The colossal failure of credit rating agencies to prevent the global financial crisis

The role of credit rating agencies such as Fitch Ratings Agency, Moody’s and Standard & Poor’s has been under greater scrutiny since the subprime crisis caused havoc in the US economy and spilled to others. It is without doubt that these rating agencies have been the law unto themselves and accorded absolute power to shape the perception of investors about corporates, commercial papers and countries alike. These monsters remain unregulated.

The Business Day reports that Fitch Ratings has downgraded South Africa’s sovereign credit rating from “stable” to “negative” because they somehow believe that the global downturn may drive the economy into a recession and prompt government to abandon policies which have backed its investment grade credit rating. Fitch appear to be concerned that South Africa is having to contend with the global financial crisis while faced with large imbalances in the economy, eg. the large current account deficit.

Fitch not only downgraded the country’s sovereign rating, it went further to downgrade its outlook of three major banks, Absa, Investec and Nedbank, citing deteriorating conditions in the economy. Standard Bank already had its outlook downgraded in August 2008, and interestingly the outlook on Firstrand remain “stable”. According to Fitch, “the global credit crisis is expected to lead to lower levels of activity within the domestic economy, which is likely to add to the challenges already faced by the banking sector due to the continuation of high interest rates and record-levels of consumer indebtedness.”

Now that is absolute rubbish! The Q2 2008 economic growth was an impressive 4.9%; and while none of us disputes the indubitable fact that economic growth would slow down, it is rather pathetic to suggest that it is probable to consecutively decline to a point of recession. The forecast for 2009 economic growth is 3% and sounds reasonable, given the massive infrastructure expenditure by government which would serve to bolster private companies and keep them afloat amidst turbulent financial current. Oil prices, the primary cause of rampant inflation in recent months, have dropped to about $60 per barrel and consumers are already seeing reprieve at the petrol pumps. This considerable decline should positively impact on inflation and bodes well for the economy.

Credit rating agencies have lost their credibility, particularly for the role they have played in the current financial turmoil. They have been accused of looking at falling share prices and credit default swaps as a guide to what their ratings of institutions should be; but agencies are adamant, perhaps rightly so, that price fluctuation is just one barometer that figures in their ratings. Precipitous decline in share prices may result in companies being unable to raise capital in order to bolster their financial positions and offset the impact of credit losses. The question we need to ask is to what extent is price fluctuation a determining factor of these ratings. A shocking decline alone cannot be an indicator of the health of any particular entity. The credibility of the ratings methodology of Moody’s has already been called into question and one has to ask whether there exist any flaws in the methodology employed by the other two agencies.

The colossal problem about these rating agencies is the possible negative influence of competition among themselves on the ratings they provide. The ratings quality is likely to be impacted by the need to generate revenue. Like all other businesses, these rating agencies are driven by the need to generate exorbitant profits for their shareholders instead of the quality of service they provide to their clients. Logic suggests that with high quality service comes growth of market share and associated reward for superior performance. Despite their questionable quality of service that this cartel has subjected their clients to, their revenue has been growing exponentially for the past five years. Corporates are to blame for rewarding mediocrity and ensuring it prospered. Competition in this instance among these agencies is unhealthy and detrimental to the overall financial system.

The subprime crisis is the case in point, where these agencies assigned favourable ratings to questionable collateralised debt obligations (CDOs) and residual mortgage backed securities (RMBS). These rating agencies should have known that some of the CDOs and RMBS securities rated by them were far riskier than the plain vanilla bonds. It is clear that these agencies, while motivated only by the need to generate revenue, have failed dismally to provide early-warning to potential problems lying ahead. Could they not have foreseen the imminent bankruptcies of Enron and WorldCom, including the recent subprime crisis? But these rating agencies have been quick to shift blame to their clients and accusing them of misusing the ratings.

Regulators have been criticised for doing little to prevent the current financial crisis. Regulated institutions such as banks escaped closer scrutiny of regulators who allowed risk management practices to slip. Credit rating institutions have not been regulated and the time has arrived that regulators subject them to regulatory oversight. The European Union has already made proposals to regulate the industry. As expected the issue of independence is cited by agencies as they deem regulations to be interference in the ratings process.

Regulation should enhance their corporate governance and prevent conflict of interest, as there have been numerous cases of clients been offered other services. The opposition to regulation may be motivated primarily by the need to close the industry to new entrants and protect their territory. It is evident that attempts at self-regulation have failed!

Their failure has encouraged them to now be excessively conservative in their assessment as we have noticed with the recent downgrade of the outlook of South Africa and its banks. The level of unnecessary conservatism would only serve to increase the cost of borrowing in the long-run and threaten the flow of foreign capital. The country and the banking industry, as well as the growth of the economy, should not be held hostage to errors committed by these credit rating agencies. It is time that credit rating agencies are held accountable!