IN TIMES OF financial abundance credit ratings go largely unnoticed. In downturns, however, they come under greater scrutiny and are often deemed insufficient. The dotcom crash of 2000-01 revealed that the ratings of some former corporate stars, including Enron, were absurd. The worst was yet to come during the financial crisis of 2007-2009, when the three major rating agencies—Moody’s, S&P and Fitch – helped the cause by trading reputation for profit and giving incredibly high ratings to securitized mortgages. An official report on the crisis called the agencies “essential cogs in the wheel of financial destruction”.
It’s no surprise, then, that the ratings oligopoly is facing another potential backlash, now that an even bigger pile of debt threatens to deteriorate, thanks to covid-19. Eyebrows were raised as agencies rushed to write down bonds and loans of all types. The rate of downgrading in March was the fastest on record. Since May 5, S&P had downgraded or placed on negative watch one-fifth of the corporate and sovereign issuers it rates, in response to the virus and the fall in the price of oil – and more than three-fifths in the most affected sectors, such as autos and the entertainment. This burst of activity fuels a well-known suspicion: rating agencies dropped their standards in the start-up years, only to belatedly scramble to make amends once the markets turned.
The accuracy of ratings is important because the approved companies that issue them wield great power in the capital markets. A downgrade can skyrocket a company’s funding costs or cause a bank run. It can also force a company or sovereign borrower out of an index, depleting the pool of investors willing or permitted to lend to it.
Far from having their wings clipped after having spoiled before 2007, the rating agencies have taken advantage of the windfall of the debt of the last decade (see graph 1). At the end of 2019, global corporate bond debt stood at $13.5 billion, double the 2008 level in real terms. As central banks use ratings to filter potential fodder for their asset purchase programs, these ratings have become even more crucial determinants of who can hold what.
The agencies say their ratings hold up well when examined “throughout the cycle,” rather than over short periods. They also point to the changes imposed on them after the financial crisis that have reinforced the walls between their analysts and their business teams. Ratings are paid for by the issuer; With the approach of the financial crisis, it was largely the fear that large clients, often banks, would relocate their activities that led agencies to give overly generous ratings to toxic loan pools.
It is also true that much of the lower quality debt raised in recent years was badly rated from the start. At the end of 2019, nearly two-thirds of US leveraged loans rated by S&P were single-B (the mid-range of high yield, or “junk”) or lower; at the end of 2007, just over a third were. Rating agencies point to a plethora of reports they issued as debt piled up, warning things could get messy as sentiment sours. And for years, they’ve highlighted the gutting of “restrictive covenants,” or legal protections for creditors in the event a borrower’s finances spiral out of control.
James Grant, editor of Grant’s Interest Rate Watcher, a newscaster and longtime observer of credit markets, is not a big fan of rating agencies, which he described as “usually the market opinion leaders.” Still, in a recent note, he acknowledges having “noticed termites in the house of credit” long before the pandemic. Central banks deserve more blame this time, he argues, for “corrupting” credit with ultra-loose monetary policy that distorts prices.
There are, however, still plenty of critics to chew on. A 2013 study found an inverse relationship between the quality of ratings and the state of the markets: agencies are more likely to issue less accurate ratings when fee income is high, the hiring of quality analysts higher is more expensive and the probabilities of default are low. In 2019 a the wall street journal investigation revealed that the six largest agencies had, in the previous seven years, made changes to the rating criteria which led, at least briefly, to an increase in market share, particularly in the securitized loan market .
Two more recent studies have found evidence of ratings inflation after the financial crisis. A report from OECD in February found that agencies were giving borrowers more leeway on leverage, relative to earnings, in 2017 than a decade ago (see chart 2). The agencies say factors such as lower interest rates and increased corporate diversification, rather than sloppy ratings, explain the discrepancy. “There’s no question that some companies are over-leveraged for their ratings,” says Colin Reedie of Legal & General Investment Management. “We have already seen it at the same stage of the cycle, when [rating agencies] giving management too much the benefit of the doubt on promises to return to equal footing.
In a working paper, Edward Altman of New York University finds what he calls “an overestimation problem” just above junk food. Based on analysis of a set of measures including leverage, liquidity and sales, he concludes that more than one-third of corporate debt that was at the bottom of the investment grade pre-pandemic should have been at least one rating lower. In other words, it was junk apart from the name.
It addresses the most pressing question facing rating agencies today: what to do with the more than $3,000,000,000 of triple-rated corporate debt.B, on the precipice above the junk. In 2010, 45% of all high quality debt was in this lower tier; now it is just under 60%.
the OECD study found that downgrades of triple-B trash are rarer than elsewhere on the ratings spectrum, suggesting that agencies may be reluctant to force borrowers through this Rubicon. Another explanation is that companies are making particularly strenuous efforts to avoid such a downgrade, to so-called “fallen angel” status, aware that it may mean a sudden spike in borrowing costs.
In March and April, some $193 billion of triple-B the ties fell off. The credibility of the rating agencies rests on dealing rigorously with the rest of this band if there is no quick recovery. But this requires clear information, and fog abounds: 114 firms in the S&P The 500 index suspended its earnings forecast.
Another test will be their management of secured loan obligations (CLOs), sets of junk-rated business loans. the CLO market has more than doubled since 2010 to $600 billion. The analysts of UBSone bank, predicts default rates of up to 22%, with up to half of lending pools sliding to three –VS, the lowest level. The big risk for rating agencies is the top, triple-A, bandaged. If it were to suffer losses, as has happened to mortgage-backed securities known as CDOs in 2008—their reputation would take a hit.
A third challenge will be securing good sovereign ratings as public finances are under strain. What, for example, of the US Treasury borrowing a record $3 billion this quarter? And what would justify reducing Italy’s rating to the trash? (Moody’s and Fitch have it a cut above; S&P, two.) It would send the country’s bonds off key indexes, forcing many investors to sell them. A decade ago, rating agencies were accused of accelerating the euro zone’s sovereign debt crisis by downgrading some of the bloc’s big economies, including France.
How agencies handle these tests will determine whether the crisis prompts more calls for fundamental reform of the ratings market. The financial crisis produced such a clamor, but regulators simply tinkered. The issuer-pays model has proven resilient, despite the potential for conflicts of interest, because the alternatives are also imperfect. If investors were to pay for ratings, for example, their access would be limited to those who could afford to subscribe instead of being available to everyone, as is currently the case.
A more fertile area for reform concerns the overreliance on ratings. They are embedded in all sorts of regulations and investment mandates, often in a mechanical way that discourages investors from doing their own homework. They help determine everything from banks’ capital requirements to what mutual funds are allowed to buy. Here too, however, change has proven elusive. A 2018 study found that references to ratings in US bond fund investment mandates had actually increased since 2010.
As for the competition, several upstarts are jostling for business. The rating agency Kroll Bond, founded in 2010, achieved a turnover of 140 million dollars last year. But Moody’s, S&P and the smaller Fitch still has a combined global market share of almost 95%.
The reluctance of many bond issuers to stray from the major ratings agencies has helped create a “moat” around them and allowed them to raise prices by 3-4% a year, says Craig Huber of Huber Research Partners. Moody’s and S&P have operating margins of 50%. Both stocks have been a sound long-term investment, propelled both by the ratings boom and a broader push towards data analytics (see chart 3); their combined market capitalization is $117 billion. A lucky long-term shareholder is Warren Buffett, whose Berkshire Hathaway owns 13% of Moody’s.
Even the coronavirus may not throw them off course. Moody’s and S&P both posted record first-quarter revenues – $1.3 billion and $1.8 billion respectively – thanks in part to a fresh wave of bond issuance as companies scrambled for cash . Their latest forecast, released in late April, predicts 2020 earnings close to or even higher than last year’s record high. A triple-A of shareholders seems likely, then, if not of almost everyone.■