Looking for the epicentre or root cause of any catastrophe usually reveals a series of failures.
In the case of the global financial system unravelling about five years ago, ratings agencies and analysts were top of the reasons for why it collapsed – namely the “inaccurate” ratings of the banks and the level of risky assets they held.
Indeed, the “soft” ratings placed on banks only revealed a veneer of trouble facing banks, and subsequently led to the systemic collapse and change in the global banking sector.
However, times have changed and market participants have become more trusting of the entities. Steve Collins, global head of dealing at London & Capital Asset Management, tells Euromoney:
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“Before, in 2007/2008, ratings agencies were behind the curve, but now it is safe to say that the ratings agencies are more in line. However, they can’t go in front of the curve, as there would be a risk of litigation (in other words, being sued).”
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Monday’s release from Moody’s provides an example of agencies being more astute when it comes to rating sovereigns, as it decided to keep a “negative outlook” on Ireland, despite Irish bank capital positions having improved:
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The negative outlook has been in place since 2008 and continues to reflect:
(i) the banks' weak funding and liquidity profiles;
(ii) the still very challenging operating environment; and
(iii) the rating agency's view that profitability will remain weak.
The improved capital positions of Irish banks only partly mitigate these fundamental weaknesses. The outlook expresses Moody's expectations for the fundamental credit conditions in this sector over the next 12 to 18 months.
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However, a number of conversations within the market place has given us at Euromoney Skew a cause for pause on why ratings agencies got it so wrong a few years ago.
Interestingly, Collins' observation on ratings agencies not going further in their assessments (“going ahead of the curve”) is a poignant one. While market participants see ratings agencies as one of the contributory root causes to the collapse of the financial system in 2007, it would be interesting to assess what the root cause of why rating agencies failed to deliver so many years ago.
Could it be a conflict of interest?
Collins says:
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“There is a general market perception that at times there can be a conflict of interest because the companies or sovereigns who want to be rated are paying the agencies to grade them. This obviously includes auditing their accounts.”
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Indeed, this comes at a time when the infamously bearish banking analyst Mike Mayo, who is now a managing director at Credit Agricole Securities, published his book 'Exile on Wall Street: One Analyst's Fight to Save the Big Banks from Themselves'.
In an excerpt, published by the Wall Street Journal, Mayo revealed that he was under pressure to keep bank stocks on either hold or buy, in what seems like a thinly veiled threat of "biting the hand that feeds you":
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“Over the past 12 years, long-time banking analyst Mike Mayo has issued numerous calls to sell bank stocks, a rarity in a system where nearly all stocks are rated buy or hold. His negative ratings have frequently gotten him in trouble with banks, clients and his own bosses, who didn't want to alienate those companies. In this excerpt from his new book, Exile on Wall Street, Mr Mayo gives an inside view of the fights, the scolding and the threatening phone calls he received as a result of yelling "sell" – and offers a proposal to fix the banking sector.”
Source: The Wall Street Journal
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Mayo’s published experiences coincide with another set of crossroads that the ratings agencies and analysts face.
While ratings agencies have recouped most of their credibility over the years, the sometimes ignored theory of a conflict of interest could become another problem.
Mayo's experience has illustrated, in the excerpt published in the Wall Street Journal, the pressure from sales and, of course, the financial entities that pay for ratings in the first place.
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At the company's morning meeting between analysts and the sales staff, I gave a short presentation on the report. "In no uncertain terms," I said, "sell bank stocks. I'm downgrading the group. Sell Bank One, sell Chase Manhattan...." The message went out over the "hoot," or microphone, to more than 50 salespeople around the world. They would relay my thoughts to more than 300 money managers at some of the largest institutional investment firms in the business.
Afterward, I went back to my desk. Safe so far, I thought, and picked up the phone to call some of the biggest banks that had been downgraded, to give them a heads-up, along with some of the firm's institutional-investing clients. Not long after that, I was summoned back to the hoot for a special presentation to the sales force, something that had never happened before. They wanted me to clarify my thinking. Why not just leave the ratings at hold?
I laid out my case again: declining loan quality, excess executive compensation and headwinds for the industry after five years of major growth driven by mergers.
The counterattack started almost immediately. One portfolio manager said, "What's he trying to prove? Don't you know you only put a sell on a dog?" Another yelled, "I can't believe Mayo's doing this. He must be self-destructing!" One trader at a firm that owned a portfolio full of bank shares – which immediately began falling – printed out my photo and stuck it to her bulletin board with the word "WANTED" scribbled over it. I'd poked a stick into a hornets' nest.
Source: The Wall Street Journal
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Pressure for ratings agencies and analysts to help keep firms buoyant in the markets seems to be an underlying worry for some market participants.
Indeed, the situation Mayo described and "fears of litigation" that Collins illustrated could be signals for the conflicts of interests that underlies that market.
We saw the reaction to the downgrade of the US and, of course, market sources have expressed it would be highly unlikely for any agency to downgrade France, for example.
One senior source in investment banking told us that:
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“You know for a fact that the ratings agencies will not downgrade France. If any report hints that France has a lot or possibly too much exposure to deal with, the government is quick to get involve or criticise it. For instance, if you look at BNP Paribas, it is now one of the largest custodians by assets. On top of that, you got to see how all the French banks are exposed to sovereign debt. The government has systematically proclaimed that it would never let BNP Paribas, Société Générale or any of its banks fail, but that means that the government has taken on, of course, a whole other level of risk. While I do think the ratings agencies are doing a good job at the moment, it is possible that a conflict of interest could arise when rating sovereigns in the future."
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While some market participants have dismissed the idea of a conflict of interest for ratings agencies as "conspiratorial", the initial proposal by Michel Barnier, the European internal market commissioner – who called for banning credit ratings in "exceptional circumstances" – does not bode well in this argument.
Although Barnier last week backed down on the proposed ratings reforms, the idea of such control over the rating agencies would surely damage the credit markets and bring us back to where we were in 2007?
- Euromoney Skew Blog
