Since You Asked

What’s all the fuss and bother about ratings?

“Plans to ban sovereign credit ratings in “exceptional circumstances” have been shelved by Europe’s top financial regulator after he came under pressure to retreat from the controversial measure to rein in the agencies that issue the assessments of national financial strength.”

Financial Times, Nov 16

What are rating agencies again?

They are private companies that express opinions about the likelihood that, for example, Italy will pay the money it owes bondholders. Sometimes they express opinions about how much money people will get back if Italy defaults on its loans. One way or another they’re providing opinions about the risks that creditors face.

That’s it? Just a bunch of opinions?

Basically, yes. And there are plenty of other opinions out there from journalists and particularly from people who put cash on the line and buy and sell these bonds. But the rating agency opinions have real-world significance in a way that a bloke in the pub doesn’t. Many investment funds promise their investors that they will only hold assets with ratings above a certain level. If a rating is downgraded, those funds have to sell, even if they think the asset is a bargain. Ratings are also hard-wired into regulatory rules, with similar effect. And another thing: unlike most opinions, they’re quantified.

Quantified on a scale of 1-10?

No, quantified on a scale of D through CC+ and BBB- all the way to AAA. Or alternatively, au choix, from C through Caa2 and Ba1 to Aaa. Depending on which agency you’re looking at.

Why?

For ABSOLUTELY NO GOOD REASON.

You seem a bit touchy.

I’m not the only one. Rating agencies are not popular. Start with the timeliness of ratings upgrades and downgrades. Moody’s, for example, did not downgrade Lehman Brothers to A2 until two months before its bankruptcy, and did not place the A2 rating under review until five days before bankruptcy.

That seems quite late in the day to be giving a low rating. Come to think of it, is A2 a low credit rating?

No it isn’t. The A2 rating indicates low credit risk although acknowledges the presence of long-term risks. Perhaps by “long term risks” what it meant is “bankruptcy by Monday buycialisquality.com morning”. Hard to say.

The most notorious problem is the way rating agencies seemed happy to publish very positive opinions about structured sub-prime mortgage products that subsequently turned out to be utterly worthless.

I see. So European legislators want rating agencies to be tougher and quicker out of the blocks?

Of course not. They want rating agencies to be a lot gentler and slower out of the blocks. European governments have been very grumpy about what the rating agencies have been doing. The previous Greek finance minister complained bitterly about a downgrade of Greek debt in March. The Portuguese were not impressed by a downgrade in July. And Paris was livid last week when Standard and Poor’s accidentally told website subscribers that they were downgrading France, when in fact they weren’t. It is fair to say that the French, at least, have a valid point.

So what is the European Commission proposing?

It’s quite simple. It was about to propose disbarring ratings agencies from downgrading countries at awkward moments. Then it changed its mind.

Shame. It would have been good for somebody to fight back against the agencies.

The enemy of my enemy is not necessarily my friend. The commission’s plan was pretty strange. For one thing, if the commission suddenly suspended the credit rating of Italy next week how is that likely to be received by people lending money to Italy? Are they likely to say, “oh well, no news is good news”?

I see the point.

The whole thing seemed almost calculated to make the situation worse. It’s common for the agencies to downgrade somebody – Japan, or more recently the US – with investors not batting an eyelid, either because they don’t care or because it’s old news. The European Commission screeching into town, sirens blaring, and metaphorically sealing off the crime scene, is guaranteed to make everybody take notice of ratings for a change.

So they did the right thing to dither and pull back?

It seems to be the default response for Europe’s leaders, and for once it is the right one.

Also published at ft.com.