Credit rating agencies are scrambling to adjust to the coronavirus pandemic, slashing assessments of vulnerable companies under the scrutiny of critics who blame them for exacerbating the last financial crisis.
The agencies — led by the big three of S&P Global, Moody’s and Fitch — have pushed through large amounts of rating downgrades as the Covid-19 outbreak has accelerated. March had the fastest pace of downgrades, on records going back to at least 2002, according to a report last week from Bank of America. The bank added that more issuers could expect to have their ratings docked in the weeks ahead.
To critics, this is a rerun of the 2008 financial crisis, when ratings that were set too high came tumbling down, magnifying a sense of alarm, particularly in markets for securitised products that were packed with mortgage-backed bonds.
“Here we are, déjà vu all over again,” said Dennis Kelleher, head of Better Markets, a consumer advocacy group. Ratings are being cut “after what appears to be . . . significant ratings inflation, also just like last time”, he said.
Agencies say they are simply reacting to changed circumstances, reflecting sudden strains that have emerged as a result of the coronavirus outbreak. “We are really just trying to call it as we see it, being balanced, but also acknowledging that this is a very big stress that the economy is facing,” said Craig Parmelee, global head of practices at S&P.
About 80 per cent of S&P’s ratings actions since early February — about 213 downgrades out of 4,000 rated non-financial companies — have been on issuers already in “junk” territory before the coronavirus crisis, the company noted.
“We are taking a considered approach to downgrades across geographies and asset classes,” said Anne Van Praagh, head of Moody’s credit strategy and research. “Our job is not to move all ratings down; that does not serve anybody. Our job is to identify the outliers.”
Concerns that ratings were set too high before the coronavirus outbreak stem from the business models of the agencies, which are paid by the companies and the governments whose creditworthiness they assess. A rating from a top agency can make the sale of a bond or a loan much easier, providing investors with notionally independent views of the borrower’s prospects. Such views are also hard-wired into the mandates under which many fund managers operate, forcing them to sell bonds if ratings drop below certain thresholds.
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But issuers generally pay to be rated — a structure that can cause conflicts, leading to accusations that agencies compete to win business by offering high ratings.
In 2015, S&P agreed to pay the US and states about $1.4bn to settle allegations that it boosted ratings on mortgage-backed securities in the run-up to the crisis, admitting that it held off on downgrades for fear of losing market share. Moody’s paid $864m in 2017 to settle similar charges.
Today the pair accounts for 81 per cent of outstanding credit ratings, according to a January 2020 report from the Securities and Exchange Commission. Fitch makes up another 13.5 per cent of the market.
Before the outbreak intensified, regulators had been asking questions about the agencies’ business practices. In November SEC chair Jay Clayton said the activities of the agencies should be “continually” monitored, while asking whether there were “alternative payment models” that would better align the interests of rating agencies with investors.
Egan-Jones, a smaller rating agency that is paid by investors rather than issuers, said in a January letter to the SEC that “no amount of disclosure or internal separation of ratings and marketing staff is sufficient to overcome the taint created by such conflicts”.
In their letters of response to the SEC, Moody’s and S&P said potential conflicts were inherent in all rating-agency business models.
Analysts note that the “issuer pays” model also causes some recipients of downgrades to behave as if they are aggrieved customers of the agencies, rather than subjects of unbiased assessments. Last month SoftBank, the debt-laden Japanese group, complained about a downgrade from Moody’s, saying the agency had made “excessively pessimistic” assumptions about the market environment.
Investors often make decisions independently of the assessments of rating agencies. This week, cruise operator Carnival paid handsomely for a new bond issue despite its “investment-grade” ratings, as fund managers judged the company to be in peril after the viral outbreak.
The debate over rating agencies’ business models is unlikely to fade, as this time the scope of cuts is much broader than the realm of structured products. Already, downgrades of big companies such as carmaker Ford and retailer Marks and Spencer, from the lowest rung of investment-grade ratings into junk, have appeared to cause ructions in credit markets.
The old flaws in business models are becoming obvious once more, said Riddha Basu, an assistant professor at George Washington University.
“It is still the same after 10 years,” he said. “Nothing much has changed.”