International Forecaster Weekly

The Ratings Game

Rating agencies as the secret weapon of 21st century warfare. For years critics have made the argument that the entire 2008 financial crisis would never have happened without the active collusion of the ratings agencies in giving their AAA prime rating to the toxic mortgage-backed securities that were at the heart of the subprime meltdown.

James Corbett | June 28, 2014

If it is true that we are entering an era of “new cold war” between the NATO powers and their BRICS-affiliated resistance bloc counterparts – and it is true according to all the usual globalist think tanks and media mouthpieces – then this war will not be fought with armies on battlefields but with corporations and pipelines and contracts. And if economic warfare is the new normal for the 21st century, then Russia and China have just revealed one of their key weapons in this fight. It is neither a missile nor a tank, not a stealth fighter nor an electromagnetic weapon. No, it's something altogether more fearsome: a credit rating agency.

    The announcement was made early this month by Russian Finance Minister Anton Siluanov. “In the beginning, the agency will assess Russian-Chinese investment projects with a view to attracting of [investors from] a number of Asian countries,” the minister said on a recent trip to Beijing. “Gradually, based on the progress and authority of such an agency, we believe it will rise to a level where its opinions will attract other countries.”

    In the modern age of economic warfare, that's the equivalent of a shot across the bow. But in order to understand the importance of this announcement and the potential good that it can do in bringing competition to a market dominated by three US-based firms, it's helpful to re-examine what credit ratings agencies are and what they do, as well as how they have functioned in the past as tools of geopolitical leverage for Washington over its political rivals.

    Ratings agencies assign credit risk ratings to large scale borrowers, whether corporate or governmental, from AAA prime rating status all the way down through “D” for “in default.” Anything below BBB- is considered junk bond status and governments are especially keen to avoid being assigned such a rating to stave off a stampede of sellers in their bond market and rocketing interest rates on their sovereign debt.

    Although the agencies like to give the air of mathematical or statistical certainty in their assessments, the ratings are actually highly subjective, based on each agencies' judgement of information about debtors' risk of default. Neither do ratings represent any particular probability of default. Instead, the letter grading scale represents relative risk of default and are generally characterized in lengthy descriptive phrases. When the subjectivity of these ratings are combined with the fact that the credit ratings market is overwhelmingly dominated by just three agencies—Moody's, Standard & Poor's and Fitch Ratings—all of which are American agencies which derive much of their income from the very Wall Street banks they claim to be impartially evaluating, the potential for abuse is rampant. It should be no surprise, then, that the historical record is rife with examples of the “Big Three” agencies' corruption.

    For years critics have made the argument that the entire 2008 financial crisis would never have happened without the active collusion of the ratings agencies in giving their AAA prime rating to the toxic mortgage-backed securities that were at the heart of the subprime meltdown. After all, as Matt Taibbi pointed out in an article on the subject last year:

    “A triple-A rating is to the financial world what the USDA seal of approval is to a meat-eater, or virginity is to a Catholic. It's supposed to be sacrosanct, inviolable: According to Moody's own reports, AAA investments 'should survive the equivalent of the U.S. Great Depression.'”

    In that article, Taibbi published the details of a trove of internal emails from within the Big Three agencies themselves, uncovered as part of an investigation brought about by a pair of lawsuits. The emails confirmed the suspicions of the agencies' critics in the starkest possible terms. One senior S&P analyst confides that “I had difficulties explaining 'HOW' we got to these numbers since there is no science behind it,” while a senior S&P executive calls the agencies' dealings a “f***ing scam” and another warns ominously that he hopes “we are all wealthy and retired by the time this house of card[s] falters.”

    The documents detail how the banks used regulatory loopholes to create entities called Structured Investment Vehicles (SIVs) which could be used to keep mortgage backed securities and other risky investments off the books of the main bank. This allowed them to raise money on the commercial paper market at low interest rates and earn high interest rates by buying toxic subprime mortgage securities. The ratings agencies gave their double stamp of approval; first their AAA prime status to the toxic subprime sludge that was being bundled up in the mortgage-backed securities that the SIVs were buying, and then to the SIVs themselves.

    But, unfathomably, the Big Three ratings agencies—the very institutions that are supposed to provide a reliable, unbiased, independent, disinterested, third-party assessment of the credit risk of any given asset, corporation or government—are compensated directly by the issuer of the product that they are rating. The SIVs were paying for the prime ratings they were receiving, and pay they did. Ratings agencies' fees doubled from 2002 to 2007 (from $3 billion to $7 billion) on the back of a quadrupling of fees related to mortgage-backed securities.

    The internal documents show that the agencies made the deliberate choice to sign off on deals they didn't understand without any scientific or historical backing for their ratings, because, as one Moody's executive wrote in 2004, “To put it bluntly, the issuer could take its business elsewhere unless the rating agency provides a higher rating.” The Big Three were not without their conscience-racked would-be whistleblowers and frustrated analysts, but in the end the execs won out and the rest, as they say, is history.

    If only the agencies were simply the tool of mammoth financial conspiracy. Alas, they are also the tool of the US State Department and an instrument of geopolitical warfare. If there is a single issue that unites nations around the globe these days (except for Wall, Washington, of course), it is probably this one. As EconMonitor explains:

    “Russia’s president Vladimir Putin and Germany’s finance minister Wolfgang Schäuble speak of 'abuses' and 'abusive behaviour,' Turkey’s premier Recep Tayyip Erdoğan makes claims of 'unfair' decisions, and José Manuel Barroso, president of the European commission, directly accuses the agencies of a 'bias […] when it comes to the evaluation of specific issues of Europe.'”

    Indeed, Europeans know whereof they speak in this case. The Big Three waited for Greece's sovereign debt refinancing package to go through to downgrade Spanish bonds, and when the EU brokered a deal to aid Spain they downgraded Portugal. The EU came to shore up Portugal's mess and the agencies circled back to downgrade Greece, and on it went, round after round. Not that the countries involved didn't deserve their downgrades, but that's precisely the point; they deserved their downgrades long before that point. But the agencies had somehow “missed” that fact until the very time that the EU was running around with their bailout manna from heaven trying to smooth things over. The ratings agencies were pouring gasoline on the EU debt crisis, and Europe recognized that fact.

    China has been aware of the political nature of these ratings shenanigans for years and have taken their own steps to counteract them. In 1994 they set up their own credit rating agency, Dagong Global Credit Rating, which rates short-term and long-term debt, including sovereign bonds. The agency has been given short shrift internationally, but did make headlines around the world for its decision to downgrade American debt twice in 2011 after Congress raised the debt ceiling by $2.1 trillion.

    For Russia, the final straw appears to have come in April (in the midst of the Kremlin's dual with the White House in the Ukrainian proxy region) when S&P downgraded the country's sovereign debt from BBB to BBB-, just one notch above junk status. This was, in fact, the very point at which Russia went full nuclear in its own financial war with Wall Street. Directly after the announcement, Russian presidential advisor Sergei Glazyev announced a new plan for economic disengagement from the US and the dollar, including the possibility of withdrawing all dollar and Euro-denominated assets from NATO countries to neutral ones, reducing Central Bank holdings of dollar assets, selling sovereign bonds of NATO member countries and any country that supports sanctions on Russia, and using national currencies rather than the dollar in bilateral trade. Then, days later, the Russian government made it even more explicit, announcing that they would formally push for their BRICS partners and Eurasian Union counterparts to establish their own rating agency to avoid Washington's political influence over international debt markets.

    This is the context in which we have to understand this latest proposal to found a joint Russian-Chinese agency. The proposed agency, the Universal Credit Rating Group, would combine the already-existing Russian RusRating agency, China's Dagong Global Credit Rating Co, and the American non-Big Three Egan-Jones Rating.

    UCRG will have an uphill battle in establishing itself as a reliable and non-politically motivated agency given the circumstances of its founding. It would be hard for outsiders to see this move as anything other than part of a political tit-for-tat over recent skirmishes between Russia and the US, and for the agency to be taken seriously at all it will have to build up trust with international partners. But it does have potential allies in places like Europe, still wary of the Big Three after the last round of Eurozone crisis. China made inroads in Europe last year when its Dagong Europe Credit Rating won approval from the European Securities and Market Authority to operate as a rating agency in Europe. The new agency is given further gravitas by the fact that its CEO, Richard Hainsworth, is an influential UK financier with long experience in the Russian ratings market, and someone who helped to forge the ties between Dagong and Egan-Jones.
    At this point, it is far from certain that UCRG won't just be another political tool of its host countries to engage in economic warfare with the US and its “Big Three.” But even if that's all that the new agency amounts to, it will still be valuable for that. Simply giving the global market a viable alternative to the Wall Street fat cats' rating agency of choice will help to balance the equation and help third parties evaluate risk by comparing ratings and subtracting biases. It still remains to be seen how far this new venture will go, and it will still take years before it will be able to establish itself on the global market, but the added competition can't but be a good thing for a credit rating industry that is badly in need of a shake up.

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