Punishing S&P Won’t Stem Market Turbulence

By Shihoko Goto – Exclusive to Resource Investing News

Worries about Europe’s ongoing debt crisis and the United States’ economic outlook continue to plague global financial markets, but blaming private credit rating agencies for the ongoing turmoil not just in equities and bonds, but also commodity prices worldwide would be a mistake, according to analysts.  So while Standard & Poor’s decision to downgrade the United States credit rating last month led asset prices into a downward spiral, the agency should not be faulted for the market’s reaction to its analysis, nor should its rating downgrades of European debt be accused of undermining the continent’s fiscal outlook. Instead, the question investors should be asking is to what extent they should be relying on the assessments of rating agencies such as S& P and Moody’s in the first place. Likewise, regulators ought to be concerned about improving the fairness and transparency of the agencies’ ratings system.

US government reaction to S&P downgrade

In fact, Congressional reaction to S&P’s downgrade itself was more worrisome than the fact that the US long-term credit rating was downgraded to AA-plus from AAA, argued Jeff Glenzer, Managing Director of the Association for Financial Professionals.

Coming under attack from US lawmakers in recent weeks, S&P’s President Deven Sharma has stepped down as the company continues to face investigations by the Securities and Exchange Commission about the possibility of insider trading prior to the downgrade, while the Department of Justice is looking into whether or not S&P improperly rated dozens of mortgage securities in the years leading up to the financial crisis.

Yet the fact that Congress is demanding explanations from S&P about the downgrade is in itself “sour grapes” on the part of lawmakers, Glenzer said.  “It was hypocrisy in process.”

Legislators “weren’t happy with the lowered rating…and to call in (S&P executives to complain) about the bad grade is wrong,” Glenzer added, maintaining that had the rating remained AAA, the executives would have never been asked to testify before Congress in the first place.

Due diligence needed from investors

As for the credit rating agencies themselves, S&P, Moody’s, and Fitch have always maintained that they provide opinion as much as analysis of government and corporate debt. The problem, however, is that the Big Three agencies wield a great deal of influence, and their opinions have more impact on financial markets than any fund manager or equity analyst. What’s more, the need for credit ratings has only increased over time as investors are faced with ever more products to assess amid greater time constraints. So the credit rating system has allowed portfolio managers to spend less time analyzing each and every bond issuer, but at the same time, it has made investors too dependent on their judgment.

Yet while the ratings agencies can be a helpful point of reference, their assessments should be treated accordingly by the markets, some analysts argue.

“Use the ratings as a guide, but don’t trust them unquestioningly like religious dogma,” said Charles Sizemore, founder of Sizemore Capital Management and editor of the Sizemore Investment Letter.  “If you want a high-quality portfolio, you can start with a pool or AA and AAA-rated bonds and then do the next round of due diligence yourself.”

Reforming agencies’ pay model

That isn’t to say that S&P and its rivals are without fault; in fact, far from it. Charges by both the SEC and the US Department of Justice remain under investigation, and the future of the company will depend on the outcome of those probes. But even without the charges pressed against S&P, all three rating agencies clearly can do much to improve their business practice, most notably by avoiding the conflict of interest that arises as the issuer pays the agency for rating their bonds. Having investors as well as the bond issuers pay for grading bonds would certainly go a long way in increasing the transparency and credibility of the given ratings.

The agencies have also come under attack for dominating the market and calls to crack down on their monopoly are mounting. After all, the Big Three together corner about 95 percent of the global business of bond rating, and the smaller eight companies carry significantly less influence among investors. For instance, credit rating agency Egan-Jones Ratings Company too had downgraded US debt nearly three years ago, but its assessment made little impact on the global market at that time.

A European alternative?

In fact, European legislators have been ahead of their US counterparts as many blame S&P, Moody’s, and Fitch for aggravating the European debt crisis. Indeed, well before the S&P downgrade of US debt, French central banker Christian Noyer advocated the creation of a European ratings agency to break the Big Three’s global monopoly, specifically by establishing credit insurers such as Euler Hermes or Coface Group to take on the role. The problem, however, is that a new European agency won’t necessarily be able to provide better analysis, said the Association for Financial Professional’s Glenzer. Indeed, while S&P’s decision to downgrade US debt seemed a logical conclusion to the debacle on Capitol Hill to raise the country’s debt ceiling, neither Moody’s nor Fitch followed suit, and yet S&P’s analysis alone had hammered global financial markets. It is questionable whether or not investors’ knee-jerk reaction to S&P’s decision would have been less had a fourth major credit rating agency been in existence.

One thing is for certain. For all the problems that the Big Three have, credit rating agencies are here to stay, and the more access to varying opinions that investors have, the better. The cost of rating credit risk, however, does need to be spread across the board and not just be the responsibility of the debt issuers, while investors themselves need to be prepared to do their own legwork and not simply take the assigned rating at face value.