratings agencies from accused to accuser in less than three years is remarkable.
"It flabbergasts me that we are all on 'pins and needles' as to the verdict of the rating agencies as if the rating agencies themselves have any credibility after completely missing the crisis of '08 and '09," said Stephen Roach, senior executive at Morgan Stanley.
They are no strangers to criticism. During the 1997-98 Asian currency crisis, ratings agencies were castigated for failing to spot unsustainable capital inflows that led to currency collapses across Eastern Asia and deep recessions.
In 2001 they came under heavy fire for taking too long to lower Enron's credit ratings, leaving the company with a high investment grade even as its impending collapse became obvious.
The harshest public criticism of late comes from European governments, where the agencies have become a pariah for their sovereign downgrades. They are accused of untimely actions that immensely complicated the cost and the structure of international rescue packages.
When Greece lost its investment-grade status from the big-three ratings agencies in early 2010 at the start of the euro-zone's sovereign debt crisis, its borrowing costs soared, locking it out of financial markets and forcing the European Union and the International Monetary Fund to come up with a rescue package.
When the EU last month was trying to structure a new Greek bailout where private sector bondholders would take on more risk, Moody's said any requirement that they roll over their debt would be tantamount to a debt default. EU officials were furious because defaulted Greek bonds would have wrecked bank balance sheets and worsened the cost of the euro zone crisis.
German Finance Minister Wolfgang Schaeuble called for the agencies "oligopoly" to be broken. European Central Bank President Jean-Claude Trichet has expressed similar sentiments. Notwithstanding S&P's heavy corporate presence in London European Commission President Jose Manuel Barroso has suggested the agencies may hold an anti-European bias.
In the United States, the Obama administration has chafed at S&P for a steadily ratcheting up its warnings since last October of a potential U.S. downgrade, sources have told Reuters.
Jared Bernstein, a former economic adviser to Vice President Joseph Biden and now at the Center on Budget and Policy Priorities, sees an element of 'shoot the messenger' in such criticism.
"You're well within your rights to take a jaundiced view of the bond raters -- they didn't exactly distinguish themselves when they were giving high grades to dangerous mortgage bonds a few years ago. But I agree with their assessment: 'the probability of a default on interest payments is low but no longer de minimis,'" he said on his blog.
The two companies have in many ways the same story, which has a lot to do with trains.
At the turn of the 20th Century, John Moody revolutionized markets with his Moody's Manual of information on stocks and bonds. His business failed with the 1907 market collapse, but he went back to the well in 1909 with a system of analyzing and rating railroad stocks and bonds.
Within 15 years the company was rating virtually everything in the bond market. In the 1970s, the business made a shift in its fee structure, one that would become a central point of criticism during the recession -- it started charging issuers for ratings as well as charging subscribers for its reports.
Critics say that makes Moody's (MCO.N) beholden to issuers, on whose fee revenue it relies; the company, in its corporate history, says "the rationale for this change was, and is, that issuers should pay for the substantial value objective ratings provide in terms of market access."
By age, though, Standard & Poor's takes pride of place. The company dates to Henry Varnum Poor's 1860 "History of the Railroads and Canals of the United States," an attempt to consolidate the financial details on the railroads.
Around 1906, aspiring actor Luther Blake formed the Standard Statistics Bureau, publishing cards with news on industrial companies outside of the railroads. He had taken a job at an investment bank to pay the bills while trying to make it on Broadway, a not-unfamiliar path even today.
In the 1920s, Standard Statistics and the company that had evolved into Poor's Publishing started rating bonds. In 1941 the two merged, ultimately going public in 1962. The publishers McGraw-Hill MHP.N acquired the company in 1962 and remain the owners today -- though just this week, activist investors started a push to break the company up and sell S&P.
THE PEOPLE AND THE PLACE
The ratings agencies hire a broad spectrum of experienced people, from Wall Street investment banks, central banks and from outside, including former journalists. The deeply analytical environment, one that is almost professorial far from the cut and thrust of Wall Street is an attraction, former employees say. And they are respected.
"They may have had different views from me, but they were very sharp," said Claudio Loser, an international economist who was at the International Monetary Fund during the Latin American debt crisis in the 1980s and 1990s.
Two former agency managing directors said working at a ratings agency is a lot like being in graduate school. One said in his experience the companies favored trained economists; perhaps one-in-four would have a doctorate, and their experience would mirror a lot of other Wall Street resumes.
"We used to have a lot of people (who) came from the Federal Reserve Bank of New York -- very good research department -- some people came from academic backgrounds, some from the banking sector," he said.
They also get paid well for the work they do.
Glassdoor.com, a website that specializes in anonymous reviews and data about companies, says Moody's pays up to $155,000 a year, while comparable analysts at S&P top out at $167,000. Media reports this year on attempts to poach Moody's analysts by other upstart agencies said the best can command more than $200,000 a year, rates that are competitive with investment bank analysts.
Their offices are befitting that sort of status. Moody's has a sleek building designed with clean lines inside and out in downtown Manhattan. One hallway features large photos, mostly artistic aerial views, of the cities where the company has offices. Not all is picturesque, though; at one time, even after Moody's had upgraded Brazil's sovereign rating to investment grade, the picture of Sao Paulo featured a shanty town.
The ratings process that the analysts undertake in those offices is, by all accounts, intensive.
A lead analyst on a country, usually a Ph.D. with language skills, becomes something of a private investigator writ large, talking to figures from government, the media, academia, the banking sector and strategic industry to piece together economic trends and evaluate credit risks. The point, veterans of the process say, is to develop a report the ratings committee can use to help guide its decision.
Such meetings start with a written report from the country analyst, containing a core recommendation that is debated by the committee members.
Those debates even for a complex topic like the U.S. sovereign rating only take a couple of hours. Yet debates are intense, which veterans of the process say comes from efforts by the agencies in the 1990s to "professionalize" their ratings staffs and increase the profile of sovereign-debt teams.
"The sovereign committees are much more heated" than for corporate or other credit products, said Jerome Fons, executive vice president at the Kroll Bond Rating Agency who previously spent 17 years at Moody's and chaired its fundamental credit policy committee.
"There's more divergent opinion expressed. In many cases there was just a bare majority voting for a rating outcome whereas in other areas, structured or corporate, you were more likely to see unanimous ratings decisions."
For sovereign rating actions, committee members include the country analyst, sector analysts such as banks, sovereign analysts from other countries to ensure that peer analysis is a core part of the process. The committee size can vary but for Moody's the sovereign committee can be as big as 20 people.
That is one of the key frustrations for those being rated - they do not know who is on the committee, as those names are never published. The thinking, veteran ratings agency executives say, is that to reveal the names would lead to undue pressure on the raters. Even internally, one source said, committee notes omitted voting.
"Like here in the U.S. where you have these ridiculous jury trials and they have got the jurors that are all made public and then the press goes and hounds these people, the same kind of thing would take place with analysts that are part of the rating committee process," said one former agency director.
When the committee comes to a decision, majority rules. Governments are told before they are downgraded and given a chance to appeal, though by all accounts any new material has to be quick and convincing to make any sort of difference.
That interaction has become a source of contention with a member of the U.S. House of Representatives opening a probe into whether the U.S. Treasury tried to influence the contents of an S&P press release.
No matter how the committees are composed, or how they operate, when it comes to sovereign ratings everything they do has an impact. Their horizon for a country rating decision is medium-term, looking out five to 10 years at the trajectory of fiscal and macroeconomic policies. This often clashes with the short-term objectives of politicians and some investors, causing increasing political tension.
Western governments are unused to seeing their sovereign credit under the microscope. For decades, their ratings were stable, and downgrades were the provenance of ill-run emerging economies such as Argentina, Russia or Brazil. Now the tables are turned.
"One of the causes of the dramatic reactions we have gotten in Europe over the last few weeks is that people aren't accustomed to seeing S&P and Moody's and Fitch ratings change very much, and why is that? It's because generally speaking their ratings (were) stable," said Rapid Ratings' Gellert.
For the United States, a potential credit ratings downgrade would be a particular shock, given the benchmark role that Treasury debt plays in pricing credit instruments worldwide. The U.S. securities industry trade group last week estimated a downgrade to double A would push up Treasury yields by 0.6 to 0.7 percentage points.
"That's on the order of $100 billion over time that we will add to our funding costs," Terry Belton, global head of fixed income strategy at JPMorgan Chase said.
It would also deliver a blow to the prestige of the sole world power, used to lecturing others on the virtues of open democracy and capitalism. S&P and Moody's both have said they need to see a burying of political differences so that Congress can agree on a credible, medium-term plan for cutting the U.S. budget deficit. Somewhere in the realm of $4 trillion would be "a good start" S&P said.
"We believe there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling. As a consequence, we now believe that we could lower our ratings on the U.S. within three months," S&P said on July 14, adding the downgrade could be by one or more notches.
For reasons that remain unclear, S&P has been a much more aggressive on the U.S. rating than Moody's has, accelerating the deadline three times since October for a possible downgrade.
The Obama administration has grown increasingly frustrated with S&P during the debt limit crisis, accusing the agency of changing the goal posts in its downgrade warnings, according to sources familiar with discussions.
Some administration officials believe much of S&P's analysis of the political dynamics in Washington is poor and the agency is underestimating the willingness of both parties to tackle long-term deficits.
In telephone calls to top S&P sovereign credit analysts, including the head of its ratings committee John Chambers, the administration has asked why the ratings agency keeps shortening its timeframe over its demand for a long-term deficit reduction package, and shifting its warnings over when a downgrade could come, sources familiar with discussions said.
In an interview with Reuters on July 22, Beers said from what he has seen so far, S&P disagrees with the Obama administration's belief that it can reach a deal with Congress to significantly shift the country's debt trajectory.
He is ready to be proven wrong. "If it turns out to be true, and we see that ... we would expect to reaffirm the rating," Beers said.
Beers in many ways has become the face of the rating agencies in the current imbroglio, while Moody's keeps quietly on the sidelines. Beers met with dozens of House Republicans recently to talk about what could cause S&P to downgrade the country's rating. After the meeting, Republicans said they were more convinced than ever that Congress had to rein in government spending.
Injecting the agencies into politics raises some eyebrows. Kroll's Fons said ratings agencies should avoid making detailed demands on how much they want to see long-term deficits reduced.
"Once they do that, they lose their independence. They insert themselves into the political process, which is not where they want to be, and it's not a comfortable position for them to be in. The relationship between the U.S. government and the ratings agencies should be as arms length as possible.
"Once you are in the politics of this, you are no longer a referee, you are a player and you suddenly have a stake in the game -- and you should not be doing that." (Additional reporting by Emily Flitter and Kristina Cooke in New York, Tim Reid in Washington and Marc Jones in Frankfurt; Writing by Ben Berkowitz, Editing by Stella Dawson)