Downgraded agencies

Credit ratings agencies have come under fire after a spate of eurozone downgrades, with critics raising questions about how much credibility the three largest US-based agencies deserve.

Ratings agencies have become judges of national economies and the governments that seek to control them.

"We are independent commentators of the facts," Standard & Poor's Germany head, Torsten Hinrichs, told Deutsche Welle.

But what and how they commentate is the issue.

Based on a simple system that ranges from the best at AAA to the worst at D, an agency rates a country's (or company's) ability to service its debts.

A downgrade makes it more expensive for a country to accrue debts - new money is lent at higher interest rates - and that can have political ramifications. Studies conducted by German political scientist Jens Rosenbaum show that ratings downgrades reduce a politician's chance of re-election.

The agencies can also be called auditors. By evaluating the credit of others, they set a standard to which financial institutions have to stick.

"The significance of ratings agencies is primarily in their efficient and successful role as communicators between issuers and investors," said Torsten Hinrichs.

This description was tenable for a long time. Investors do require solid information about companies to whom they intend to turn over their money. And it's the ratings agencies that provide this information in exchange for payment from investors.

Questionable clients

But as time went on, debt issuers - that is, the companies that want to collect capital from financial markets - also became paying customers of the ratings agencies.

Critics say it's a clear conflict of interest.

It's a conflict that became especially glaring during the 2007 subprime mortgage crisis in the United States. Ratings agencies that count banks as their customers gave top grades to the mortgages backed by those same banks. Evaluation criteria were watered down to an extent "because the competition between agencies was significant and the profit was substantial. Some people stopped looking at things very closely," wrote Susanne Schmidt in her bestseller "Markt ohne Moral" (A Market without Morality).

The subprime crisis may have marked the most consequential error among ratings agencies, but it is not the only time they have failed.

Credit evaluators reacted too late to Enron's massive bankruptcy scandal in 2001, and they were also slow two years later in the case of the Italian food corporation Parmalat. For years, S&P had given Parmalat good ratings despite the company's allegedly falsified balance sheets. The agency later accelerated Parlamat's bankruptcy with a hectic series of downgrades.

American bias?

Some European critics also accuse the three largest ratings agencies of biased in favor of the US.

One noteworthy protest came from German companies in 2003 following an S&P downgrade of ThyssenKrupp, Linde, Deutsche Post and Munich Re. S&P cited changes in the status of the companies' pension funds for employees, but the companies claimed S&P had failed to take Germany's business culture into account.

Despite criticism over these episodes, many continued to believe that ratings were an vital guideline for investor interests.

European politicians tended to consider the three biggest agencies in the US as providing good information, but also as needing stronger controls. They turned ratings agencies into important players in finance by requiring banks and insurance companies to only offer products of a certain rating.

But the reputations of the top three US-based ratings agencies have declined significantly in Europe since the eurozone crisis began. It was the ratings agency Fitch that was first to deprive Greece of its magical "A" status in 2009, and it was the first of a wave of downgrades.

Market catalysts

"Rating agencies function as catalysts," said Rudolf Hickel of the University of Bremen.

When they signal an impending downgrade, they have the power to unleash turbulence in the financial markets. Interest rates for state bonds go up. That's before the actual downgrade has been announced. And the situation gets worse as the cost of refinancing becomes unbearable in the long term. It is a vicious cycle.

But the agencies are seldom officially commissioned to rate countries. Very few pay Moody's and others for a country's rating. That leaves room for speculation and conspiracy theories. After S&P's eurozone downgrades in mid-January, politicians in Germany's ruling Christian Democratic Union party voiced concerns that the agencies may have secret clients on Wall Street.

An EU counterpart

Some EU politicians say it's high time that Europe got its own ratings agency - one that could act as a counterweight to the Americans. Economists fear an agency with close ties to the EU would fail to inspire confidence among investors.

Plans are, however, afoot.

The Europe-based ratings agency planned by the Roland Berger consultancy will likely fare better in terms of credibility. A foundation will provide financing for the agency to minimize outside influence. Organizers hope to avoid conflicts of interest by operating the agency as a non-profit. Operations will begin in summer 2012 with the first ratings announced by early 2013.

But some of those who oppose the idea, like Axel Weber, a former president of the German Federal Bank, say a European ratings agency would offer little. And more than this, Weber says ratings agencies are all too often scolded for being the bearers of bad news and have unfairly been blamed for the crisis in Europe that was caused by the politicians.

Author: Zhang Danhong / gsw
Editor: Zulfikar Abbany