01 October 2018 by Anthony Hilton
Ten years on from the financial crash and the ratings-agencies conundrum has still not been resolved
Ten years ago the investment world held its breath as Lehman Brothers collapsed. Today we have still not fully escaped the consequences. And there are doubts about whether bank regulation would stand up to another crisis on the same scale.
Arturo Cifuentes, who some of you may remember was an expert witness at the US Senate subprime hearings and is now an adjunct professor at Columbia University, argues that at least we have tried with bank regulation. Other actors, in contrast, have continued without sanction.
Writing in the Financial Times, he says, in particular, the ratings agencies are every bit as powerful today as they were then.
“The agencies were conflicted, mainly because they are paid by the companies whose bonds they rate”
When Cifuentes testified is 2010, he seemed to be pushing on an open door. Moody’s and Standard & Poor’s (now known as S&P Global Ratings) were found by the Senate to have produced triple-A ratings on financial instruments that turned out to be worthless.
According to the senate, the ratings agencies failed to show proper scepticism in giving approval to complex derivatives based on subprime mortgages and investors who bought them because they relied on the rating subsequently lost vast amounts of money. The agencies were conflicted, mainly because they are paid by the companies whose bonds they rate.
But they were also conflicted in other areas that are less visible. For example, they took on some of the equity research the investment banks had been forced to give up in the regulatory settlement that followed the ‘dotcom’ boom. This was a questionable tactic as the investment banks had the ability to influence the rating agencies’ income.
The idea in the Senate was that there should be legislation that put distance between the agencies and the client by suggesting that government should decide which agencies get which slice of business. The theory was that this would stop one firm getting too big for the sector and it would also stop a race to the bottom as they compete for new work.
But nothing came of it. There was a $1.4 billion settlement in 2015 where the agencies admitted to irregularities, but that was it. Now, as Cifuentes reveals, the two principal agencies are even more the de facto regulators of the bond markets than they were then – effectively dictating what investors can and cannot buy. Their opinions have a huge influence on interest rates.
But they are not accountable to anyone.
Some agencies are even looking at Brexit. Fitch, one of the smaller agencies, recently said that it thinks a no-deal scenario ‘is a material and growing possibility’. Previously it anticipated an orderly departure of the UK – and Moody’s and S&P still hold this more favourable view. The UK has an AA rating from Fitch with a negative outlook. Any Brexit outcome could have a major effect on the economy.
The lack of accountability for ratings also seems unfair when compared to what happened to accounting firm Arthur Andersen. Although he was around before the financial crises, Raymond McDaniel of Moody’s has stayed on and in fact earned $11 million last year. Contrast this with Arthur Andersen, Cifuentes says, which surrendered its licence in 2002 after the Enron scandal and collapsed. In addition, some of the Enron executives faced fraud charges. But the fact is that Enron today is comparatively forgotten by many – and it never caused a global crisis.
“Perhaps we should embrace the old Senate plan and insert a civil agency rather than a private company into the process”
The listing agencies are not only more entrenched than ever, but with QE and liquidity causing a massive leap in bond sales in the past 10 years, their canvas is much wider too. Yet many believe rating agencies forfeited their right to an independent future and resistance to change.
Perhaps we should embrace the old Senate plan and insert a civil agency rather than a private company into the process. It would be a simple matter to say that no bond could be issued in the London market without first getting a rating from a Whitehall department, the Bank of England, the UK Listing Authority or the FCA – although obviously only one of these. The rating agencies could still do their research but they would have to sell it to investors rather than issuers.
The issuer would still have to pay, but to a regulator. There are parallels in other industries, which work perfectly well. Aircraft manufacturers are not allowed to shop around for a certificate of airworthiness for their planes. Pharmaceutical companies are not permitted to market their drugs to the public until they are approved and licensed by a public body.
These companies accept that this is part of the cost of doing business. Companies making bond issues also accept that they have these costs – but then they ruin it by giving the money to a rating agency. It really is time for them to engineer a change.