Ratings are not credit - and a new agency won't change that

Investors from the developing world should base their risk assessment on their own research and the interest rates in the open market

PUBLISHED : Friday, 11 October, 2013, 12:00am
UPDATED : Friday, 11 October, 2013, 3:41am

You can be pretty sure someone is clueless about finance if they start blaming the 2008 crisis on the Big Three credit rating agencies.

Sure, Standard & Poor's, Moody's Investors Service and Fitch Ratings badly blotted their collective copy book by helping Wall Street banks repackage toxic subprime debts as investible securities with topnotch credit ratings.

But the sins of the rating agencies pale into insignificance beside the wrongs committed by central banks, which kept interest rates far too low, governments, which encouraged reckless borrowing, and bank bosses, who threw prudence out of the window and leveraged up in pursuit of profit.

In any case, anyone who paid any attention knew - or should have known - that the agencies' credit ratings were barely worth the paper they were printed on.

Asian investors learned that in 1997, when the agencies signally failed to warn of the rash of defaults that spread across the region following the devaluation of the Thai baht.

The economic crisis was … the beginning of the end of Western privilege

And the conflict of interest that renders agency ratings largely worthless should have become clear to the rest of the world in the run-up to the 2008 crisis. In 2007, just seven US corporations carried the coveted AAA top credit rating. Yet in the same year, the agencies managed to award more than 1,000 AAA ratings to complex structured financial products.

More than half of the structured products rated by Moody's carried the top credit rating. It was obvious that most were not merited.

As former junk bond king Michael Milken told a Hong Kong audience in the depths of the financial crisis: "Rating is not credit … you shouldn't invest based on ratings."

Yet many people, including politicians with only a hazy understanding of finance, continue to credit the rating agencies with an importance they don't deserve and powers they simply don't possess.

This tendency is particularly strong in emerging economies, where many prominent figures believe the agencies are part of a Western conspiracy designed to hold back developing-world borrowers by giving them poor ratings, so shutting them out of international capital markets.

The answer, some have concluded, is to set up a new "unbiased" agency to provide the sort of ratings developing-country borrowers deserve.

The result is Hong Kong-based Universal Credit Rating Group, backed by the mainland's biggest agency, Dagong Global Credit Rating (which made a splash in 2010 when it rated China more creditworthy than traditionally AAA-rated borrowers like France).

Yesterday, the chairman of Universal's advisory board, former French prime minister Dominique de Villepin, made an impassioned pitch for the new agency, declaring: "The economic crisis was the beginning of a worldwide revolution - the beginning of the end of Western privilege."

The agency, he reckons, will be one of a suite of new global institutions supporting a new, fairer financial architecture.

By taking into account "cultural factors" that the existing agencies ignore, he expects Universal to award more appropriate ratings to borrowers in countries like Pakistan, allowing them to compete for credit on a level playing field.

"More competition in this area will be good," he declared.

It's a well-meaning idea, but it is wildly misconceived.

Experience has taught us that competition between rating agencies can be dangerous. Because agencies derive their earnings primarily from issuers, not from investors, the most obvious way a newcomer can compete with the established businesses is by awarding risky borrowers higher ratings.

This upward ratings creep will be even more likely for emerging economies where an agency that claims to represent the developing world will come under political pressure to hand out respectable investment-grade ratings even though debt markets are shallow and illiquid.

Big developed-market investors are unlikely to pay much attention. The managers of US$50 billion bond portfolios avoid Pakistani debt because the local market is too small for a prudent allocation to boost their performance by any detectable amount.

But there is a chance that international investors from the developing world might be tempted to take the new agency's ratings seriously. If so, they should recall Milken's advice. And if they want to get a picture of how risky issuers really are, they should ignore agency ratings, do their own research and look carefully at the interest rates they have to pay to borrow on the open market.

Markets do get things wrong, but prices still tend to be a much better indicator of risk than any agency rating, whatever de Villepin might say.