Reviewing the credibility of credit ratings.
As a rookie reporter for a capital markets magazine, I once asked an investment banker what credit rating the World Bank carried. ‘Goodness, my dear, you are green,’ he laughed. How was I to know that it was AAA? And that I shouldn’t actually refer to it as ‘A-A-A’ but instead triple A? At that time, the only AAA firms I knew were the wily plumbers and electricians in the Yellow Pages.
In very simple terms, the banker explained, a rating determined a company’s ability to repay debt and therefore its likelihood of default. Countries obviously had a huge advantage; they could print more money. And the World Bank had an even bigger advantage, because it was financially supported by member states.
There was a bit more to it than that, obviously, but the better the rating, the better the financing terms a company could achieve. These coveted ratings were awarded to the crème de la crème of businesses, which at that time included Kellogg’s, Procter & Gamble and Campbell Soup.
To their equity investors, the credit ratings mattered little. But to the fixed-income funds that snapped up debt offerings, these ratings were viewed as an important indicator of financial health.
Even a rookie like me could see that there were some anomalies to the ratings process, however. The Republic of Italy was an AAA-rated borrower for many years, even when its spending was as out of control as Paris Hilton in a Balenciaga store. And when the boffins behind complex derivative structures used to boast that they explained to the ratings specialists how these things worked and why they justified AAA status, little alarm bells used to ring.
In theory, AAA-rated firms were equal; in reality, they were not. Those who rarely visited bond markets could achieve better terms than more regular users. On occasion, such was a company’s status that it could actually borrow at better terms than the benchmark government bond. So did the ratings really matter?
I have always erred toward the ‘no’ camp. For example, Kellogg’s, Procter & Gamble and Campbell Soup all lost their coveted status, yet are still highly respected, financially stable companies that – as far as I am aware – have had no funding problems. By contrast, Iceland’s banks, whose finances were about as stable as a defrosting iceberg, were briefly rated AAA, and who can forget the raft of prime-rated collateralized debt obligations? Certainly not those investors who were left with junk after the agencies realized the error of their methodology and slashed ratings to the bone.
And now Standard & Poor’s has put the UK’s AAA rating under review. The British media have devoted column inches to the subject, incensed that a ratings agency has the chutzpah to suggest the government may have difficulty in repaying its debts.
Britain has problems; that is undisputed. But the fact that rating agencies – whose own record of financial analysis is under attack and which have provided little evidence of reform – are still able to issue such high-profile ratings is, to my mind, even more worrying.
