First published in the Telegraph on 31 December 2010
We all know how atrocious a job the credit rating agencies did in the run-up to the financial crisis. And yet far from sinking into obscurity and irrelevance, as one might have assumed, they have if anything become more influential. Now, as 2011 arrives and the sovereign debt crisis intensifies, the economic fate of many countries rests on the assessments of these agencies; they are courted by governments, lobbied by finance ministers, all in a desperate attempt to safeguard their finances from an investor exodus.
Should we be surprised at this remarkable survival story? Perhaps not, if history is any yardstick. According to a working paper from the Bank for International Settlements [http://www.bis.org/publ/work335.htm], the ratings agencies completely failed to foresee the Great Depression and the 1930s sovereign debt disaster. In the run-up to World War Two, more than half the countries which had issued debt in New York the previous decade defaulted – an economic catastrophe which certainly contributed towards the nightmare years that followed. But on the basis of the ratings appended to that debt even months before by the ratings agencies, you would hardly have guessed that the greatest sovereign debt disaster in history was looming.
That’s right – the ratings agencies were around even back then – the first of them was set up in 1909 by John Moody after he went bankrupt in the 1907 crisis (really), and Fitch and Standard (which eventually merged with Poors to become S&P) in 1922. In a relatively short space of time, They became enormously successful, hawking their ratings to enthusiastic investors, and each boasting that they had the smartest analysts and best statistics. Each pledged that their ratings were the most reliable.
Of course, this was exposed pretty quickly as utter rot. The damning paragraph from the BIS analysis is this one:
Since this was the time when rating agencies started to be relied upon by regulatory authorities in the US, there is a possibility that the agencies had somehow outsmarted the market – even if only by a modest margin… [However] there does not seem to be anything specific or exceptional about the performance of rating agencies in assessing borrowing governments’ relative credit risk over the interwar period compared to what could have been inferred from market prices, except at longer time horizons.
This, we reckon, is certainly consistent with the fact that, even if they do not face alleged conflicts of interest, rating agencies should not be expected to stand too far outside market forecasts. And if the market at large missed the crisis, why should rating agencies have been any different?
In fact, far from predicting a crisis, the ratings agencies behaved pro-cyclically – in other words, when everything looked good they gave sovereign debt unmerited glowing references, before panic-slashing the ratings when crises hit. Again, sound familiar?
One might have expected that this rather shameful effort would have reminded people that putting their faith in ratings agencies was not only futile but potentially harmful. On the contrary, in what has to go down as one of the most scandalous victory-from-the-jaws-of-defeat stories in financial history, the agencies somehow managed to attain even more power, not to mention quasi-official status, in the years that followed. Their importance today is directly connected with the responsibilities they were bizarrely awarded back then.
For in the summer of 1931, as the depression spread around the world, the US Office of the Comptroller of the Currency took an emergency decision to base the value of American banks’ bonds portfolios on credit ratings’ formulae. As the BIS paper puts it, “From that point on, ratings became the main instruments through which regulators supervised banks’ risk exposures – which suggests that they were seen then as part of the solution, not as part of the problem.”
I’ve come across many examples of rewards for failure in my time. Bank bosses were awarded millions of dollars in salaries and bonuses despite directly contributing to a crisis which has impoverished almost every country in the world. Many in the financial sector continue to leech enormous sums from the fiscal and monetary rescue packages despite their shared culpability for the crisis.
This rather astonishing history lesson shows that the credit ratings agencies did a woeful job in the run-up to the Great Depression, yet on the back of it they became an entrenched part of the financial system – a system which has now collapsed in eerily similar circumstances. I suppose one day we might learn our lesson, but judging by the continued influence of the agencies, I wouldn’t hold your breath.