Introduction
The "Big Three" global credit rating agencies--U.S.-based Standard and Poor's, Moody's, and Fitch Ratings--have been under intense scrutiny since the 2007-2009 global financial crisis. They were initially criticized for their favorable pre-crisis ratings of insolvent financial institutions like Lehman Brothers, as well as risky mortgage-related securities that contributed to the collapse of the U.S. housing market. But since 2010, the agencies have focused on U.S. and European sovereign debt. That resulted in S&P's unprecedented downgrade of the United States' long-held triple-A rating in early August 2011, initially prompting a global sell-off and market volatility not seen since December 2008.
Since the spring of 2010, one or more of the Big Three relegated Greece, Portugal, and Ireland to "junk" status--a move that many EU officials say has accelerated a burgeoning eurozone sovereign debt crisis. In January 2012, amid continued eurozone instability, S&P downgraded nine eurozone countries, stripping France and Austria of their triple-A ratings.
Both the United States and Europe have taken steps to regulate the three main rating agencies and ensure more transparency and competitiveness. In July 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created an Office of Credit Ratings at the Securities and Exchange Commission to hold rating agencies accountable and protect investors and businesses. In early 2011, the EU established an independent authority known as the European Securities and Markets Authority (ESMA), tasked with regulating the activities of rating agencies relative to EU standards.
The Role of Credit Rating Agencies
Credit rating agencies are meant to provide global investors with an informed analysis of the risk associated with debt securities. These securities include government bonds, corporate bonds, CDs (certificates of deposit), municipal bonds, preferred stock, and collateralized securities, such as CDOs (collateralized debt obligations) and mortgage-backed securities. The riskiness of investing in these securities is determined by the likelihood that the debt issuer--be it a corporation, bank-created entity, sovereign nation, or local government--will fail to make timely interest payments on the debt.
Credit rating agencies are meant to provide global investors with an informed analysis of the risk associated with debt securities.
Raters' opinions are usually characterized by a letter grade, the highest and safest being AAA, with lower grades moving to double and then single letters (AA or A) and down the alphabet from there. The ratings handed out by each of the Big Three have widespread implications for investors and global markets. "The three major rating agencies hold a collective market share of roughly 95 percent. Their special status has been cemented by law--at first only in the United States, but then in Europe as well," explains an analysis by DeutscheWelle.
Industry Structure: "Issuer Pays" vs. "Subscriber Pays"
Most criticism of credit raters centers on the "issuer-pays" model--the system employed by S&P, Moody's, and Fitch--whereby a bond's issuer pays the rating agencies for the initial rating and ongoing ratings of a security. The public (and investors) then have access to these ratings free of charge. Many rating agencies shifted to this model in the 1970s, after years of following a "subscriber-pays" model, which required large institutions investing in bonds and other securities to pay for their ratings instead. This shift may have occurred in part because raters found issuers more willing to pay for these services than investors, since the issuers needed certain ratings in order to sell their bonds to regulated financial institutions, suggests this 2010 Organization for Economic Cooperation and Development report (PDF).
Subscriber-pays raters have used the recent controversy surrounding the issuer-pays firms to tout the virtues of their alternative model. Egan-Jones Ratings Company, a subscriber-pays firm based in Haverford, PA, for instance, has criticized the Big Three in numerous congressional hearings for allegedly being monopolistic and enabling biased ratings. A 2008 report by the American Enterprise Institute (PDF) comparing different types of raters showed that Egan-Jones provided more accurate ratings than Moody's and S&P.
Role in the Financial Crisis
In 2008, during the global financial crisis, rating agencies were chastised in congressional hearings and lawsuits for miscalculating the risks associated with mortgage-related securities. They were accused of creating complex models to calculate the probability of default for individual mortgages and also for the securitized products these mortgages made up. Raters deemed many of these so-called "structured" products top-tier triple-A material for several years during the housing boom, only to downgrade them to below investment-grade status when the housing market collapsed. In 2007, as housing prices began to tumble, Moody's downgraded 83 percent of the $869 billion in mortgage securities it had rated at the AAA level in 2006.
Critics said the raters failed to judge the likelihood of the decline in housing prices and their effect on loan defaults. These inflated ratings also failed to account for the greater systemic risks associated with downgrading structured products, as opposed to simpler securities like corporate and sovereign bonds. Rating agencies also came under fire for allegedly sacrificing quality ratings to win a bigger share of the booming structured products business. By 2006, Moody's had earned more revenue from structured finance--$881 million--than all its business revenues combined for 2001.
The Big Three argued that rating decisions were made by rating committees, not individual analysts, and that analysts were not compensated based on their ratings. As for the criticisms of the issuer-pays system, the agencies maintained that subscriber-pays raters suffered from their own conflicts of interest. Investors might pressure rating agencies for lower ratings because the securities, if deemed riskier, would pay higher yields. Short-sellers might also benefit financially from negative ratings. The real issue then, the Big Three argued, was not whether the system was issuer-pays or subscriber-pays, but how transparent raters were with the models they used.
In February 2013, the U.S. government filed a civil suit against S&P in a California court, seeking damages of $5 billion for the agency's alleged role in misleading investors during the run-up to the financial crisis. If S&P is found guilty and forced to pay such a penalty, it could spell the end for the embattled ratings agency and its parent company, McGraw-Hill. The suit opens the door to further civil action against the major rating agencies by investors who bought presumably safe triple-A financial products before the crisis. However, the Justice Department's decision to prosecute S&P, while sparing Moody's and Fitch, has been criticized by some as politically motivated. S&P was the only one of the Big Three that took the unprecedented step of downgrading U.S. debt in August 2011. The S&P case is characterized by an embarrassing paper trail left by analysts, describing what appears to be a widespread effort to make the firm more competitive by lowering ratings criteria.
Impact on the Eurozone Crisis
Conversely, the EU has long accused the Big Three of issuing overly aggressive ratings in the eurozone financial crisis. Many EU officials continue to blame the rating agencies for accelerating the European sovereign debt crisis as it spread through Greece, Ireland, and Portugal--all which have received EU-IMF bailouts to avoid defaulting on their debt obligations. The ball was set into motion with S&P's April 2010 decision to downgrade Greece's debt to junk status. The move weakened investor confidence and deepened the country's debt woes, making a financial rescue package in May 2010 all but inevitable.
European countries again came under the "grip" of the Big Three through the spring and early summer of 2011. Efforts by EU leaders to negotiate a second bailout for Greece--one that would see private creditors pick up some of the slack--have been complicated by S&Ps July 2011 announcement that it would likely classify as a default any planned or voluntary restructuring of Greek debt. European officials reacted strongly, with German Chancellor Angela Merkel saying, "It is important that we do not allow others to take away our ability to make judgments."
But many experts, including Benn Steil, director of international economics at CFR, think S&P's forceful stance on Greek debt is justifiable. "It [a restructuring] is clearly not voluntary if the terms can be said to involve significant concessions from the creditors," he says, "and in this case, the creditors know that the alternative to accepting some sort of voluntary plan is an outright default."
The eurozone crisis was also compounded when Moody's downgraded Portuguese debt to junk status in July 2011 and warned that the country may need a second bailout, just over a month after EU and IMF leaders agreed to a first rescue package. A week after Moody's verdict on Portugal, the agency downgraded Ireland to junk status, unleashing temporary panic in European and global markets.
After a brief lull in eurozone market volatility at the end of 2011--fueled by an EU agreement to create a fiscal union, along with an injection of liquidity into the financial sector by the European Central Bank--the crisis again accelerated at the start of 2012. Borrowing costs continued to rise for core sovereigns and there were renewed fears over EU bank liquidity. These issues were aggravated on January 13 when S&P downgraded nine eurozone states. Most notably, France and Austria lost their triple-A ratings, leaving Germany as the only country in the seventeen-nation euro bloc to hold the prized ranking.
Preferential Treatment?
European officials have publicly accused the Big Three of showing preferential treatment to the United States, which until August 2011 maintained a triple-A rating, despite carrying an unsustainable deficit and increasingly high levels of public debt. The EU has also criticized excessive speculation by the U.S. agencies over European debt, even as concrete budgetary policies are being implemented by eurozone periphery states. "It shows there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe," European Commission President Jose Manuel Barroso, of Portugal, said in the summer of 2011.
Many European officials, including European Commissioner for Internal Market and Services Michel Barnier, have called for the creation of an independent, European rating agency to counter the influence of the Big Three.
But could a new rating agency compete with the well-established Big Three? "If you are a rating agency, and if you want to be a rating agency that enjoys credibility on the markets, you need to be able to demonstrate that you have a big stock of clients who are buying your services because they believe in what you're doing," explains Frederick Erixon, director of the European Center for International Political Economy. Erixon questions whether a European-created agency would be able to maintain independence, particularly when rating sovereign debt, since it would be "a politically created body." Still, Markus Krall, a management consultant with Munich-based consulting firm Roland Berger,who reportedly has the support of Barnier and Bavarian Finance Minister Georg Fahrenschon, is trying to raise $426 million from banks, insurance companies, and investment funds to develop a European alternative to the Big Three.
Unprecedented Downgrade
On August 5, 2011, S&P downgraded U.S. debt for the first time in U.S. history, by one notch from AAA to AA+ . The move came after weeks of wrangling between Republican and Democratic lawmakers over how to cut the deficit to allow for a rise in the nation's $14.3 trillion debt ceiling. Congressional leaders and the White House reached a deal to avert a default in the nick of time, but, in the opinion of S&P, did not implement significant measures to reduce the U.S. deficit over the next ten years.
"The more government has power and is meddling with rating agencies, the more the rating agencies will be brow-beaten into giving a generous rating to the sovereign."--Sebastian Mallaby, CFR
The Obama administration lambasted the rating agency's decision, with Treasury Secretary Timothy Geithner saying S&P showed "terrible judgement" and a "stunning lack of knowledge." In an August 8 address to the nation, President Obama sought to diminish the importance of S&P's verdict, citing investor Warren Buffett, who said the United States should have a "quadruple-A rating." S&P forcefully defended its decision in the wake of criticism.
Regulating the Rating Agencies
Critics of the Big Three in the U.S. and Europe have long voiced concern that legislation and financial regulations have created institutional frameworks that rely too heavily on the raters, leaving investors few alternatives. In 1975, the U.S. Securities and Exchange Commission began choosing which raters could be used to determine the minimum capital levels required for financial firms to trade certain debt securities, depending on their riskiness. The three raters initially chosen--Moody's, S&P, and Fitch--were deemed "nationally recognized statistical rating organizations," or NRSROs. Though the SEC added more rating agencies to the list over the years, Moody's, S&P, and Fitch maintained their dominant positions.
In addition to creating an Office of Credit Ratings at the SEC, the Dodd-Frank invested the SEC with the authority to examine NRSROs on an annual basis, levy fines when necessary, and even deregister an agency for providing inaccurate ratings. Similarly, the EU's oversight mechanism, the ESMA, "contributes to the development of a single rulebook in Europe" by ensuring the "consistent treatment of investors across the Union . . . and enabling an adequate level of protection of investors through effective regulation and supervision."
But CFR's Mallaby, for one, argues that government regulation is unlikely to solve the conflicts inherent in credit rating agencies, particularly when it comes to sovereign debt. "The more government has power and is meddling with rating agencies, the more the rating agencies will be brow-beaten into giving a generous rating to the sovereign," Mallaby says. The best way to counter the monopolistic power of the Big Three, he argues, is to stop putting so much weight in their ratings.
"The reason why the subprime bubble could happen, or the reason why the European sovereign debt crisis can happen is, largely, that very blind investors bought bonds relying on ratings, and [didn't do] their own homework about what the real credit risk was in the bonds," says Mallaby.
Andrew Godinich contributed to this report.