July 28 (Bloomberg) -- Just a few years ago, credit-rating companies were the sleuths who didn’t see.
In addition to awarding strong ratings to Icelandic banks, Lehman Brothers Holdings Inc. and other dubious enterprises, companies such as Fitch Ratings, Moody’s Investors Service and Standard & Poor’s slapped their AAA endorsements on shoddy securities constructed from subprime mortgages. When the housing boom exploded, the services’ hurried downgrades were too late to help anyone.
At a House subcommittee hearing yesterday, U.S. financial regulators acknowledged that the rating companies lately have been doing a better job. Alarmed by Greece’s unsustainable borrowing, the companies have slashed Greek debt to below investment grade. Troubles in Ireland, Portugal and Spain aren’t as severe, but those countries are under appropriately close scrutiny by rating services. Even the U.S. has been tagged for a downgrade if it can’t sort out its debt-ceiling and spending problems -- and maybe even if it does.
Now that the companies are taking bolder action, some European leaders are wishing they wouldn’t. There are calls to revoke the Big Three raters’ European licenses, to encourage the formation of smaller (perhaps more pliant) competitors, or to impose penalties for ratings that turn out to be too pessimistic. One proposal would require raters to give three days’ notice of possible downgrades to affected countries, so borrowers can privately lobby for gentler treatment.
Such measures might win spendthrift governments a few extra weeks to unload more debt on the marketplace, but they wouldn’t forestall a reckoning. The telltales of trouble -- rising bond yields and soaring prices for credit-default swaps -- are impossible to ignore for long, so the sooner the facts are known, the better.
French Phone Call
Countries already enjoy a 12-hour period to plead their cases in private before a ratings downgrade is announced. That suffices; additional delay simply invites a market in inside information. As Fitch’s president, Paul Taylor, told Britain’s House of Lords in May, “You inform the Greeks of a rating decision and you get phoned up by the French. That is quite disturbing.”
In the U.S., the raters have described what spending cuts they deem necessary for the country to retain its prized AAA credit rating. Although this skirts uncomfortably close to the political playing field, such specificity is part of the job. Rating companies can’t limit their work to analyzing the past. Whether rating a sports arena or a superpower, they must shed light on future scenarios and their consequences.
Rating companies still have far to go to establish their independence. They collect much of their revenue by charging issuers for the privilege of being rated, creating ample potential for conflicts of interest. Congress should weigh whether laws need to be revised to eliminate such risk. (Decades ago, rating companies got all their money from investors, their true clients.)
New rules being developed by the Securities and Exchange Commission will soon require additional disclosure of rating companies’ methods. In addition, the Dodd-Frank Act requires regulators to devise new standards for measuring creditworthiness, abandoning an overreliance on ratings in U.S. laws. In the process, the agencies must take care not to harm credit availability, or introduce too much subjectivity. Ratings should be viewed as just one piece of investment analysis.
Meantime, regulators around the world are redrawing rules so that ratings work with internal bank analyses and market prices in assessing risk. Such broader applications will enhance transparency and aid investors.
The rating companies’ new prominence has put them in the spotlight. So far, executives from Fitch, Moody’s and S&P have done a solid job of explaining their most controversial calls. It appears that public scrutiny and transparency may be the best medicine for raters and their subjects alike.
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