Rating agencies have been playing a significant role in the endless loop that the EU sovereign debt crisis has become.
It is recent news that S&P downgraded several EU member countries, by one to two notches, setting off a storm of panic and accusations across the continent. In particular, and not for the first time, France, Italy, and Spain found themselves at the center of much negative attention. Yet, the storm was short-lived. Today, the spread between Italian BTPs and German Bunds is hovering around 460 basis points (i.e., the Italian government pays about 4.6% greater interest than the German one when borrowing for ten years). This is about 70 basis points lower than prior to the negative announcement by S&P. Thus, as it has happened several times before, the markets shrugged off the negative judgement of the rating agencies.
What is happening here? Rating agencies exist to provide for-fee, better-informed, unbiased assessment of the creditworthiness of borrowers. In the aftermath of the bursting of the real estate bubble in the United States, the deficiencies of these agencies have been put sharply into focus. The dubious usefulness of the rating system, the agencies’ blatant conflict of interest, and self-evident biases in their assessments have long been discussed.
There is, however, one issue that has not received much attention in this debate, namely the simple observation that very rarely, especially when assessing the creditworthiness of governments, rating agencies are better-informed than the market. In the past, rating agencies played a very important role by
1) aggregating information that was unavailable to most investors,
2) interpreting it in a uniquely sophisticated manner, and
3) disseminating it in a coarse, yet easy to interpret fashion: letter ratings.
Acknowledging this role, national regulatory bodies and commonly accepted practices gave these ratings special treatment. For instance, many institutional investors (mutual funds and pension funds) cannot hold (sovereign or corporate) bonds rated below investment grade, and in most cases borrowers cannot issue bonds without a rating. The special treatment, in turn, contributed to making the ratings necessary, and the consequences of downgradings severe, regardless of their actual information content.
As in many past occurrences, however, financial markets have evolved at much greater speed than their regulations. In today’s global, interconnected financial markets, information is widely available and almost instantaneously disseminated. This is especially true for macroeconomic, country-wide information. Thirty or forty years ago, the rating agencies were among the few sophisticated players able to collect and interpret information on GDP, CPI, trade balances, or government expenditures. Today, that is not the case. Government reports on each aspect of a country’s economy are avidly read and interpreted by countless small and large traders, hedge funds, mutual funds, and the like. Most governments, having embraced transparency, release information in well-defined formats at regular dates to as many market participants as possible. These market participants have the same or better models than the rating agencies to interpret the available information.
In short, I do not believe sovereign ratings have any novel information content. The information rating agencies use to produce their coarse judgements has already been received, examined, and digested by the markets weeks and months in advance. So, why do we still pay so much attention to them? Two reasons. First, the regulations I mentioned above have not been revised (yet) to account for the seismic shift in the markets’ information environment, and continue to assign these ratings a special role. In other words, the importance of rating changes is “built in” the system, regardless of their information content, e.g., forcing mutual funds to liquidate positions in government bonds downgraded below certain thresholds. Second, rating changes may act as coordinating devices leading markets to a downward spiral of distress selling and collapsing prices. As I discussed in a previous blog post, financial markets are inherently fragile, and a rating change may quickly and painfully lead to a run to a company, a bank, or a government, in absence of lenders of last resort.
The current debate on reforming the rating system is likely to lead to changes in these anacronystic rules and regulations. New such rules may then attenuate the extent to which market participants follow rating changes and react to them. When this happens, rating agencies will be the most likely financial market participants to be downgraded.