Offshore Capitalist

Ratings Firms’ Influence Under Fire

The ratings agencies played a substantial role in the 2008 financial crisis.  Now some criticize their actions in the Greek/European debt crisis…
An interesting article.. click the link at the bottom to see the full original.

WallStreetJournal:  Europeans took aim Wednesday at debt-rating agencies, accusing them of worsening the plight of financially-stretched governments such as Greece that are struggling with heavy debts.

Standard & Poor’s was in the line of fire Wednesday, as it downgraded Spain one notch to AA from AA+. This came a day after it provoked a selloff in financial markets around the world by cutting the ratings of both Greece and Portugal. Greece became the first of the 16 nations that use the euro to have its debt rated as junk.

The downgrades came at a sensitive time as euro-zone governments and the International Monetary Fund attempt to fashion a financial-rescue package for Greece, which has yet to win approval by the German parliament.

The ratings moves heightened fears that the package, even when finally delivered, wouldn’t be enough to avoid a debt restructuring by Greece in which bondholders would be forced to take losses. S&P estimated that if Greece needed to restructure, investors would lose between 50% and 70% of their capital.

“We have a vicious circle in the last few days with Greek debt,” said Sylvain Broyer, economist with the French bank Natixis.

He said actions by ratings firms had been a reaction to previous sharp declines in government-bond markets, and were now a cause of further bond-market declines. “The behavior of the rating agencies is entirely pro-cyclical,” he said.

On Wednesday, the yield spreads between benchmark German 10-year bunds and Greek, Spanish and Portuguese debt of comparable maturities all widened.

IMF chief Dominique Strauss-Kahn said it wasn’t clear whether the rating firms were reacting to the financial markets, or vice versa. “You shouldn’t believe too much what they say even if it may be useful,” he said in Berlin.

Ratings agencies have been strongly criticized for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been panned for throwing fuel onto the fire of crises by belatedly ratcheting down ratings, stirring many investors to scramble to sell securities.

Many European investment institutions, like those in the U.S., are highly sensitive to debt ratings. Life-insurance companies typically seek to hold only very safe investments, which means that when bonds are downgraded to junk, they sell them.

Many institutions have in-house rules that assign a percentage of a portfolio to top-rated triple-A bonds, and a smaller percentage to lower-rated double-A bonds and so on down the ratings ladder.

After a downgrade, the institutions adjust their holdings, selling the downgraded debt and seeking to replenish their quota of high-rated debt. Many rely on just one agency and for investors in government bonds that was most commonly S&P, Mr. Broyer said.

Banks, also big investors in government bonds in Europe, are also sensitive to debt ratings. They are forced to increase the capital they must have as a cushion against losses if bonds they hold are downgraded to junk. This reduces their profitability, and encourages them to sell.

Another way the feedback loop between the markets and rating agencies can be extended is through portfolios tied to indexes mandating certain holdings of Greek debt–but only if the bonds maintain a certain credit quality. For example, the Barclays Euro Government Bond Index uses whichever rating is lower from S&P and Moody’s. Greece has been 4% of that index but will be excluded starting May 1, due to S&P’s downgrade. That in turn would likely force selling from investors tracking that index.

via Ratings Firms’ Influence Under Fire – WSJ.com.

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