Downgrade your expectations: it pays to be wary of credit ratings agencies

Prem Sikka

Evaluating the creditworthiness of countries is far from an exact science, yet the influence of credit ratings agencies is extraordinary.

Recently, the UK government’s debt rating has been downgraded by credit rating agency Moody’s from AAA to Aa1. It joins France, whose credit rating was downgraded to Aa1 in November 2012. In August 2011, Standard & Poor’s (S&P) had downgraded the US from AAA to AA+.

Credit ratings enable investors and markets to assess the risks of government securities. In the case of the UK, a downgrade could increase the government’s borrowing costs. It would also further reduce the value of the pound sterling and thus stoke inflationary pressures by increasing the cost of imports, though the weak pound may help British exporters.

But the notions of social stability, justice, and fairness are beyond the remit of credit ratings agencies. The general message from the Moody’s downgrade is that the UK government must deepen its austerity program and attack hard-won social rights on education, pensions, healthcare and unemployment.

Credit ratings can have serious impact on national and household accounts, but are also a major money-spinner. In 2012, Moody’s reported profits of $1,077 million and 2012 is expected to produce record profits as investors seek shelter from growing financial uncertainty. However, the models used by credit rating agencies continue to produce odd results, and there is an urgent need to check the economic, social and political power exercised by the rating agencies.

The UK government has provided around a trillion pounds in loan and guarantees to ailing banks. For many years, the UK-based banks engaged in organised tax avoidance, money laundering, interest rate manipulations, mis-selling of pensions, endowment mortgages, payment protection insurance and many other scandals. These scams did not persuade credit rating agencies to reduce the UK’s credit rating. Perhaps they approved of hot money rushing to London to take advantage of scams. Just as the regulators began to show signs of getting off their bended knees to giant corporations, Moody’s has downgraded the credit rating.

The very concept of risk assessment requires some openness and a relatively free flow of information, but credit rating agencies continue to give higher ratings to opaque jurisdictions. Bermuda, whose opaque structures often enable corporations and wealthy elites to avoid taxes elsewhere, is rated Aa2, while the economic powerhouse China is rated Aa3. Oil-rich Saudi Arabia is rated Aa3, the same as the Cayman Islands which is well-known for its secrecy, opaque structures and fiddle factories that facilitate tax avoidance. Iceland, bailed out by the European Union and the International Monetary Fund enjoys a credit rating of Baa3. It shares the same rating as India, which has foreign currency reserves of around $300 billion. In December 2009, Moody’s boldly stated that “investors' fears that the Greek government may be exposed to a liquidity crisis in the short term are misplaced”, but barely four months later, the Greek government was negotiating bailout deals.

Credit rating agencies have a history of poor performance. Enron, the fraud-ridden US energy giant, collapsed in December 2001. Right until its demise, it continued to attract favourable credit ratings. These enabled the company to overstate its profits and assets and understate its liabilities. Credit rating agencies said that lessons will be learnt, but the banking crash once again has shown that the emperor had no clothes. Moody’s, Standard & Poor’s, and Fitch, the world’s biggest credit rating agencies, maintained A-ratings for Lehman Brothers and US insurance giant AIG until early September 2009, just days before their collapse and bailouts.

In 2008, just prior to the banking crash, there were about twelve AAA-rated companies and about the same number of AAA-rated countries, but around 64,000 complex financial instruments received the AAA-rating. Banks sliced, diced and repackaged subprime mortgages, collateralised debt obligations and structured finance deals into what they described as “safe investments”. This illusion was supported by the AAA-ratings given by rating agencies, which subsequently turned out to be junk. The regulators were content to let the banks hold less capital for AAA securities and, as a result, banks did not have the buffer to deal with toxic debts. Investors, governments, taxpayers and markets were duped, and the whole financial system came tumbling down.

Credit rating agencies wield enormous economic, social and political power, but do not owe a “duty of care” to the stakeholders affected by their opinions. These issues have now become the subject of legal disputes. In February 2013, The US Department of Justice sued Standard and Poor’s (S&P) for issuing “inflated ratings that misrepresented the securities’ true credit risk”.

The Australian case of Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 held that credit ratings agency S&P was liable for the “misleading and deceptive” ratings issued by it because it made unfounded and irrationally optimistic assumptions in its analysis. Protracted litigation will follow as credit rating agencies try to wriggle out of any social obligations. These issues are important because credit ratings form the basis of economic experiments that can result in austerity drives, unemployment, loss of social welfare, and ruined lives.

This article first appeared at The Conversation