European leaders take aim at rating agencies

Amid speculation that Greece may have no choice but to default on some debt and growing fears that debt levels in Italy are unsustainable, European leaders are refocusing attention on the potentially negative influence of credit-rating agencies, which were widely seen as complicit in fomenting the 2008 financial crash.

It was the sudden four-level downgrade of Portugal's credit rating to junk status by Moody's July 6 that prompted a rash of unusually strongly worded criticism in recent days. The barrage comes in the wake of what leaders considered poorly timed downgrades to Greek and Spanish debt last year, and is leading to fears that the rating agencies are helping push the eurozone further into crisis.

German Finance Minister Wolfgang Schäuble is pushing to "break the oligopoly of the rating agencies." Luxembourg's Prime Minister Jean-Claude Juncker - president of the Eurogroup, the gathering of eurozone finance ministers meeting as this issue went to press - called the influence of credit rating agencies "disastrous."

Greek Foreign Minister Stavros Lambrinidis said Moody's downgrade had "the wonderful madness of self-fulfilling prophecy," referring to the common market reactions to credit-rating downgrades, in which the cost of borrowing rises in accordance with greater perceived risk, making it more expensive to borrow money and therefore more difficult to pay it back.

Vladimír Pikora, chief economist at Next Finance in Prague, said the ratings downgrades have a "psychological effect" and contribute to a "vicious circle."

"They are in the middle of the circle, not the beginning," he said. "Politicians are looking for somebody to blame."

Indeed, a cycle does emerge whereby international advisers and markets clamor for austerity and a sell off of state assets in troubled economies, and once complete, those countries see their ratings drop as cuts make for lower economic growth prospects. And it is more than just politicians who are targeting credit-rating agencies, as headlines across Europe exemplify wider disgust.

"Moody's sows seeds of terror," said Poland's Gazeta Wyborcza; "Europe (finally) in revolt against rating agencies," the Spanish daily Publico wrote; and the Portuguese daily i led its front page with "Against the agencies, marching, marching."

Yields on Portugal's 10-year bonds now exceed 11 percent, compared with German 10-year bonds' 3 percent yield.

"The timing of Moody's decision is not only questionable, but also based on absolutely hypothetical scenarios which are not in line at all with implementation," said European Commission spokesman Amadeu Altafaj. "This is an unfortunate episode, and it raises once more the issue of the appropriateness of behavior of credit rating agencies."

Moody's did not respond to multiple requests for comment.

European Commissioner for Financial Services Michel Barnier told Bloomberg News that something must be done to curb rating agencies' "power and influence."

"One can even question the need to rate countries undergoing [international rescue programs], seeing as they benefit from this support and protection," Barnier said.

This is not the first time the big three New York-based agencies - Moody's, Standard & Poors and Fitch - have generated concerns, including about conflicts of interest.

All three agencies gave both Lehman Brothers and AIG at least an A rating through Sept. 15, 2008, the day Lehman declared bankruptcy and a day before AIG received the first in a series of multi-billion dollar U.S. government bailouts. Those events are seen as a flashpoint in the international economic crisis unleashed in the following months, from which much of the world is still trying to recover.

In a self-admission that they had inflated credit ratings on a grand scale, Standard & Poors downgraded more than two-thirds of its investment-grade ratings, and Moody's reduced ratings on more than 5,000 mortgage-backed securities within weeks of the Lehman collapse. Among the largest concerns that have been raised about the agencies is the very business model they are based on, whereby the firm, or country, being rated pays for its own audit.

Jeremy S. Fons, the former director for credit policy at Moody's, said as much during testimony before the U.S. Congress in 2008.

"While the methods used to rate structured securities have rightly come under fire, in my opinion the business model prevented analysts from putting investor interests first," he said.

Despite the short-term outcry, the rating agencies - which cite protection by the U.S. Constitution's First Amendment, guaranteeing freedom of speech - still curry a dominating influence on markets.

"There is no doubt the rating agencies were wrong in 2008," said Simon Tilford, chief economist with the Centre for European Reform in London. "But now the agencies are doing the eurozone a favor by exposing the unsustainability of these plans moving forward."

In early July, Standard & Poors said that Franco-German plans for a rollover of Greek private debts could constitute a "selective default." This was seemingly the single greatest factor in shifting talks of a second Greek bailout in a direction where it seems Brussels may eventually come to terms with a partial default by Greece on some of its debts - assuming it will help prevent so-called contagion.

Pikora said the threat of a eurozone default "domino effect" remains, with Portugal and Ireland among the members most at risk. Most recently, markets have rekindled fears of problems in Italy, the eurozones' third-largest economy.

"I'm surprised people are surprised," Pikora said.

An Italian collapse represents a considerable threat to the eurozone, as the country's economy is more than twice the size of Portugal's, Ireland's and Greece's combined. Italy has debt surpassing 120 percent of annual GDP, and a public war of words between Prime Minister Silvio Berlusconi and his finance minister adds to worries.

In the wake of steep drops on shares in Italian banks in early July, Italy's market regulatory watchdog banned short-selling on the Milan stock exchange July 11. The yield on Italian government bonds has risen in recent days surpassing 5.75 percent at the market-close July 11, a record high over German yields since the creation of the eurozone.

The perceived ill effect of rating agencies on the efforts to combat the eurozone debt crisis has led to speculation that a new European-based agency is necessary.

"If a private-sector one emerges, great," Tilford said. "But if we are talking about a rating agency funded with public money, it will have no more credibility than a rating issued by the Chinese government."

While there remains disagreement over whether rating agencies are helping or hurting the eurozone as of late, there does seem some consensus that the agencies raise two big concerns: a tendency to perpetuate existing trends and power concentrated in just a few hands.

"It is clear that there is an element of pro-cyclicality, which is embedded in the functioning of credit-rating agencies," said European Central Bank President Jean-Claude Trichet. "It is also clear that a small oligopolistic structure is not ... desirable at the level of global finance."

Benjamin Cunningham can be reached at
bcunningham@praguepost.com