Forgotten but not gone

This week the pound fell from a three-month high against the dollar after Fitch Ratings said the U.K.'s sovereign credit rating is most at risk among top-rated nations. David Riley, Fitch's head of "global sovereign ratings" said Britain needs the "largest budget adjustment" among countries it rates AAA. Not exactly revelationary stuff. We all know that the UK is in quite the financial pickle, so why does anybody care what a discredited rating agency has to say about it? And why did literally billions of pounds worth of sterling assets see their demand fall on the back of this seemingly innocuous, and not new, information? The reality seems to be that these guys are actually more relevant than ever - and the ratings that they provide are more critical for companies and governments than they ever have been.

Back when I worked at Lehman Brothers we used to have a term to describe dubiously structured investments in the credit world: "Fitch only". To explain - Fitch is one of the 3 main credit rating agencies; they get paid fees for assessing the credit worthiness of governments, companies or any other flora and fauna of the financial markets - you name it and they will stick a rating on it for a fee. In the rating agency world there was a clear hierarchy - Standard & Poor's at the top, Moody's a close second, and the black sheep of the family was Fitch. Given their position in the hierarchy, our sense was that Fitch tended to be a bit more liberal with the credit ratings applied to particular structured investments - it appeared to be their way of "competing" with their more exalted brethren. Consequently if ever you spotted a bond that was solely rated by Fitch, the inside track was that this was probably something to be avoided at all costs. Thus "Fitch only" became the blanket term.

Having said all that, the service that each of the rating agencies provided had clear benefits to their clients (and to us bankers, who paid their fees). A high rating from one of these guys significantly altered the regulatory capital requirements for a particular asset, and consequently made that investment more appealing. I won't go too much into the detail, but essentially the lower the capital requirement for an asset the higher potential return on equity for an investor. In effect the rating agencies were a great leverage-enabler. At the start of 2008, there were about 20 nations and only 12 corporations that had a AAA rating. At the same time more than 64,000 structured financial products, such as mortgage backed securities were given a AAA status.

As has been widely reported, many of these assets are now worthless. When the financial crisis kicked off in earnest with the collapse of many of these "AAA rated" assets, governments of the world roundly criticised the outrageously conspiring behaviour of these rating agencies. Ironically, as governments and companies now have an increased requirement for funding their budget deficits, the power of the rating agencies stamp of approval seems to have actually increased since the crisis started. Last Tuesday the UK government found this out to their significant cost, when our old friends at Fitch ratings suggested that Britain might lose its AAA status at some point in the future.

The Independent said of Fitch this week: "Were it to come out with something of a little more significance like, oh, let's say, lopping a notch off that prized AAA rating, the consequences would be truly awful. The cost of all that debt would increase dramatically, for starters. Sterling would execute a nosedive and we would probably find ourselves at parity with the euro, and maybe the dollar as well." It's a bit mad then that with so much at stake, so much is in the hands of a band of fairly second rate and potentially morally dubious folks. Why is this so?

The truth is that this is a financial regulatory issue. The world's financial regulators have placed the rating agencies at the center of the process of measuring whether banks and other financial institutions are "sufficiently capitalised". In theory if you have a good asset, then there is minimal chance of a catastrophic loss. Consequently less "insurance" against a catastrophic loss for a good asset is required. For banks "regulatory capital" is essentially a form of insurance against a catastrophic loss. Where the rating agencies come into the equation is that the world's financial regulators have made their ratings the determining factor in deciding how much capital a bank has to hold against each of its assets. A 'AAA' rated government bond requires very minimal (or none at all) capital, whereas a 'CCC' rated asset requires a lot of capital.

In a way, the responsibility for knowing whether an asset is good or not has been outsourced from people who are professionally trained to do so (the investors themselves), to the rating agencies - who basically aren't very good at it. In the case of Britain's debt, if a downgrade were to take place, it wouldn't matter if the world's financial institutions disagreed with Fitch, the regulatory situation would mean that whatever UK debt these institutions owned would suddenly be less attractive to own. In order to then compensate investors, all future debt would have to pay a significantly higher interest rate.

This year the total amount of sovereign debt (of national and state governments) that needs refinancing globally is estimated to be $3 trillion, and that figure is likely to be similar in coming years. The global "bun fight" to compete for that money is therefore likely to be intense - so a AAA rating will only become more relevant. The world's financial regulators are the ones responsible for the relevance of these ratings and they should be looking to re-establish regulatory capital rules in a complete overhaul, so that regulatory capital is not so inextricably linked to ratings. This is unlikely, so it appears that the band of discredited rating agencies will remain center stage for the foreseeable future.