Monday, 7 August 2017

A Microcosm of the Credit Rating Agency Problem: An Almost Parasitic Existence

Today’s post focuses on a passing article published in Bloomberg last week regarding the credit rating agencies and how they have survived the post-crisis regulatory era to remain as engrained as ever. As this author specialises in studying the regulation of this particular industry, this post serves as an indulgence, with the aim being to present an example of how the agencies operate and, crucially, why they persist in spite of such awful performance. Whilst some of the issues raised will be specific to the example promoted within the post, the underlying sentiment that rating agencies profit and develop when the economy is in decline is the one developed in this post and, in truth, in all of this author’s other work: when considered in that analytical light, it is an almost parasitic existence led by the leading rating agencies.

The article in question, which presents an introductory account of the complex issue, begins by discussing how there has been a level of shock or confusion regarding the lack of impactful regulation aimed at the rating agencies after their behaviour in relation to the Financial Crisis; the article quotes a research advisor who states that ‘I, like everyone else, thought S&P, Moody’s, and Fitch would fail to exist as companies, as they would blow up in a storm of litigation and no one in the markets would use them again… yet, they seem stronger than ever before’. Furthermore, the article continues by quoting from a recent Securities and Exchange Commission (SEC) report that describes how, almost ten years on from the crash, the rating agencies still maintain breaches in their internal firewalls and inflate their ratings, two of the key components to their agencies’ complicity in the Crisis. Discussing the dominance of the ‘Big Three’, which, in essence, is the ‘Big Two, if we look at the actual market share of S&P and Moody’s, the article concludes that the dominance will continue in the face of opposition because of the industry’s make up and the ‘conservative investment practices’ that call for ratings to be incorporated. It is worth noting that this article certainly is not wrong in any sense, but it is important to note that this understanding is introductory at best and fails to examine some of the key reasons for the agencies’ ability to withstand extreme pressures.

In this author’s book Regulation and the Credit Rating Agencies: Restraining Ancillary Services, due to be published next year, this notion of examining the industry’s ability to withstand pressure is examined from within a very large lens. The reason for this is that the development of the rating industry, when viewed from within silos, presents a limited problem. However, when we assess the history of the agencies as a whole, the purposeful nature of the agencies and their actions becomes clear. Professor Frank Partnoy has written extensively on the development of the rating agencies, and in basing his examination from the 1930s onwards presents the idea that the agencies produce what he terms as ‘regulatory licences’ – the meaning being that regulators allow the ratings of agencies to carry a regulatory weight via delegation, which forces industry participants to the rating agencies. If we look further back, as we can with the assistance of the excellent research conducted by Professor Marc Flandreau and his doctoral colleagues, we can see that this systemic support for the agencies goes as far back as 1900, and arguably before, with the development of what Flandreau terms ‘legal licences’. However, in this working paper, produced by this author, a lineal analysis reveals that the industry has experienced times of great hardship, which in turn has an extraordinary impact upon how the leading firms choose to operate. In the face of mounting legal pressure from the outset of the creation of commercialised rating agencies, we see that the agencies responded with a particular viciousness that became the blueprint for their behaviour – survival at all costs. That sentiment carried over into the turn of the century and the economic upheaval of the 1930s, but the so-called ‘quiet period’ of the 1940s, 50s, and 1960s, combined with the dominance of just one rating entity – the National Credit Office of Dun & Bradstreet - left the largest agencies on the brink of extinction before the crash of Penn Central in 1970. We have discussed these developments before here in Financial Regulation Matters, and they are covered in even more detail in the working paper, but the sentiment of the agencies profiting and expanding at times of economic decline are clear.

Therefore, a deduction that can be made is that there is an incentive for the agencies to do one of two things: either promote an air of negativity in the marketplace, and/or become involved in schemes that inherently increase the risk to the marketplace, with the ensuing result being a positive result for the agencies; as people flock towards anything standardised and easily explained/assimilated in times of economic downturns, the rating agencies arguably have a vested interest in maintaining that dynamic – the sentiment being that they have learned from their past in that ‘quiet periods’ are a direct threat to their existence. With that being said, perhaps it is worth presenting a contemporary example so as to provide support to what may sound like a contentious insinuation but in fact is just a deduction from an analysis extracted from the ‘wider lens’. Recently, Moody’s was fined $864 million by the Department of Justice for its role in the Financial Crisis (loosely, anyway), which would usually signify quite an impactful punishment. Yet, at the end of July Moody’s was given the regulatory clearance by the European Commission to purchase a Dutch business intelligence provider for a massive $3.27 billion. The purchase of Bureau van Dijk represents one of the largest-ever acquisitions by the agency, which follows on from its acquisition of German structured-finance data provider SCDM for an undisclosed amount; the actions are said to have contributed to a massive 22% increase in the value of the agency’s shares this year alone. Yet, this period of growth and prosperity comes at exactly the same time the global economies are struggling, with the agency being the loudest in telling people so.

For example, Moody’s recently raised a number of British banking institutions’ ratings to stable from negative, with the inference being that the banks have an increased resilience to the U.K.’s ‘expected deterioration’. Yet, the agency has been promoting this idea of a massive downturn on the horizon more than most, with recent proclamations stating that: ‘the rating agency expects the UK economy to slow, impacting banks’ revenue and credit quality’; that rising household indebtedness, among other elements, were the ‘key drivers’ in reducing the ratings of most U.K. asset-backed securities; and finally that there is a ‘substantial probability that [Brexit] negotiations will fail and no agreement will be reached’. Whilst it is not the case that the agency is fabricating these opinions, the enthusiasm with which the agency proclaims them, when compared to the absolute lack of information regarding rating methodology changes or the underlying risk of securitised pools, leads one to wonder whether the agencies understand that an increase in systemic uncertainty and worry results in profit for them – it is contested here that they certainly do understand this.

The ability to acquire a company for over $3 billion in the wake of a company-record fine reveals a number of important things. Firstly it shows that the fines were completely ineffectual, to the point where it is questionable why they were even considered. Second, it points to a realisation that the agencies are so embedded, that they are actually impervious to negative economic conditions (some would say, one imagines, that this is to be admired – although when we consider that the agencies were central to causing the current economic malaise, perhaps any admiration should be withheld for the moment). Thirdly, the acquisition of such a company (van Dijk) will either raise concern or comfort, depending upon one’s opinion of the rating agencies: either they are acquiring more services to provide a better overall service to the marketplace, or they are bolstering their position in advance of another onslaught upon the marketplace. All of these considerations will be resolved in due course, but in order to conclude, it is worth looking at the aim of the Bloomberg article one more time. The article aimed to examine why the agencies have survived the post-crisis regulatory era, and put forward the reasons of continued conflicts of interests, an oligopolistic structure that protects them, and a regulatory structure that serves to promote their continuation. It would be foolish to argue with these reasons, mostly because the evidence supporting them is overwhelming but, more abstractly, the agencies survive because they are aware of their predicament more than anyone else is. The agencies realise that they can only survive in the harshest of environments and that if they are to continue to thrive they must either promote negativity, or be part of its creation – a rather incredible deduction, but then again we are talking about a rather incredible industry. 

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