Poor Standard and pretty Moody !

Last week, the US Department of Justice charged Standard and Poors of intentional fraud - of making 'limited, adjusted and delayed updates' to its rating criteria resulting in the agency giving favourable ratings to several structured finance papers , leading to massive losses to investors.

S&P and their ilk do not give recommendations - they just give 'opinions', and hence they have always claimed constitutional protection for freedom of speech....and so, they cannot be just pulled up for. Some argue that what happened was essentially a mistake on the part of the investor.... caveat emptor ( buyer beware !) -nothing prevented the investor from doing his own due deligence.

While this does appear to be a strong point for the agencies, there is a catch. Regulators across most countries, insist that investments made by banks and financial institutions have to be rated and they also specify acceptable rating agencies and S&P , Moodys and Fitch surely figure in most of these lists. (While rating agencies do a lot of things these days, I am not sure if the agencies would be in the pure ratings business if regulators do not insist on investments being rated). This means, they 'enjoy' a quasi-official status. Investors hence rely on their ratings to invest. There hence is a fiduciary responsibility that agencies owe - to protect investors by giving a true and objective assessment. So, while one should not take away the responsiblity of an investor to look with care before he invests, one should not also take away the responsibility of the agency to be true - particularly as the investor is directed to take the view into consideration, by regulators. And the standard of work by the agencies in discharging this responsibility has been pretty poor.

The other way of looking at this is that a seller is responsible for ensuring that his product performs to standards that it claims to have. Agencies, certify the level of standard and get paid for it. So, when the product fails to meet the standards, the seller has to be pulled up - and with him the Agency which abetted in the sale.

Any which way one sees this, the agencies need to be made accountable. Ever since the financial crisis, there have been several attempts to pull up the agencies for their flawed ratings and to regulate them. And frankly, I am happy that S&P is being hauled to courts - and irrespective of the final judgment ( or settlement), there are two possible gains :

1) Investors will not rely on these ratings beyond a point (infact, investors of sovereign debt market have begun to repudiate rating actions.
2) Agencies will hopefully become more responsible in their job.

The move by the US Gov is however surprising - why is there a case against only S&P ?... Moodys and Fitch too played their part in the crisis. Is it because the US Gov is still in a bad mood after the S&P downgrade in August 2011 ?

Forcing policy changes by threat

Fitch Ratings , the international rating agency has reiterated its negative outlook for India and has warned of a downgrade. The agency complains that structural reform process is sluggish. This is the era of policy making by threat. The agency is concerned over
a)India's economic and fiscal outlook
b)Sharp slowdown in growth
c)persistent inflationary pressures
d)weaker public finances.

Probably these are concerns, but should the government choose to cut back spending to ensure that the fiscal deficit is contained, it will impact the already fragile recovery , and should the central bank increase rates to cut out inflation, it will affect growth. Less taxes may help growth, but will increase the deficit. Cut rates to spur growth and you have the threat of inflation picking up again. Look anywhich way, the Goverment cannot really do much. And this is after the spate of 'actions' taken by the Government.The fact is that we will need to live with this situation till global growth rates pick up. What the agencies would desire is a cut in subsidies (which is only huge in absolute amounts - in relative terms it is not really as big a problem as it is potrayed to be), lowering of taxes and a cut in rates. They forget that this country has a population of 1.2 billion and all that we have been taking in terms of growth has not been very inclusive. NSSO data clearly shows that the growth has not resulted in increased employment - it is a jobless growth.These policy prescriptions by Fitch or S&P will only aggrevate the problem. Running a country is not like running a company. And that is where the problem is.

Ratings are statements of opinions and the track record of thees agencies in rating corporate bonds is decent. What is questionable is their ability to rate other issues (their track record in rating mortgage backed securities is disastrous) and sovereigns. Sovereign debt rating is almost entirely unsolicited and the ratings and policy prescriptions of the three big agencies Fitch Ratings, S&P and Moodys has played a major role in accentuating the EU crisis, forcing governments to consider placing curbs on the timings of release of such un-solicited ratings and curbing ownerships. There is nothing to prove that these agencies have been successful in predicting crises.

What happens is that rating changes affects the ownership pattern of sovereign bonds - as most institutions. Because most institutions have allocations for bond holdings based on the ratings of the bonds, when a downgrade happens, it results in a huge sell off.... well that is what is supposed to happen in theory. But when US had its AAA ratings stripped, its bonds rallied ! Bloomberg reports that 'Predicting the consequences of a rating change by S&P or Moody’s may be little better than flipping a coin, with yields moving in the opposite direction than suggested 47 percent of the time, according to data compiled by Bloomberg in June on 314 upgrades, downgrades and outlook changes going back to 1974'....

So should the Government worry ? Reforms are required. But we should make haste slowly. Policy should not be made under threat.