How ratings agencies work and why they are feared

Last Friday, S&P Global Ratings downgraded its outlook for Italy's sovereign debt, while leaving its credit rating untouched.
Last Friday, S&P Global Ratings downgraded its outlook for Italy's sovereign debt, while leaving its credit rating untouched.PHOTO: BLOOMBERG

ROME • Depending on whom you ask, ratings agencies are either would-be guardians of financial probity or an indispensable valuation tool for investors.

Their reputation was badly tarnished by the 2008 financial crisis when critics said they failed to notice the warning signs in over-extended banks. But since then, they have tightened up, promising new rigour in their analyses of government and corporate finances to ensure investors make the best-informed decisions possible.

Their actions - like S&P Global Ratings raising pressure on Rome last Friday by downgrading its outlook for Italy's sovereign debt, while leaving its credit rating untouched - accordingly have great influence over markets, investment decisions and governments needing to raise money.

The world's top three ratings agencies are American: Moody's Investors Service, Fitch Ratings and S&P. Their job is to judge the creditworthiness of countries and companies. Governments and corporations pay them in return for a critical review of their debt.

The agencies' ratings, designed to be fully impartial and credible, are a requirement for many investment funds before they make a decision to buy a given security, be it a share in a company or a government bond.

The investment return or yield demanded by creditors will vary according to the agencies' reports. A weak notation will push borrowing rates higher, while a strong one may bring them down.

Ratings range from top grade AAA all the way down to D, which signals a default. Only 11 countries have a "triple A" rating. They are Germany, Denmark, the Netherlands, Sweden, Norway, Switzerland, Liechtenstein, Luxembourg, Canada, Australia and Singapore. At the other end of the spectrum, Venezuela and Mozambique are believed to be incapable of repaying their debts.

Ratings range from top grade AAA all the way down to D, which signals a default.

Only 11 countries have a "triple A" rating. They are Germany, Denmark, the Netherlands, Sweden, Norway, Switzerland, Liechtenstein, Luxembourg, Canada, Australia and Singapore. At the other end of the spectrum, Venezuela and Mozambique are believed to be incapable of repaying their debts.

Agencies regularly revise their ratings but can also, in a less drastic step, change the outlook for their current note from negative to positive via neutral, a move that often leads to a later change in the rating.

Political developments, major social and economic events or a large company acquisition can all trigger notation updates.

An agency ratings downgrade can quickly become a thorn in the side of spendthrift governments that suddenly find themselves with greater debt-servicing costs. Since their creation early in the 20th century, ratings agencies have often been the target of bitter complaints.

European Union governments, for example, protested against the simultaneous downgrade of nine euro zone countries in February 2012, at the height of the financial crisis.

The pressure that governments feel when agency notations turn against them is considerable.

If the agencies declare that governments are having trouble servicing their debt, investors will sometimes demand drastic measures, usually deep cuts in government spending or much higher rates of return, before returning to the market.

"The greatest capacity to force the hands of a government lies with the markets today," says Mr Christopher Dembik, an analyst at Saxo Bank.

Ratings agencies came under severe criticism after the 2008 collapse of US investment bank Lehman Brothers, for having given strong ratings to derivative products - which included very risky sub-prime assets - that were sold to banks and investment funds across the world.

When the US real estate bubble burst, hundreds of thousands of home owners were unable to meet their mortgage payments, in turn inflicting heavy losses on the banks and funds holding the toxic loan derivatives.

European leaders called for the role of ratings agencies in the crisis to be examined. They also toyed with the idea of creating a European body to break the US ratings agency monopoly, but that idea has not been followed up by action.

AGENCE FRANCE-PRESSE

A version of this article appeared in the print edition of The Straits Times on October 29, 2018, with the headline 'How ratings agencies work and why they are feared'. Print Edition | Subscribe