Credit Rating Agencies

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I was reading this past winter's The International Economy and read an article called, "Das empire strikes back: German banks have had enough of Standard and Poor's and other agencies, and they're not going to take it any more." I cringed reading this(no link since the article isn't available on the mag's site):


For more than a decade, bankers, industry executives and politicians on the Continent have complained about Europe's humiliating dependence on the almighty U.S.-regulated rating oligopoly. Now, the revolt against America's unchecked rating power is pressuring politicians to push the European Union towards regulating the global rating trio. There is a groundswell of support for establishing a European rating agency. But all this is easier said than done.

As European companies move from borrowing money from their banks to tapping the world's capital markets directly--by issuing bonds, medium-term notes, or commercial paper--their securities need to be rated. But there is a problem: Europe doesn't have a major rating agency that would take into account the special characteristics of European accounting or the prevailing differences in financial ratios as they evolved in a bank-based financial system.

Finally, this problem is becoming political. Proposals by the European Parliament's Committee on Economic and Monetary Affairs to establish a European Registration Authority for rating agencies under the auspices of the Committee of European Securities Regulators (CESR) may be far ahead of the curve. They point to "a European nightmare--that unchecked American rating agencies become the Continent's boss men." EU parliamentarians are looking for ways to contain American rating power by putting global rating giants like Standard & Poor's, Moody's, and Fitch under some kind of new EU regulation. So far the Brussels Commission--with the British government keeping a watchful eye on the stakes for London as a global financial center--is playing for time. But the German government, faced with a domestic revolt against damaging rating decisions by Standard & Poor's, is under mounting pressure to control what is perceived as an excessive level of American rating power.


Then I found it amusing. Why does everything have to be humiliating? Overall, it's a pretty good read; the Germans may have an issue or two, but what if they regulate the agencies to irrelavency? For all the sniping from Europe when Worldcom, Enron and so forth happened, European business is more convoluted and the relationship between them and government is cosier. What if they mandate an unsound business practice because it's a local common practice? Of course, when they say American firms don't understand Europe, they have a point; large companies inevitably get bailed out in some form or another, so why bother with ratings at all. If you click below, the guarantees going to the Landesbanks merely turn from explicit into implicit, in my opinion.

edit: A visitor posted an interesting comment, click to read.

By announcing, on November 13, 2003, that it would come up, by November 24, with down-grades on unguaranteed Landesbank obligations, Standard & Poor's was set to deal a fatal blow to an important sector of Germany's banking system, the Landesbanks. This is why. Under an agreement with the EU Commission in Brussels, eleven Landesbanks must phase out state guarantees by July 18, 2005. This is considered an important step toward securing a level playing field in European financial markets. The Landesbank guarantees have supported top-notch credit ratings, which in turn meant cheap funding. Critics charged that by publishing Landesbank ratings on the basis of unguaranteed obligations immediately, i.e., long before the phase-out of state guarantees in 2005, Standard & Poor's was unsettling the difficult phase-out process. Indications from the "unguaranteed debt" ratings that were leaked following the announcement on November 13 suggested that all but three Landesbanks would be allocated ratings in the BBB--range, compared with the AA and AAA ratings they currently receive. What a blow.

To large segments of Germany's political and financial establishment, Standard & Poor's rating action amounted to a declaration of war. It was noted in German official and business circles that Moody's, the other major U.S. rating agency, distanced itself from Standard & Poor's bombshell. Juergen Berblinger, managing director of German operations for Moody's (who left at the end of 2003), indirectly criticized his competitor's rating action by stating: "In our view it is inappropriate and premature to publish unguaranteed ratings." He was supported by Moody's veteran European bank analyst Samuel Theodore, who sharply criticized Standard & Poor's move toward publishing notional ratings. Fitch, the smaller rater, first kept its powder dry by signaling that it would only put out ratings on an unguaranteed basis in case the Standard & Poor's went ahead with their announced notional ratings. When it became clear that Standard & Poor's had reversed itself and announced that it would publish their unguaranteed ratings about half a year later, Jens Schmidt-Burgel, head of Fitch in Germany, followed suit by telling the press, "It's clearly the wrong time to publish such ratings."

There was unprecedented political pressure exerted by the German government, financial supervisors at BaFin (the German Financial Supervisory Authority), and the Bundesbank on Standard & Poor's not to publish those "notional" or "fictitious" ratings. They argued that it was much too early to do this. Parallel ratings would unsettle the difficult transition process between now and the middle of 2005. Such ratings would not adequately rake into account the fact that all obligations issued by Landesbanks expiring before 2015 would be covered under the state guarantees.

As was to be expected, German banking associations representing the Landesbanks and their main shareholders, the Sparkassen, mounted a fierce counter-offensive. Argues Karl-Heinz Boos, executive managing director of the Bundesverband Offentlicher Banken Deutschlands (VOB): To issue notional ratings at this time when most Landesbanks are in the process of adjusting their capital base and business plans is "irresponsible and unprofessional." High officials in the Berlin finance ministry reacted angrily: Should Standard & Poor's issue parallel ratings (with and without guarantees), this would mean that the lower ratings would stick to obligations even if these were covered by state guarantees--which damages the is suing bank. Edgar Meister, the Bundesbank's banking supervisor, told a press conference: "These notional ratings are not particularly appropriate for evaluating a situation that won't be here until 2005. We should grant the Landesbanks time to adapt and implement their strategies. Publishing such ratings could make this more difficult."

And Jochen Sanio, Germany's chief financial supervisor, told Handelsblatt, Germany's business and financial daily, that he "cannot see any valid arguments that Standard & Poor's could put forward to justify fictitious ratings for Landesbanks at this time." Sanio sees today's major rating agencies as "uncontrolled world powers that are directing global capital flows by appraising the credit standing of debtors." And pointing to the bitter fight of German corporations against Standard & Poor's downgrades because of differences in accounting for pension liabilities, Sanio warns: "It is simply not acceptable that corporations have no way to defend themselves in important accounting disputes by appealing to an independent authority." Therefore, Sanio argues, "European corporations should think seriously again of supporting a European rating agency that in its initial phase could get additional credibility by putting itself under a financial supervisory agency." And he warns: "Until now rating agencies have been able to operate without being forced to adhere to generally recognized or binding principals. This cannot go on." Although rating agencies have not been brought under financial supervision so far, one should expect that they adhere to the highest ethical standards, says Sanio.


The downside to fighting back:

When an empire strikes back, there are winners and losers. On November 24, Standard & Poor's had to scrap plans for the highly contested rating down-grades of the country's public sector banks in a move, says the Financial Times, "that sent worrying signals to investors." Without giving names, the Financial Times quoted prominent bankers at Germany's Landesbanks warning that "political attempts to influence rating agencies' plans for the sector could be catastrophic for the country's reputation in financial markets." The paper quoted another banker from the state bank sector: "There are only losers in this, as far as reputations go: Standard & Poor's has egg on its face and we are left with uncertainty hanging over us."

Giving in to heavy political pressure, Torsten Hinrichs, head of Standard & Poor's in Germany, gave the state banks a year more of breathing space. He came out with a statement that, "Standard & Poor's has decided not to publish the preliminary ratings on individual banks at this point in time because the Landesbanks are still in the process of determining and developing their structures, strategies, and plans to cope with a new environment after the loss of state guarantees in July 2005." Instead, Standard & Poor's will publish the ratings on the Landesbanks' unguaranteed obligations in July 2004, one year prior to the loss of the state guarantees, on which the current ratings are based.

"Standard & Poor's has reached this decision based on the fact that many of the banks' plans are still a 'work in progress', involving fundamental decisions regarding the banks' future business models, restructuring plans, closer cooperation with the savings banks, intra-group support mechanisms, and ownership structures," says credit analyst Michael Zlotnik. But Standard & Poor's made sure to get the eleven Landesbanks working on their stand-alone ratings by announcing that "following the completion of its review of the preliminary ratings on the unguaranteed obligations of German Landesbanks ... it has determined that the ratings on such obligations from today's perspective would range from A+ to BBB." This raises the obvious question: Didn't they know this all before?

However, in the view of Achim Duebel, a veteran World Bank financial sector expert, an argument can be made in favor of stand-alone ratings. When, in 2000, Fannie Mae and Freddie Mac agreed with the U.S. Congress to solicit such stand-alone ratings, this resulted in greater transparency of the implicit guarantee given by U.S. taxpayers to these institutions. Similarly, German taxpayers are entitled to see the dimensions of support they are giving through the guarantees to the Landesbank sector. By looking at the difference between the two ratings--with and without the guarantee--the cost of the guarantee can be quantified. In the case of Fannie Mae and Freddie Mac, the stand-alone rating action had no noticeable impact on the spreads of the debt they issued.


More people who don't want to overdue regulation:

The umbrella organization of Germany's banking association (Zentraler Kreditausschuss, or ZKA) has asked the German government to push for an international regulation of rating agencies with an eye towards minimum requirements for harmonization. In this effort Germany should build on recent work done by the SEC. Pointing to the 95 percent market share of the three rating agencies, the ZKA warns European financial supervisors, government officials, and legislators to stop linking more and more regulation to ratings thereby further increasing the dominance of the U.S.--regulated rating duopoly.

3 Comments

It would seem that foreign governments don't understand that independent credit ratings are not a control variable, and that trying to make them one is an unavoidably destructive enterprise.

Great topic.

Hi -

Now this is something that I've got a direct interest in: I work for a German company that does industrial rating (we do sectors, not companies) and whose services have become a standard part of the internal rating procedures used by the German equivalent of Savings & Loans.

My take on the above is that the German banking system is simply terrified of being exposed as a house of cards, carrying significant non-performing loans and in possession of a loan portfolio that will continue to underperform for decades.

German industrial financing has been a problem for years, with most small- and mid-sized companies chronically undercapitalized. There isn't a functioning equivalent of the Nasdaq for small-company capitalization and German venture capital is almost non-existent. Hence if you need financing to expand your business, you go to the banks, and until just recently getting a loan approved was a highly subjective process, with similiar companies being treated very differently, depending on the loan office involved.

As a result of allowing loan officers to make judgement calls with only a modicum of quantitative controls, loan portfolios were and are a problem, but one that can be largely covered by performing loans and that relative lack of proper reporting (such as allowing hidden reserves to be built up and then used to compensate for poor perfomance, in effect subsidizing bad years with the profits of good years.

Having an independent rating institution actually judge, on the base of quantitative methods, the true risks involved is therefore dangerous to those hiding their problems.

And for the record, I think that using only past performance as a basis for making recommendations for the future is fundamentally flawed, since you don't loan money to the past, but rather the future. But then again, the company I work for uses industrial forecasting within a rating process in order to take into account expected future performance, so I might be a tad biased...

:-)

John

I think that's a good point. It was a bad move by S&P to come out when they did before possible changes were to be made. The article also made a point of saying that the U.S.'s GNMA and FNMA had two different ratings, but these had been long established nominally private companies.

I was just talking to somebody that is going to(I think he said yes yesterday) work for Deutsche Bank in their risk department. When he was first talking about the job, I mentioned that he would have his work cut out for him; European banks have a different attitude than U.S., which is much tighter(Imo and my direct experience in working for a bank in the Netherlands, which actually was very conservative, but I compared them to the others I worked with and my bank acted more American like in their view towards risk).

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