September 30, 2010 | By Ethel Hazelhurst
The role of credit rating agencies has often been controversial, with critics claiming they fail to alert investors of pending problems. However, in a report out yesterday, the International Monetary Fund (IMF) said, since 1975, no defaulting sovereign debtor had an investment grade rating in the year before defaulting.
A borrower's cost of funding is determined by the credit status given by rating agencies. And downgrades can spill over to other borrowers. Among the issues the IMF looked at were "negative cliff effects" that follow downgrades, potentially destabilising financial markets. It was referring to sharp falls in prices of securities affected by a rerating.
The importance of credit ratings was shown in April when Standard and Poor's (S&P) cut Greece's rating three notches to junk bond status and Portugal's rating two notches but kept it at investment grade.
The moves were a warning to investors in those countries' bonds that their chances of being repaid had been reduced. Governments in turn cut spending to restore confidence in their ability to repay debt.
Bond markets, fearing other sovereigns might also be credit risks, reacted adversely - and the damage spread to stock markets. The MSCI world index fell from more than 1200 at the end of April to 1033 on July 5.
The IMF report focused on the top three rating agencies, Fitch Ratings, Moody's Investors Service and S&P. It found they served a useful purpose, "aggregating information about the credit quality" of borrowers.
The process allows borrowers to access global and domestic markets and attract investment funds - "adding liquidity to markets that would otherwise be illiquid".
After the 1994 Mexican debt crisis and the 1997 southeast Asian currency crisis, rating agencies were accused of reacting to events rather than anticipating them. They were also accused of downgrading more than was justified by fundamentals.
However, the problem the IMF report identified was that ratings were "embedded in regulatory requirements" and also acted as "triggers in various financial contracts". Banks, for example, must hold more capital against riskier assets. And institutional investors are obliged to sell securities no longer carrying appropriate ratings. The subsequent sell-off that follows the downgrading creates the spillover effect.
The report said ratings agencies used "smoothing practices".
Downgrades are usually anticipated by a warning described as a change in outlook or a review. And, in defence of the agencies, the IMF said investors often paid "insufficient attention" to the detailed analysis and information that accompanied these warnings. The report recommended that "regulations that hardwire buy or sell decisions to ratings be eliminated".
It urged agencies to "continue to provide additional information on the accuracy of their ratings, the underlying data and their efforts to mitigate the conflicts of interests".
The model of charging issuers for their ratings created the potential for a conflict of interest, as borrowers could shop around for the best rating, the IMF said, but it noted that charging investors could also lead to conflicts. Higher risks (reflected in lower ratings) require higher rewards and an investor could apply pressure for a lower rating to raise the investment's yield.