Rating agencies brace for backlash after series of downgrades

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Credit rating agencies are scrambling to adapt to the coronavirus pandemic, slashing ratings of vulnerable companies under scrutiny from critics who blame them for exacerbating the latest financial crisis.

The agencies – led by the big three of S&P Global, Moody’s and Fitch – have imposed large amounts of rating downgrades as the Covid-19 outbreak gathered pace. March has seen the fastest rate of downgrades, with records dating back to at least 2002, according to a report released last week by Bank of America. The bank added that more issuers could expect their ratings to be docked in the coming weeks.

Critics say it’s a repeat of the 2008 financial crisis, when overly high ratings crashed, amplifying the sense of alarm, especially in securitized product markets that were teeming with asset-backed bonds. mortgages.

“Here we are again, deja vu,” said Dennis Kelleher, head of Better Markets, a consumer advocacy group. The odds are cut ‘after what appears to be. . . significant rating inflation, like last time,” he said.

Agencies say they are simply reacting to changing circumstances, reflecting sudden tensions that have arisen in the wake of the coronavirus outbreak. “We’re really trying to call it what we see it, being balanced, but also recognizing that this is a really big stress the economy is facing,” said Craig Parmelee, global practice manager. at S&P.

About 80% of S&P’s rating actions since early February — about 213 downgrades out of 4,000 rated non-financial companies — have been to issuers already in “junk” territory before the coronavirus crisis, the company noted.

“We take a thoughtful approach to downgrades across all geographies and asset classes,” said Anne Van Praagh, head of strategy and credit research at Moody’s. “Our job is not to lower all the grades; it is of no use to anyone. Our job is to identify outliers.

Concerns that ratings were too high before the coronavirus outbreak stem from the business models of agencies, which are paid by the companies and governments whose creditworthiness they assess. A rating from a leading agency can make it easier to sell a bond or loan, giving investors a theoretically independent view of the borrower’s prospects. These views are also embedded in the mandates under which many fund managers operate, forcing them to sell bonds if ratings fall below certain thresholds.

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But issuers typically pay to be rated — a structure that can cause conflict, leading to accusations that agencies are competing for business by offering high ratings.

In 2015, S&P agreed to pay the United States and the states about $1.4 billion to settle allegations that it upgraded the ratings of mortgage-backed securities on the eve of the crisis, admitting that it had delayed downgrades for fear of losing market share. Moody’s paid $864 million in 2017 to settle similar charges.

Today, the pair accounts for 81% of outstanding credit ratings, according to a January 2020 report from the Securities and Exchange Commission. Fitch still represents 13.5% of the market.

Before the outbreak escalated, regulators were asking questions about the agencies’ business practices. In November, SEC Chairman Jay Clayton said agencies’ activities should be “continuously” monitored, while asking if there were “alternative payment models” that would better align agencies’ interests. rating on those of investors.

Egan-Jones, a small ratings agency that is paid by investors rather than issuers, said in a January letter to the SEC that “no amount of disclosure or internal separation of ratings and marketing personnel is is sufficient to overcome the taint created by such conflicts”. .

In their response letters to the SEC, Moody’s and S&P said potential conflicts are inherent in all rating agency business models.

Analysts note that the “issuer pays” model also causes some recipients of downgrades to behave as if they were aggrieved clients of agencies, rather than subjects of unbiased reviews. Last month, debt-ridden Japanese firm SoftBank complained about a downgrade from Moody’s, saying the agency had made “overly pessimistic” assumptions about the market environment.

Investors often make decisions independently of rating agency ratings. Cruise line Carnival paid handsomely for a new bond issue this week despite its ‘investment grade’ ratings as fund managers judged the company to be in jeopardy after the virus outbreak.

The debate over the rating agencies’ business models is unlikely to fade, as this time the scope of the downgrades is much broader than the realm of structured products. Already, the downgrades of major companies such as automaker Ford and retailer Marks and Spencer from the lowest rung of investment grade ratings to junk have appeared to cause turbulence in credit markets.

Old flaws in business models are once again becoming evident, said Riddha Basu, assistant professor at George Washington University.

“It’s still the same after 10 years,” he said. “Nothing has changed much.”

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