“We have the phrase ‘a pot calling a kettle black’ which means trying to get the attention off you by blaming somebody else. There’s no doubt that ratings agencies did a terrible job all the way up until 2008, but we have to be careful now about who’s criticizing them and why they’re criticizing them before we can say whether that criticism is actually valid. To be fair, if S&P did make a bad decision in downgrading US debt, I think that the problem with the decision is that it should have been done sooner, and maybe it should have been an even starker downgrade than it was because it’s very unclear to us that the US deserves its current credit rating. There’s a whole bunch of systemic risk in the US system that means, to our mind and certainly to the Chinese and independent rating agencies such as Egan Jones, there’s a lot more risk in US sovereign debt than a AA rating would even imply. We have to look at why they’re giving these ratings and really what is a fair basis of criticism or not. One thing that strikes us that when we’re creating portfolios, we don’t really take into account what S&P, Fitch’s or Moody’s might think about a particular security. As president Roosevelt said, ‘There’s nothing to fear except fear itself.’ What actually happens is that no competent professional managers actually pay any attention to the S&P, Fitch’s or Moody’s ratings, but what happens when they get downgraded is that investors worry that other people are going to pay attention and then it actually becomes a self-fulfilling prophecy that you had better sell because everyone else is going to start selling even though you might not agree with what the S&P rating might be.
“There’s another problem, which requires us to understand what we’re expecting of the rating agencies and what they actually do. A lot of investments are mandated by reference to the quality of the assets that are inside the investment as dictated by the credit rating agencies. In a sense, that makes it easier to understand in that if you buy a AAA rated bond fund, you know that all the securities in there are AAA rated, but the problem is that there may be an incentive for some investment managers to go and start using poorer quality assets because if there are some AAA assets that the market prices at a certain level, but there are other AAA assets that the market is saying, ‘We’re not sure about this. We think it might get downgraded. We don’t really trust the rating.’ That would make a security available at a lower price or a better yield, and in that case there’s actually a real incentive for some fund managers maybe to go and try and get a better return, a better yield, by buying the worst possible quality debt they can find within a stipulated rating category, and that’s really what happened in Europe. When the EuroZone was formed and we started to get a common rating across the entire EuroZone, Greece and Germany fit into the same investment bracket at that stage. The markets knew that Germany and Greece weren’t the same thing even if they believed that Germany was going to back-stop Greece, and so maybe there was 100-150 basis point spread at that point in Greek debt over the German debt, which narrowed because everybody wanted to buy the Greek debt because it was apparently exactly the same risk but it was paying a much higher yield, so there really is a danger that these things create malinvestment by bunching things together and applying inappropriate ratings.”
As Paul infers, the real problem is that no-one really knows what the credit agencies’ role should be and, despite this, people still apply too much faith to these things. On one hand, we have professional managers who do not really take the ratings particularly seriously and use their own research and their own ideas. On the other hand, we have parts of the market that still apply too much faith to the agencies.
People might say that one way round that would be to introduce regulations, so rating agencies are now covered by Dodd Frank. Also, we have the S&P leak that France was going to be downgraded being investigated by the ECB.
What concerns us is, with all this going on, these are meant to be independent bodies that are going to be giving opinions about, say, the US government, and if they are going to be regulated by a US government body, but they are going to be giving negative opinions about the US government, again that is getting into the conflict of interest area as well. Going forward, it is very difficult to see what the role of the credit rating agencies will be.
What we would say is largely to tend to ignore them. Get proper professional analysis of any particular security - do not just rely on the fact it has got a particular label given to it.
If the ratings agencies are still doing anything wrong today, they are still being too optimistic about stocks and securities and for too long. Lehman Brothers was AAA rated virtually until the very end. Irish sovereign debt was AAA rated until 2009, which was two years after the crisis began, so there is a real concern that if they are still doing anything wrong, they are actually still being too lax.