/ 5 December 2016

Ratings agencies are false prophets of doom

Fitch expects the South African economy to expand by 0.5% this year.
Fitch expects the South African economy to expand by 0.5% this year.

The South African business, political and consumer communities have been hosting the “Big Three” credit ratings agencies recently. This excruciating exercise is akin to a stay of execution, lying in wait until the next potential death knell is pronounced. At the time of writing, another downgrade has been averted.

In an ideal world, I would not object to an independent method of verifying any country’s creditworthiness, economic prospects and projections. The world however is not ideal and the overwhelming, partial and undemocratic power of the Big Three is skewing those ideals even further. Their opaque methodology and the inconsistent results generated in recent years have rightly brought them under sharper scrutiny.

Even prior to their disastrous “false prophecy”, which in 2008 led to the subprime disaster and internationalised the US financial contagion, Fitch, Moody’s and Standard and Poor’s (S&P) were becoming objects of heated discussion. Public institutions were increasingly wary of the decisive and influential function that rating agencies had, despite multiple concerns and fundamental flaws. These include their sluggish pace in responding to the signals that led to the 1997 Asian crisis and their inability to detect the fraudulent failures of companies such as Parmalat, Enron and WorldCom.

The three rating agencies have headlined roles in the failure of finance. The ongoing consolidation of their dominance is largely owed to the Federal Reserve, which, since 2006, has not implemented reforms to broaden competition by accelerating validation and approval processes. Had more agencies been at hand 10 years ago, it is possible that the 2008 crisis might have been averted. Essentially, this oligopoly is anti-competitive, and though the agencies have not been prosecuted for collusion, their ratings often enforce each other.

In 2013, law firm Robbins Geller Rudman & Dowd gathered unprecedented volumes of documents for legal action relating to fraudulent actions by S&P. They proved that Moody’s and S&P have long been instruments for banks in what is essentially a “cash for ratings” scam. A senior S&P analyst said: “I had difficulties explaining ‘how’ we got to those numbers since there is no science behind it.”

Yet elected governments are prostrating themselves at the whims of privately run companies who use mafia-like techniques and are paid for by private investors who need credible excuses to exercise greater or lesser pressure on these states to provide market concessions. Even some quarters of the US itself have expressed concern with the rating agencies. Last year S&P paid a record $1.37-billion legal settlement in a case brought by the US Justice Department: S&P were charged with issuing inflated ratings and for falsely representing its ratings as independent of any business relationships with the banks.

Until the 1970s, companies paid rating agencies to recommend good investment options. Originally intended to evaluate companies’, governments’ and institutions’ capacity to service debt, the agencies’ function included apprising investors on the risk of particular forms of debt. But the agencies’ role in intensifying the financial crisis and essentially defrauding investors by offering sunshine assessments of insolvent institutions while approving inordinately risky mortgage-related securities has called their judgment into question. This renders their undue power to manufacture particular sentiment and create either panic or buoyancy extremely toxic and undemocratic, particularly for developing countries that have specific economic vulnerabilities and fiscal conditions that may affect their outlook differently.

Although the agencies publish their methodologies, the techniques have been criticised for using untested validation and lacking peer review. Some of the techniques for gathering risk data include secondary data and images of a country – in other words, Googling to find rioting South African workers and students. As facetious as this may sound, several expert commentators (myself included) have indicated that the Big Three either do not approach them to gain deeper insights into South Africa’s zeitgeist, or disregard their opinions when composing their findings. Their minutes are not open to public or country examination and there are no appeal mechanisms even when countries disagree with their findings. How can a few companies exercise so much dominance over governments and public discourses, South Africa’s current preoccupation being a case in point?

Worryingly, the ratings agencies are guns for hire that derive their mandate from whoever has secured their paid services, creating several conflicts of interest. That sovereign states should subject their economic and political prospects to the rationale of the paid services of private companies is a concern that the European Commission shares with me. They have suggested expanding the mandate of the European Securities and Markets Authority (Esma) to evaluate agencies’ methodology with a requirement that bail-out talks and sovereign debt ratings be suspended in particular circumstances.

This is the most explicit attempt that Europe has taken to reform and curb the power of an increasingly unpopular industry. The reform package marks the most aggressive attempt yet by the EU to bridle an industry that is disliked and has been blamed by some European leaders for exacerbating the sovereign debt crisis with “erratic and subjective” rating decisions. Countries such as Greece, Portugal, and Ireland were consigned to junk status; the creditworthiness of France, Austria, and other major euro-zone economies was also downgraded, leading to accusations from some European quarters, and beyond, that the ratings agencies are pro-American and that their fundamental interest is in protecting US markets.

The delayed reaction to the US sovereign debt crisis might bear this out. Only in 2011, three years after the catastrophic Wall Street outing, was US sovereign debt downgraded, after having inexplicably maintained a triple-A rating, which the then treasury secretary, Timothy Geithner, described as “terrible judgment”. S&P stood their ground, Moody’s and Fitch opted to blow kisses at the crumbling US economy, and to maintain this undeserved AAA status.

This is one among many incidents that have led to charges that the agencies are indeed partial, politicised and either unwilling or unable to take swift action when necessary. That the three companies are all US-based does not assist perceptions in this regard. The China-based rating agency Dagong has given greater emphasis to “wealth-creating capacity” and foreign reserves than the Big Three, and seems to have a less punitive approach and methodology. China has strongly criticised the domination of the Big Three, and has also called them “politicised and highly ideological”. Dagong’s assessments have been more favourable than the US agencies, and present a compelling case for various countries to create and generate their own ratings methods and indicators.

Surely we need to expand our own capacity to create favourable sentiment that includes higher employment, more diversified economics, increased growth in social indicators and a deeper commitment to growing local industries and manufacturing capacity? The straw dogs that the deeply discredited ratings agencies offer popular sentiment have exaggerated their role in determining the health and risk of African countries’ economies. Given previous disastrous and sometimes unethical behaviour, it seems the biggest risk for South Africa is in listening to these false prophets of doom.

Liepollo Lebohang Pheko is a scholar, activist, political economist and policy and economic analyst. She tweets at @Liepollo99