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Credit Rating Agencies Playing Big Roll In European Debt Crisis

STEVENSON JACOBS and DANIEL WAGNER   04/29/10 07:01 PM ET   AP

Germany Euro Greece

NEW YORK — The downgrading of European debt is turning up the heat on the firms that issue the ratings.

Some European officials are calling for curbs on rating agencies like Standard & Poor's, Moody's Corp. and Fitch Ratings. They argue that conflicts of interest and bad information make the agencies' assessments unreliable, even dangerous.

Germany's foreign minister went so far Thursday as to suggest that the European Union should create its own rating agency. He spoke after downgrades of Greece and Portugal roiled financial markets and stoked fears that Europe's debt crisis was spreading.

How ratings agencies are paid is also coming under scrutiny. The money they earn comes from the institutions whose products and debt they rate – 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 that pay system an "inherent conflict of interest."

Legislation in Congress to overhaul the financial regulatory system could change how the rating agencies do business. Critics note that the agencies gave safe ratings to high-risk U.S. mortgage investments that later imploded, triggering the financial crisis and a deep recession.

Despite the poor publicity, 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 first-quarter profit jumped 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's reduced its stake from 48 million shares to 30.8 million shares.

The profits and outsize influence of the rating firms have rankled European governments.

German Foreign Minister Guido Westerwelle on Thursday told WAZ newspaper group that the EU "should counter the work of rating agencies with efforts of its own." He cited the potential conflict of interest of having the rating firms develop, sell, and rate financial products all at the same time.

Westerwelle's comments came two days after S&P cut Greece's sovereign debt to 'junk' status and dropped Portugal's down two notches. Those downgrades sent financial markets from London to Hong Kong plunging. Investors feared that more European countries would be dragged into the region's debt debacle.

A senior German economist criticized the downgrades.

"We should not make the welfare of Europe dependent on rating agencies," Peter Bofinger of the German government's independent economic advisory panel told "Welt" newspaper. He noted the agencies' failure to spot problems before the financial crisis.

Yet less than two years after the crisis peaked, rating agencies still carry weight. A big reason 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 5 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 they do complex debt investments like mortgage securities.

"It's much easier to understand their metrics when it comes to downgrading countries," says 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.

EU officials remain unconvinced. And some are openly deriding the rating agencies.

"Who is Standard & Poor's anyway?" EU spokesman 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."

A top International Monetary Fund official also questioned the agencies' accuracy. He argued that their assessments reflect mainly investors' perceptions of a nation's financial health.

"That's why you shouldn't believe too much in what they say," IMF managing director Dominique Strauss-Kahn said Wednesday.

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," spokesman 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.

Spokesmen for Moody's and Fitch declined to comment.

All three rating agencies are facing new rules that could change how they operate in the U.S.

Under an overhaul of financial regulation being debated by Congress, investors could sue rating agencies for assigning recklessly high ratings. In the past, courts have held that credit ratings are constitutionally protected free speech.

The agencies also would be forced to register with the Securities and Exchange Commission. It addition, they would have to disclose more information about how they determine their ratings and how accurate they've proved over time. The SEC could revoke the registrations of rating agencies that consistently assign inaccurate ratings.

To address the conflict-of-interest issue, a bill passed by the House would require agencies to disclose their relationships with banks.

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.

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Wagner reported from Washington. AP Writers Robert Wielaard in Brussels and Juergen Baetz in Berlin contributed to this report.

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Filed by Nate C. Hindman  |