Credit ratings, like dodgy boilers, can still blow up the house

Date published: 13 January 2020

Patrick Jenkins

The world is awash with conflicts of interest. The plumber you call to fix the boiler insists it needs replacing, at vast cost to you and benefit to them. The car mechanic says your head gasket has blown. But has it really?

Whenever there is an asymmetry of knowledge — and many are ignorant about the ins and outs of boilers and car engines — the scope for being ripped off is large.

The realm of credit ratings is more heavily stacked against users than the flaky plumber or mechanic could even dream. It is the equivalent of a boiler manufacturer paying the plumber who recommends and installs its equipment — a bargain until the boiler blows up and destroys your house.

That, crudely, is what happened in the US subprime mortgage market in 2008, when large chunks of home loan debt, repackaged as triple A-rated derivative investments, defaulted and left end investors with billions of dollars of losses.

Global policymakers came down hard on most culprits in the financial crisis — investment banks, structured credit specialists and hedge funds all found their moneymaking curtailed by regulation.

But rating agencies got off lightly. Yes, they were fined by the US Department of Justice and they attracted some fresh regulation. But they also got a huge boost from policymakers. The decade of record-low interest rates has produced a bonanza of debt. Last year marked a new $2.6tn high for corporate bond issuance, according to Dealogic. Most of it has gone through the sausage machine of being rated for creditworthiness by the oligopoly ratings providers, Standard & Poor’s, Moody’s and Fitch.

S&P and Moody’s dominate the market and their financial performance has soared. In their last quarterly results to September, both reported a leap in profits. S&P’s net income was up 25 per cent to $617m. Moody’s rose 22 per cent to $379m. In each case, growth in rating activity resulting from the expansion of debt issuance was a key driver. Full-year numbers due soon are expected to be bumper, too.

This is not only an irony of the crisis. The root problem, whereby toxic assets were spread around the world before 2008 thanks to the misleading reassurance of a high-grade rating, remains unchanged. Today, with far more debt in issuance, the same may well be happening again.

Tougher capital rules mean banks are better protected. More vigilant regulators will help protect the financial system. But the basic premise of debt investment predicated on flawed credit ratings is the same.

The flaws are multiple. Aside from the obvious concerns about this being such a concentrated market, and the world’s failure to regulate rating agencies properly, there are two clear shortcomings that threaten to cause havoc in future.

First, rating agencies use essentially backward-looking methodologies. That was painfully evident in the financial crisis and has been demonstrated in a string of idiosyncratic company blow-ups, from Parmalat to Steinhoff, that the agencies were slow to spot. This approach also makes ratings pro-cyclical when things do go wrong.

Second, there is the boiler-destroying-your-house business model. Some big bond investors have dealt with the inherent conflict of interest of a bond issuer paying for its own rating by ignoring ratings altogether. Pimco, one of the biggest, has spent the past decade building a team of 70 in-house credit analysts, obviating the need to use S&P and Moody’s research at all. But most debt investors cannot afford such an overhead.

Small competitors such as Germany’s Scope are trying to shake up the model. At least some of its revenue comes from charging asset management clients to rate prospective bond investments, rather than earning the fees from the bond issuers. But the company remains tiny compared with the big three and the more wholesome fee model is an outlier.

That leaves a rather depressing outlook. As the world’s debt mountain grows, and credit risk with it, one of the big lessons that should have been learnt from the financial crisis has been ignored. For the foreseeable future, investors will continue to place blind faith in agencies’ credit ratings. But come the market downturn, that credit — from triple A to triple C — risks exploding in their faces.


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