Fear of Junk Status: Europe Seeks to Free Itself from Rating Agencies' Grip

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The "Big Three" credit rating agencies can determine the fate of entire countries, by deciding whether they are creditworthy or not. Now Portugal is under pressure after Moody's downgraded its debt to junk status. European politicians want to create an alternative, even though they helped give so much power to the agencies in the first place.

The offices of Standard and Poor's in New York Zoom
dpa

The offices of Standard and Poor's in New York

Strange as it may seem, there are still credit rating agencies that give cash-strapped Greece top marks. The experts at Germany's Euler Hermes Rating currently give the Mediterranean country their top AA rating, citing its "very strong business environment."

And there is little doubt that Euler Hermes can be trusted. It is the first rating agency that officially meets the tougher European regulations for the industry that were introduced at the end of 2010.

There is only one problem: Their good rating for Greece is not related to the creditworthiness of the state, but to that of Greek companies. When it comes to rating sovereign bonds, that is still done almost exclusively by the three major rating agencies -- Standard & Poor's, Moody's and Fitch -- who are collectively known as the Big Three.

That is something that European politicians have long wanted to change, and there have been repeated calls to set up an independent European rating agency. Now the European Union is working on its proposal for what such an agency could look like.

Downgraded

The influence of the Big Three could clearly be seen in the heated reaction to Standard & Poor's announcement earlier this week that it might classify a planned restructuring of Greek debt as a default. Their decision seemed to cast doubt on the prospects for a complex plan to participate private creditors in a new bailout for Greece.

Portugal's future, too, appears less secure after Moody's downgraded its debt to junk status on Tuesday, warning that the country might need a second bailout before it could return to the capital markets. The move could mean that Portugal will have to pay a higher premium to attract buyers for its debt.

But why are European politicians and investors still so dependent on the opinions of three private companies based in New York and London? After all, the Big Three were the subject of massive criticism in the wake of the 2007-2008 financial crisis, because they had awarded top ratings to highly risky financial products in the run-up to the crunch. Since then, politicians have repeatedly called for measures to curb the agencies' power. Most recently, German Chancellor Angela Merkel commented on Tuesday, in relation to Standard & Poor's announcement: "Regarding the issue of rating agencies, I think it is important that we do not allow others to take away our own ability to make judgments."

But so far there have been few visible results from the politicians' rhetoric. One reason is that politicians are partially responsible for the ratings mess that they are complaining about.

On the one hand, the sovereign debt crisis has turned Europe's politicians into pawns of the rating agencies. For decades, the agencies have been assessing the creditworthiness not only of companies and financial products but also countries, giving them a mark from the top AAA rating to D for default. Now that it is Europe that is gripped by a debt crisis, as opposed to Asia or South America, governments on the continent are feeling the power of the rating agencies as never before. The agencies can decide whether a country's debt is worthy of investment or not, arguably giving them the power of life or death over whole states.

Preferential Treatment

The Big Three's ratings are not only subject to criticism because of their failure during the financial crisis. Many observers accuse the agencies of giving preferential treatment to their home country. "No one can explain why several EU countries have worse credit ratings than the highly indebted US," says Sven Giegold, financial spokesman for the Green Party in the European Parliament.

European governments have in fact reacted to the criticism of the ratings agencies. "The politicians have been relatively active in this respect," says Brigitte Haar, an expert in business law at Frankfurt's Goethe University. During the crisis, the European rules on credit rating agencies were tightened. Since the beginning of 2011, the new European Securities and Markets Authority (ESMA) has been regulating their activities.

Further evidence of the fact that pressure is growing on the American agencies was seen on Monday, when the Italian securities market regulator Consob summoned a representative of Standard & Poor's to explain its warnings of possible downgrades over the country's debt. The agency was supposed to explain why it had negatively evaluated an austerity program before the details of the package were even made known. The ESMA has even threatened to withdraw the US agencies' European licenses if they do not abide by the new European rules.

But such gestures make it easy to forget that politicians are partly to blame for the problem. After all, the rating agencies never forced anyone to take their ratings as gospel. They are simply doing their job. Nevertheless, references to credit ratings have been incorporated into many laws, including in the EU directives implementing the Basel II guidelines on banks' capital requirements and in Solvency II, the planned updated regulations for insurance firms operating in the EU. "Politicians have enshrined the power of the rating agencies in law," says European parliamentarian Sven Giegold.

But there are also practical reasons why politicians and investors put their trust in the Big Three: They cover almost 95 percent of the market, their rating systems have been established for decades and the respective systems are very similar. Legal expert Brigitte Haar argues that shifting to new rival agencies is unattractive for investors, as it could make different ratings difficult to compare. Moreover, there is a risk of "ratings shopping," where market players would choose the agency with the most generous ratings. "There is no way out of the current situation," Haar says.

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1. Shooting the Messenger
lakechamplainer 07/06/2011
Shooting the Messenger - pure and simple.
2. No surprise.
PHOEVOS 07/06/2011
It should come at no surprise that the so called "rating agancies" have US financial interests foremost in mind. And it should also be of no surprise that the US has used the rating agency weapon to dictate to the Europeans terms of how the EU crisis needs to be resolved. Every time there is a German or French or EU proposal that does not meet the approval of the US, the rating agencies are very prompt in delivering the message of disapproval.
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European Criticism of Rating Agencies
European politicians sharply criticized credit rating agencies on Wednesday after Moody's downgraded Portugal's debt to junk status, a drop of four notches.

German Finance Minister Wolfgang Schäuble said the downgrade was totally unjustified, given Lisbon's efforts to sort out its finances. "We must break the oligopoly of the rating agencies," he said.

European Commission President Jose Manuel Barroso claimed Moody's move was fuelling speculation on the financial markets and said that the agencies were not immune to "mistakes and exaggerations." Barroso claimed there were also signs of a bias against the EU on the part of the rating agencies. "It seems strange that there is not a single rating agency coming from Europe," he said. "It shows there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe."

The Commission president also said that the EU was working on additional measures to regulate the agencies, which would be presented by the end of the year. "We plan measures to improve (the) methodology and transparency of (the) rating of sovereign debt, to reduce excessive reliance by financial institutions on credit rating, to further reduce conflicts of interest and introduce more competition," he said.

How the Rating Agencies Work
The Agencies
The rating agencies assess and value the credit-worthiness, or ability to pay back a loan, of companies, banks and states. In doing so, the agencies publish ratings as well as assessments of business sectors and management reviews. The most influential rating agencies are Standard & Poor's (S&P), Moody's and Fitch, which are known as the "big three."
The Meaning of a Rating
The worse the bonds of a market participant are rated, the more expensive and difficult it is for them to borrow money. The cost of refinancing rises and, in a worst-case scenario, lenders may withdraw their investments. Banks and institutional investors, among others, rely on credit ratings to determine who they should lend money to.
The Ratings
Agencies use letter codes to classify their ratings. Standard & Poor's and Fitch, for instance, issue a top rating of AAA. This is followed by ratings of AA, A, BBB, BB, B, CCC, CC and C. Most ratings have sublevels denoted by a plus or minus sign. BB+, Greece's current rating by S&P, is the highest speculative rating, a risky bet, and commonly referred to as "junk." Junk ratings descend to D, which denotes that a borrower is in default, or failure.
Criticism
Critics of the ratings system complain that it's often unclear how much weight mathematics, on the one hand, and opinion, on the other, are given when determining a credit rating. During the recent financial crisis, credit agencies were pilloried because they rated junk securities as safe investments. According to one risk-management firm, more than nine in 10 mortgages that were rated AAA in 2007 are now considered junk.


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