June, 15

Are Credit Rating Agencies Still Worth Your Trust?

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  • Unusual turbulence has overtaken the Credit Ratings world in 2023
  • Earlier this year, the SVB crisis sparked doubts about Agencies’ ability to predict a crisis
  • Now, Moody’s and Fitch’s subsequent US downgrades have investors wondering about CRA Trustworthiness
  • spoke with Ann Rutledge, one of the world’s leading specialists, for more insights on the matter

Credit Ratings are not the usual concern for the average U.S. stock market retail investor. In fact, prior to 2023, a whole decade had gone by without the industry significantly impacting the day-to-day decisions of stock traders and investors.

But then, all of a sudden, it feels like the tectonic plates of the financial world are moving under everyone’s feet again, and the market starts to wonder whether this is a sign of greater changes to come in the macroeconomic landscape.

2023 has proven to be an unusually turbulent period for the realm of Credit Ratings. Early in the year, amidst the banking crisis stemming from the SVB debacle, market observers found themselves perplexed by the glaring oversight of Credit Rating Agencies (CRAs) in detecting vulnerabilities within the system. This stirred echoes of the 2008 Global Financial Crisis (GFC), during which the miscalculation of risks linked to Mortgage Backed Securities played a pivotal role in fostering a deceptive sense of security among market participants.

Fast forward to August 2023, Moody’s downgrade of the U.S. long-term government foreign currency Issuer Default Rating, closely followed by Fitch’s simultaneous downgrade of ten U.S. banks, ignited a pressing question within investors’ minds: Can CRAs still be considered dependable source for assessing risk?

To try to answer that question, spoke to Ann Rutledge, one of the world’s leading specialists on the subject. According to the Founding Principal & CEO of Creditspectrum Corp/R&R Consulting, and author of two books on the topic, the answer is more complicated than it appears to the untrained eye.

  • At the beginning of the year, amid the Silicon Valley bank fiasco, we wondered why rating agencies had dropped the ball again, failing to spot the evident cracks in the U.S. banking system. Fast forward to now, does last week’s Moody’s downgrade of ten U.S. banks imply the agencies are improving their methodology?

Ann Rutledge: There’s no evidence of improvement; their methodologies have not changed recently. That fiasco was an ordinary bank run, aka liquidity crisis, not a credit crisis. The FDIC bailed out depositors, and—agree or not—that was that. Subsequently, one or more of the failed banks were merged with weaker banks. We know this because Credit Spectrum (our firm) bank ratings are a more nuanced, continuous view of bank health. While Moody’s coasted, we downgraded some banks in 2022.

An explanation that fits the facts and circumstances is that Moody’s, the lone holdout on the U.S.’s long-term Aaa credit, had to say something. Moody’s is sensitive about criticizing the U.S. One elegant way to strike at government weakness is to downgrade banks instead. See how Moody’s put U.S. second-tier, regional bank holding companies under review or negative outlooks but downgraded holding companies of much smaller entities that don’t have the same market power or commercial value for a rating agency.

Following Fitch’s rating adjustment, Janet Yellen swiftly contested the downgrade as “wholly unjustified,” given the backdrop of a robust economy. She labeled the assessment as a ‘flawed assessment’ grounded in obsolete data. It is presumed that her reference to outdated data pertains to the passage of the debt ceiling bill on June 3.

However, it is Yellen’s perception itself that might require an update. Those well-versed in the intricacies of credit rating practices understand that the true credit action lies in the outlook and watch listing. This multi-step procedure is strategically crafted to provide both the market and the issuer with an opportunity to react. Any subsequent alteration in letter grade, in comparison, becomes a mere procedural formality.

On May 23, Fitch placed the U.S. long-term IDR rating under Negative Watch, attributing this move to several factors: last-minute debt ceiling brinkmanship, potential adverse economic and financial consequences in the absence of an agreement, and persistent governance hurdles.

Subsequently, on June 2, Fitch announced its aim to “resolve” the watchlisting – indicating its intention to take a definitive rating action – during the third quarter of 2023. These were the real actions — and not the downgrades themselves.

  • IC.: It’s widely discussed that CRAs lag in spotting actual risks in the securities they cover. Is that a problem of the agencies’ methodology or the intrinsic ‘nature’ of credit ratings?

AR: The banking system is licensed to store and leverage savings to produce money for the economy. The rating agency’s function is to produce quality benchmarks to help investors steer clear of money games. Ever since Rockefeller created a global market for oil, ratings have been a valuable, unique piece of financial infrastructure. That’s a long time.

So, no, I don’t think anything is intrinsically wrong with ratings. But I do see an urgent need to rethink ratings design to better serve the modern financial economy, the diverse economic needs of 8 billion people, and the environment we are diminishing.

However, CRAs don’t want scores to change very often. The legal status of a rating is an opinion, not a score. People don’t change their opinions that often. If that changed, perhaps the world could wake up to the fact that it is not an opinion. And that might change the legal liability as regulators would understand that it is not an opinion, losing their first amendment rights.

If you actually read Moody’s methodology (not improved since 2021), you see that it is like a scoring system. Does that mean there isn’t an opinion within that? No, but that doesn’t mean it is not a model.

I realize that sounds really tedious and just a matter of semantics, but billions of dollars are into that question, which is an actual assessment of liability. And the reality is that CRAs are willing to protect their status, even if that implies being outdated every once in a while.

For example, if the loans that are backing the bonds are paying down, the risks are evolving. As such, these securities should be progressively updated over time.

Investors, I know you wouldn’t like that, but sorry. The reality is – as soon as something becomes more tradable and volatile, so do risks. And thus, a perfect ratings world would imply more ratings volatility.

In the long run, it’s so much better to fix problems than point fingers.

Perhaps the better analogy to 2023 is 1997 (the Asian crisis). That was a bank problem, not an off-balance sheet funding problem. The credit rating agencies confused the health of the bank with the health of the government that was supporting the bank. And let’s be clear. Some credit rating agencies are too small to matter—we are talking about the global players licensed by the U.S. government who call the shots in the market: the Nationally Recognized Statistical Rating Organization (NRSROs).

  • IC.: Do you think Fitch’s strategy of downgrading ten banks at once was designed to prevent bank runs at individual banks?

AR: I’ll just tell you here. I think the strategy was to partition banks based on their power—downgrading the ones of little commercial interest to Moody’s but giving two other cohorts a bit of a lifeline based on the strength of their brand.

  • IC.: Is the lagging nature of credit rating updates a problem for the global economy? And, if so, is that problem solvable in any way?

My colleague Daniel Cash often talks about how the large OECD countries and the IMF wanted to bring private credit to the table to create a truly global-scale debt capital market. This has been an ongoing challenge because the champions of neoliberalism do not actually understand the framework they have imposed on the world or fathom whether or not their idea works. Here is a case where it is critically important to update ratings. Sophisticated investors discount risky cash flows by their time value. This is definitional.

The first-order problem is that to make updating possible, you need to use data. To use data, you need a model integrated with or replacing your manual system. To have a model integrated with or replacing your manual system, (a) it has to represent the actual path of evolving risk and risk decay, and (b) it does not allow you to favor certain clients invisibly.

You can update ratings as frequently as you get new data. We have a patented process for this in structured products, but we are also doing this with U.S. banks because the regulatory disclosure requirements are so extensive–the data are also made public. But you have to know what you’re doing. AND your goal has to be to produce consistent, reliable ratings. Yet, regulation being what it is and competition for power between the silos being what it is, the public needs to demand change in order for change to happen.

All debt has optionality—the right to prepay or the ability to default. Ratings should respond to real conditions, and NRSROs should step back from commercial temptation.

  • IC: Earlier this year, Fitch placed Credit Suisse (SIX:) and its subsidiaries on Rating Watch only after the bank had effectively gone belly up. Why did they take so long to look into the situation?

AR: I can’t speak for Fitch, but I do have some general thoughts. Wasn’t it the same with Lehman? Lehman arguably was insolvent for years, hence one of my most famous quotes back then: “It wasn’t a mistake to let Lehman fail; it was a mistake to let it live so long.”

CRAs take controversial rating actions through watch-listing so that they will not be accused of causing panic. Ideally, they are able to project an orderly transition of downgrades to C, etc. You’d think so, based on their bond default studies. But in reality, downgrading is a manual, inefficient process with many factors to consider. It is one of the reasons why rating design needs an overhaul.

  • IC: Switzerland’s sovereign rating has a perfect score in all three major rating agencies (still does, even after the failure of one of its oldest and largest financial institutions). How did that part of the equation come into play in terms of giving investors a false sense of security regarding the bank’s actual situation?

AR: Brilliant observation. How could it not be a big factor? I am not close to this process, but sitting in Asia, I was on rating committees at Moody’s convened between Sovereign and Financial Institutions during the Asian Crisis. I know the propensity for rating agencies to conflate sovereign and bank ratings–they are not independent–and the theoretical challenge of getting it right if you have the wrong rating design. And then there’s perhaps the fear of losing power and authority, or marginal market share, by making the rating less grandiose, more informative. In 2023, we are seeing that fear play out in real-time.


Disclosure: Ann Rutledge is the CEO of Creditspectrum Corp/R&R Consulting and currently does not have any business relations with either Moody’s or Fitch.

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