The rating agencies that sort good investments from junk are once again injecting fear into financial markets. Only this time it's for warning investors about a possible threat — Europe's debt crisis — rather than for failing to see one coming.
Why do their words carry so much weight?
'I totally ignore the ratings agencies — to a point.' — Andy Brenner, Guggenheim Securities
These are the same firms that gave safe ratings to high-risk U.S. mortgage investments that later imploded and caused the financial crisis. Those failures raised doubts about how much the assessments of rating agencies like Standard & Poor's, Moody's Corp. and Fitch Ratings are really worth.
Yet less than two years after the crisis peaked, investors still take them seriously. Case in point: S&P on Tuesday cut Greece sovereign debt to "junk" status and dropped Portugal's down two notches. That downgrade sent financial markets from London to Hong Kong plunging.
Investors feared that more European countries would be dragged into the region's debt debacle. In the U.S., the Dow Jones industrial average sank 213 points Tuesday before recovering Wednesday — the same day S&P downgraded Spain one notch.
A big reason the agencies still carry influence is that many institutional investors — from central banks to pension funds — require safe ratings on the debt of countries, firms or securities they invest in.
A downgrade from S&P or Moody's might not tell investors anything they don't already know. But it can force a central bank or investment fund to shed the downgraded investment. That's why it can roil financial markets.
If Moody's follows S&P and downgrades Greece to junk, the European Central Bank, under its rules, could no longer accept Greek bonds as collateral in lending to Greece. It would become harder for Greece to roll over its debt into new loans. Fears of a spreading debt crisis would grow.
That doesn't mean Wall Street bows to the assessments of rating agencies.
"I totally ignore the ratings agencies — to a point," said Andy Brenner, head of emerging markets at Guggenheim Securities.
He said ratings agencies tend to act too late. Greece's debt, Brenner noted, has been trading at junk levels for weeks.
Brenner pointed out that Brazil, Mexico and Russia have credit ratings similar or worse than Greece's. Yet 10-year notes for Brazil, Mexico and Russia yield around five percent. By contrast, Greece's 10-year notes offer around 10 percent. That means investors view them as twice as risky.
Some analysts say the rating agencies have a better track record at rating countries' debt than complex debt investments like mortgage securities.
"It's much easier to understand their metrics when it comes to downgrading countries," said Andrew B. Busch, a currency strategist at BMO Capital Markets in Chicago.
Those metrics include how much tax revenue the country is using to pay down its debt and how fast its economy is growing.
Still, Busch said rating agencies sometimes surprise investors. S&P's downgrade of Portugal, for instance, had a bigger impact on the market Tuesday than its downgrade of Greece because investors weren't expecting it.
"That gave the flavour of contagion and that's what bothered people," he said.
European Union officials weren't pleased by the negative ratings.
"Who is Standard & Poor's anyway?" EU spokesperson Amadeu Altafaj Tardio said Wednesday. He said the agency should better assess "realities on the ground," such as financial rescue talks in Athens "that are making rapid and solid progress."
As investors have recognized the risks in buying debt even from developed economies, credit ratings have lost some credibility with investors, said Richard Kang, chief information officer with Emerging Global Advisors LLC, which runs emerging market funds.
He said investors are wondering if more countries haven't been downgraded because of a "reluctance with credit rating agencies to stick their neck out."
'Who is Standard & Poor's anyway?' — Amadeu Altafaj Tardio, EU spokesperson
"When they do downgrade, it will be too late," Kang said, referring to the companies' delays in downgrading billions in toxic mortgage investments in 2006 and 2007. "Credit rating agencies are famous for that."
S&P said it's confident in how it rates countries' creditworthiness.
"Our sovereign ratings generally have performed as expected, and we continue to call them as we see them when credit quality changes," spokesperson Chris Atkins said.
He said S&P improved the quality and transparency of its ratings after the U.S. mortgage meltdown. Analysts now receive more training and are rotated regularly among countries so as not to become beholden to one country's interests.
A Moody's spokesperson declined to comment on the company's sovereign rating methodology. A Fitch spokesperson didn't immediately respond to a request for comment.
Despite the poor publicity of late, the agencies are still generating big money. S&P, owned by the McGraw-Hill Cos., earned $451.5 million in revenue in the first quarter, up 15 percent from a year ago.
Moody's saw its first-quarter profit jump 26 percent to $113.4 million as more companies issued debt during the quarter, particularly junk bonds. Warren Buffett's Berkshire Hathaway Inc. remains the largest shareholder of Moody's, but since March 2009 it has reduced its stake from 48 million shares to 30.8 million shares.
The money the ratings agencies take in comes from the parties whose products they are rating — a point of contention in the U.S. and Europe. At a hearing last week on the agencies' role in the financial crisis, U.S. Sen. Carl Levin called it an "inherent conflict of interest."
"It's like one of the parties in court paying the judge's salary, or one of the teams in a competition paying the salary of the referee," the Michigan Democrat said.
In S&P's case, countries pay the company $60,000 to $100,000 a year, according to an S&P fee disclosure document.
The EU has drafted a code of conduct for rating agencies that takes effect in December. It aims to reduce conflicts of interest and force rating agencies to disclose their methodology.