Photo Gallery: In Thrall to the Big Three


Fear of the Executioners The Sinister Power of the Rating Agencies

As the debt crisis worsens, governments fear the rating agencies, which have the power of life and death over whole economies. The Big Three helped to cause the 2008 financial crisis and are now accused of worsening the euro zone's woes. But a look behind the scenes shows that there are few alternatives to the mighty agencies.

The man who will decide on the financial health of entire countries this summer wears dark suits and square wire-rimmed glasses. He has graying hair, but his face is youthful. He speaks in a sonorous baritone tinged with a southern German accent. Yes, this ratings guru is from Germany.

His name is Moritz Kraemer and he makes a friendly and relaxed impression. But when his critics talk about Kraemer's work, they characterize him as "highly dangerous" and a "firebrand," one of those murderous men "who destabilize all of Europe." His powerful opponents include the German chancellor, the president of the European Commission and the French head of state, to name just a few.

Kraemer is the head of the European sovereign credit ratings unit at Standard & Poor's. Together with his colleagues at the rating agency, he has helped ensure that Greek government bonds are now seen as "junk" and those from Portugal and Ireland are rated only slightly better. Being saddled with such a low rating makes it far more difficult for these countries to take out additional loans.

Kraemer and his team have repeatedly downgraded Greece's credit rating over the past two years -- and each step down the rating ladder has escalated the European debt crisis. "That was really rough," Kraemer admits in a surprisingly calm manner, "but we're simply obligated to promptly inform investors of our opinion of the risks involved." Kraemer assesses the creditworthiness of countries and addresses the question of how likely it is that they will become insolvent. Working with his colleagues, he takes hundreds of pieces of data, combines this with people's views and opinions, and finally distills this to a rating. The highest rating, AAA, has become the ultimate seal of approval. From there it goes downhill over nearly two dozen rungs to D, for default. Germany is rated AAA. Greece is hovering just above D.

Repercussions for Whole Continents

Kraemer's job is normally a rather low-profile position that is only important for bond dealers, central bankers and other financial professionals. But these are no ordinary times. The currency market is teetering on the brink of disaster and suddenly everything Kraemer does has repercussions for entire countries -- and even continents.

Ever since he and his colleagues downgraded the US government's AAA sovereign credit rating  on the Friday before last, shockwaves have been reverberating around the globe. Stock markets are plunging and politicians are dashing from one crisis summit to the next. When the rating agencies give the thumbs-down, the markets are obliged to follow. Indeed, most investors have no choice but to rely on the assessments of rating agencies. Their role is enshrined in countless statutes and regulations stating that institutions such as banks, insurance companies and pension funds may only invest in companies, financial securities and government bonds that are classified as practically risk-free. If the rating falls, they are forced to sell.

This gives enormous power to this tiny sector. The agencies' verdict decides whether, and at what price, a country can raise money on the capital markets -- and if the crisis will continue to escalate. If a country is downgraded, this price rises, which exacerbates its plight -- which could in turn lead to the next downgrading.

The governments of the euro zone, which are struggling to find a way out of the crisis, are forced to watch helplessly from the sidelines as the rating agencies make life more difficult for them. When they moved to have private-sector creditors shoulder part of the burden of a new aid package for Greece, the rating agencies threatened to give Greece a "default" rating, which would have caused renewed turmoil in the markets. It took intense negotiations to hammer out a compromise.

To make matters worse, all of this power lies largely in the hands of three private companies that have their headquarters in the US: Standard & Poor's (S&P), Moody's and Fitch (which has dual headquarters in New York and London). They form the infernal trio of the financial world.

Is it acceptable for so much power to be concentrated in private companies whose objective is not a stable financial system, but their own profit? Or is this precisely what global public finances need: an independent oversight that forces governments to tighten their belts and keep their budgets in order? Americans are only beginning to truly ask these questions now. The debate has been raging in Europe for months, however. European politicians across the political spectrum have harshly condemned the agencies, arguing that they are a threat to the global financial system and that they fuel the bloodletting on the markets.

These critics contend that in the run-up to the 2008 crash, the agencies helped spark the crisis by giving far too lenient ratings to American mortgage-backed securities. Now, they say that the agencies are being too harsh -- and are thus again responsible for widespread misery.

'You Need to Have a Thick Skin'

What effect does this have on Kraemer? Can he still sleep at night? And when he sees protests and street battles in Greece and Spain, does he feel partly responsible?

"No," says Kraemer. "You need to have a thick skin in that respect. Countries don't have to trim their budgets for our sake, but because they have accumulated too many debts."

Kraemer's office is located on the 27th floor of the Frankfurt Main Tower. The view extends all the way to the Taunus mountain range, but Kraemer is rarely here. Instead, he spends much of his time traveling around the world. "At least once a year we send a team to every country that is rated by S&P," he explains.

Many doors are opened for Kraemer, right up to the heads of government: "Ministers brief us on policy guidelines." He says that this dialogue with the governments is part of the rating process. "We of course listen to what they have to say -- anything else would be unreasonable."

At the same time, he adds, the rating agency doesn't rely too much on the plans and data presented during these visits. "We make our own analytical decisions."

'There Were No Calculation Errors'

That's hardly surprising. After all, many official figures are questionable. It's been common knowledge for some time that Greece's deficit figures were unrealistic. But how do you rate a country in such cases? "If the flow of information is too slow, we don't pull a rating out of a hat," says Kraemer, explaining that S&P withdrew its rating for Libya for this very reason. In the case of Greece, he adds, "there was, in our opinion, sufficient information available for an assessment."

Apparently, the information didn't shed a positive light on the country: In only 500 days, S&P downgraded its rating of Greece by seven notches. "The situation in Greece deteriorated much faster and more dramatically than was initially apparent," says Kraemer. "From today's perspective, though, no one would say that these steps were exaggerated."

Generally speaking, Kraemer also sees very few problems with the work of his agency -- not even with the fact that S&P initially apparently misinterpreted the US federal deficit. When analysts decided to lower the long-term sovereign credit rating for the first time from AAA to AA+, the US Treasury immediately sounded the alarm and contended that S&P had made a $2 trillion (€1.4 trillion) error in its calculations of the country's future debt. The agency asked for a few hours to think it over. It then confirmed the downgrade, but the reason had suddenly changed. Now, instead of highlighting its financial calculations, the agency cast doubt on the country's political leadership.

"There were no calculation errors," Kraemer says. "We only used an alternative scenario to examine the anticipated growth in expenditure." The reaction from politicians is not surprising, he says: "If there is bad news, they often first try to play it down and discredit the analysis." The US Treasury sees things differently: "They (S&P) have handled themselves very poorly and they've shown a stunning lack of knowledge about basic US fiscal budget math," said Treasury Secretary Timothy Geithner.

History of Past Mistakes

It wouldn't be the first mistake made by the Big Three. They have made errors time and again in the past, not only in evaluating countries, but also with companies and securities, which are their main business.

This hasn't harmed the growth of this miniscule industry, however. Ever since John Moody began to publish systematic ratings of railway bonds in 1919, things have gone mostly uphill. The more the world was dominated by numbers, the more important the ratings became. And sometimes they were completely wrong.

Shortly before the collapse of the Lehman Brothers investment bank, for example, the agencies gave it an A rating, which is in the third-best category of ratings and well within investment grade.

The American International Group (AIG), which required an enormous bailout from the US government, was rated as safe. A Senate investigations panel has concluded that the rating agencies were primarily responsible for triggering the financial crisis. S&P is "the last place anyone should turn for judgments about our nation's prospects," Nobel laureate economist Paul Krugman recently wrote.  But they are continually being asked to do just that -- including by the investors around the world who stock up on US government bonds. Nearly one-third of all US debt is held abroad, mainly in China.

Hunger for Capital

The insatiable cross-border hunger for new capital is the reason why rating agencies began to play a role in the fortunes of entire nations. From the Great Depression of the 1930s until the 1970s, there was virtually no international market for government bonds. American bonds were held by American institutions. For most countries, it was impossible to acquire money abroad. It was only when developing countries began to raise money on global bond markets, and investors had to assess which countries to grant loans to, that the agencies came into play.

"There was a huge increase in ratings because international finance changed significantly and created enormous demand," says Vincent Truglia. Back in the early 1970s, Truglia was already working for large banks doing country risk analysis. He came fresh from university. They needed him not so much for his degree in economics but for his linguistic abilities. In addition to English, he also spoke German, Italian, French and even Greek.

Truglia had to fly around the world to gather information. "There was almost no data. You had to guess what debt levels were. They were considered secret," Truglia recalls. "Nobody knew how to do sovereign risk analysis. So I created a sovereign risk department." Truglia became one of the world's leading experts. He went to work for Moody's and from 1996 to 2008 served as the global head of the agency's Sovereign Risk Unit, which was responsible for evaluating over 100 countries.

Today, Truglia is a principal in an investment firm in Manhattan. It only takes about 45 minutes to travel by ferry to the small coastal town in New Jersey where he lives, only 50 meters (165 feet) from the beach, in a four-storey house full of heavy, leather furniture. Back then, when he was a Moody's man, he could meet anyone, including "presidents, heads of government and heads of central banks," he says. "But most governments came to us," he explains. They came to New York, where the agency has its headquarters.

"Access to people was remarkable," he says. "But in all those decades I never got a single thing from a government that was not publicly available." Rather, he says, governments explained their point of view.

'You Can't Allow Yourself to Get Emotionally Attached'

Did they also perhaps mention the consequences that a downgrade could have for millions of people? Truglia says he had "never given it a thought or consideration." He says that you can't allow yourself to get emotionally attached to a rating. "Ratings do not judge whether a country is good or bad. They just assess creditworthiness." This isn't decided by a large team of experts, but rather just a handful of people: "When I left, there were 22 or 23 of us." Each lead analyst works with a junior analyst at his side and handles 10 to 12 countries.

At Moody's, ratings are not determined by the country analysts alone, but by a more or less spontaneously assembled committee that varies in size and membership -- and usually consists of eight to 15 analysts. The only ground rule is that the majority of participants have to be responsible for a region that differs from the one where the country being assessed is located. In the end, a vote is held and decisions are passed by a simple majority.

The criteria for classifying a country are also far from clear at Moody's. There is no uniform basis for decisions. "It will vary from country to country," says Truglia. "When it comes to an emerging market, you have to pay close attention to current account balances, debt service ratios, international reserves, the net liquidity position of the country and its banks, and exchange rate policies, to name just a few aspects."

It's another story altogether when rating industrialized countries: "The more important drivers for advanced industrial countries were always the domestic numbers, what was the nature of general government debt," he says.

Screaming and Yelling

But which criteria are ultimately decisive? "The rating committees were going on for hours, screaming and yelling at each other with passion" says Jerome Fons, who also once had a position high up in the hierarchy at Moody's. Until 2007, his job included serving as chair of Moody's Standing Committee on Rating Symbols and Practices, which established the methodology. Now, risk consultant Jules Kroll has hired him to help establish a new agency.

Most other rating committees would need maybe half an hour for their meetings, Fons recalls. "But the sovereign rating committees would be these calamitous affairs." This was despite the fact that country ratings don't bring in much money for the agencies: Each country pays between €50,000 and €200,000 for a rating. Usually these are developing and emerging countries. Western industrialized nations such as Germany and the US don't have to pay anything, but they are powerless to influence the ratings.

Fons says that there exists a clear methodology for many rating categories that is "highly modeled and technical," with defined variables, ratios and formulas. He says that he told them he also wanted to see a clean methodology from them. But they weren't able to agree on anything, he says.

This is precisely what is lacking in the agency's decisions: confirmability. That, at least, is the opinion of Michel Barnier, the EU commissioner responsible for financial services. "We need more transparency and tighter regulation of the agencies," says the 60-year-old bureaucrat. He is sitting in the back of his official limousine on the way from Strasbourg to the southwestern German town of Schwanau, juggling two iPhones and ranting about the rating agencies.

He says that the agencies are "one of the reasons for the crisis," and that they "have failed in their mission." The EU commissioner welcomes plans to establish a competing European agency.  For over a year, Roland Berger, a German consulting firm, has been lobbying banks, insurance companies and financial service providers to support the plan. But setting up the necessary analytical structures is expensive, and €300 million will have to be raised for it to become reality.

The proposal has not been enthusiastically received by either the financial industry or experts. After all, it is highly probable that such a European agency would become a political instrument -- or at least be perceived as one by financial markets, and not be taken seriously as a result.

Driving Up the Fever

The case of Greece has shown just how much Europe's political leadership is willing to ignore reality when it suits their purposes: They have striven to delay the country's bankruptcy as long as possible and blatantly demanded that the agencies back them up with sympathetic ratings.

Now, by taking a hard line with the US, Standard & Poor's has proven that it won't allow politicians to dictate anything. European Commissioner Barnier also wants a new agency to be free of any political influence: "It cannot be a public agency." He says it's equally important that the inspectors themselves be inspected, in other words, that there is clear regulation of existing agencies. This will be the responsibility of the Paris-based European Securities and Market Authority (ESMA), which was established at the beginning of this year. Barnier says that's not enough, though. He wants to submit a draft law with tighter regulations in November.

Brussels wants to force the agencies to disclose their data and methods. The ratings should "be reduced to the essentials," he says. Barnier is even considering having ratings banned for countries that are drowning in debt and currently benefiting from a bailout package. He says that it is "not normal and not fair when countries are downgraded while they are being monitored by the European Central Bank and the International Monetary Fund."

He has a nice analogy for the excessive power of the agencies: "If the thermometer is driving up the fever, something is wrong." But nothing can be sold on the bond market without some kind of rating system. After all, a total lack of any rating is primarily a sign to investors that they should avoid something like the plague.

Too Closely Linked

The main problem is that, for far too long, lawmakers themselves have promoted this link between ratings and every form of financial investment. As early as the 1930s, in response to the Great Depression, policymakers began to integrate ratings into financial market regulations -- as a security measure to primarily force large financial institutions to make less risky investments.

This idea has long since become an accepted practice everywhere. For decades, lawmakers around the world have made rating certificates an integral part of an increasing number of financial market regulations. Their importance has steadily grown, but the accuracy of the ratings has not always kept pace with developments.

The most obvious solution -- perhaps even the only solution -- to break the power of the agencies without also destabilizing the entire financial system would be to remove the rating stipulations from the regulations. This would allow investors to seek alternative sources of information without being bound, for better or for worse, to the agencies' opinions.

Surprisingly, support for this idea comes from the Big Three: "It wasn't our desire for the ratings to be so tightly entwined with regulations," says S&P's Moritz Kraemer. "Politicians have forced this importance upon us. We perceive it as a burden, one that our ratings weren't designed to handle."

Translated from the German by Paul Cohen
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