At first glance, the past few years have not been good to the ratings agencies. During the financial crisis, a collapse in bond markets cut the industry’s revenues by a third. Worse, they were blamed for helping to precipitate the crisis, by giving unduly high ratings to mortgage-backed securities (MBS) that later turned sour. Worse still, last February America’s Department of Justice sued Standard & Poor’s (S&P), a big ratings agency, for $5 billion, claiming that it knowingly issued overgenerous ratings. S&P says the case is retaliation for lowering of America’s credit rating.
Yet in spite of these problems the “big three” agencies — Moody’s, S&P and Fitch — are now thriving again. Revenues from ratings services at all three outfits surpassed pre-crisis levels last year. Profits at Moody’s are at a record high; S&P’s are not far off. With margins at an enviable 52 percent and 44 percent of ratings revenues respectively, Moody’s and S&P now look more attractive as businesses than most other financial firms do.
The ratings agencies’ swelling profits derive in part from increased activity in the bond markets, according to Flavio Campos at Credit Suisse, a bank. Last year companies issued a record amount of bonds by value. There was even increased demand for ratings of structured bonds — the sort sliced into different tranches with varying exposure to default, which featured prominently in the crisis.
The fact that issuers still pay for ratings, rather than investors, has also helped maintain demand. Companies issuing bonds benefit from getting them rated by the agencies. The return in lower borrowing costs can be up to ten times as much as the fees paid for the rating. Regulations that still make it virtually impossible to sell unrated bonds in America are also a boon.
All this would have seemed improbable only a couple of years ago, when talk abounded of reforming ratings agencies and diminishing their role. Some critics complained that allowing issuers to pay for ratings gave agencies an incentive to inflate them, to please their clients. Others questioned the huge role that the private, profit-making firms had in the regulation of public markets.
The European Union set up a whole new regulator, the European Securities and Markets Authority, in part to keep a closer eye on rating agencies’ conduct. (Among those it looks at is the Economist Intelligence Unit, our sister company, which conducts sovereign credit ratings.) In America, the Dodd-Frank Act of 2010, which instituted a host of financial reforms, required the Federal Reserve and the Securities and Exchange Commission (SEC), Wall Street’s main regulator, to tighten regulation of the agencies and to reduce references to ratings in their rules for banks.
The SEC was meant to issue new regulations about ratings agencies by May 2011, but three years later they are still yet to be finalized. Critics, such as the Consumer Federation of America, a lobby group, complain that they fail to reduce the ratings agencies’ influence as much as Congress wanted. In part, that is because it has proven much “easier said than done” to replace ratings with other indicators in risk models, according to Sam Theodore at Scope Ratings, a boutique agency.
A new NBER paper by Harold Cole at the University of Pennsylvania and Thomas Cooley of the Stern School of Business also challenges the notion that it would be better to get the investors who are buying bonds to pay for ratings. They might choose not to release the ratings they pay for, it points out. Patchy information, in turn, could increase the likelihood that the market would misprice securities.
All told, the ratings agencies’ business “has not been threatened much by extra regulation or competition,” says Douglas Arthur at Evercore Partners, an investment bank. Although outfits like Scope have tried to challenge the big three’s dominance, the trio still control around 95 percent of the global ratings market: the same as before the crisis. With bond markets booming again, ratings agencies are back to their profitable and controversial old selves.
© The Economist Newspaper Limited, London (April 19, 2014)