Who Decides Whether a Country Can Be Trusted? Three Private Firms

A rating is an opinion about the likelihood that a borrower will pay what it owes on time, expressed on a scale running from the highest grade down through progressively weaker ones to categories indicating default. The boundary between investment grade and everything below it is the critical line, since many institutions are permitted or required to hold only the former. Ratings apply to particular debt instruments as well as to issuers, so a company can have several. They are explicitly opinions rather than recommendations or guarantees, a characterisation the agencies maintain vigorously, and which has been central to their defence against legal claims.

A letter has consequences out of proportion to its apparent informality:

• •The interest rate a borrower pays, directly and substantially
• •Whether pension funds and insurers may hold the debt at all
• •How much capital a bank must hold against it under regulation
• •Whether the debt qualifies as collateral at a central bank
• •The terms of existing contracts, many of which reference ratings
• •Political consequences, since a sovereign downgrade is treated as a verdict

The agencies are paid by the issuers whose debt they rate, which is an obvious problem and is the arrangement the industry has operated under since the 1970s. Before that, investors paid for ratings through subscriptions, and the shift was driven by photocopying making subscription publishing unsustainable and by demand from issuers who wanted a rating to sell their debt. The result is that a firm seeking a rating can approach several agencies, discuss the likely outcome and commission the one offering the best, which is known in the industry and was documented extensively afterwards. Agencies argue that reputation disciplines them, since a rating nobody trusts is worthless, and the record does not support that argument strongly.

Rating a government is a different exercise from rating a company, and the difference is worth understanding. A company can be wound up and its assets sold, so the analysis concerns whether the money will be there. A state cannot be, so the analysis concerns whether it will choose to pay, which involves political stability, the willingness of the population to bear austerity, the history of previous defaults and the strength of institutions, all of which are judgements rather than measurements. A government borrowing in its own currency can always create the money to pay, so a default there is a policy choice, which is why ratings distinguish debt in domestic currency from debt in foreign currency. Critics argue the exercise imports political preferences under a technical label.

Complex securities built from American mortgages were rated at the highest grade in enormous volume in the years before 2007, and a very large proportion of those securities were subsequently downgraded severely or defaulted, which was central to the financial crisis. Investigations found that models underestimated the probability of many mortgages failing at the same time, that the agencies competed for the business of the banks assembling the securities, and that internal communications showed employees aware the ratings were unreliable. Two agencies later paid settlements of over a billion dollars each without admitting liability. Regulation since has required disclosure of methodologies, separated analytical and commercial staff, and attempted to reduce references to ratings in law, with limited success.

A letter grade expresses an opinion about repayment likelihood, and the line between investment grade and below determines who may legally hold the debt. The grade sets borrowing costs, bank capital requirements and collateral eligibility. Issuers pay for their own ratings, an arrangement dating from the 1970s. Mortgage-backed securities rated at the highest grade defaulted in volume, and two agencies later paid settlements exceeding a billion dollars each.