The credit rating agent’s thumb

I dropped into the offices of one of the credit rating agencies this week. The one that caused confidence in Greece to fall through the floor: Standard & Poors.

The agencies are interesting places at the moment as many attributed the AAA-rated toxic mortgage derivatives to their watch, so now they’re being cleaner than clean and holier than thou. Or that’s my take on this.

That’s why S&P came out with a negative rating on Greece just when Greece needed a cheerleader. Downgrading their sovereign wealth to junk bond status at the end of April, just at the point where sensitive bailout terms were being agreed, created the meltdown in the euro. Equally, I suspect they’ll do the same for Spanish bonds next, followed by Portuguese and Italian debt later.

The fear is that this could create a contagion effect, with Europe on the point of fragmentation and the end of the euro in sight. Hedge funds are betting big time against the euro and Angela Merkel and Nicolas Sarkozy are fighting for the future of the Union.

With all of the repercussions, it makes you realise the power the rating agencies now wield. They are almost being looked at as the Credit Rating Caesar of today in the Colisseum of Investments where the Hedge Fund Lions surround the Sovereign Debt Christians for a good Short Selling Gladiatorial meal.

Will the Credit Rating Caesar raise his thumb skyward or to the ground?

Will the Hedge Fund Lions attack or be held back to allow the Sovereign Debt Christians to fight another day?

I hear that our European leaders are calling their national regulators to call their credit rating contacts to plead for the thumb to be raised skyward.

We shall wait and see.

In the meantime, it gave me a chance to pop in and pick up a copy of S&P’s excellent weekly publication Credit Week, and guess what? Page 38 explains and defends the reasons for the Greek downgrade in a one-page article by David T. Beers.

It makes for fascinating reading, particularly in light of the fact that the credit rating agencies will come under a new EU regulatory mandate from 1st January 2011.

Will Barnier outlaw credit rating agencies from doing another Greek downgrade in the future? I wonder.

Specifically, is it agreeable for the ECB to hold ‘junk’ bonds ... they do now, as they’re backing the Greek funding crisis.

Anyways, here’s what S&P has to say about it:

Standard & Poor's Ratings Services' recent decision to lower its sovereign rating on Greece has drawn various comments: some supportive, some suggesting it is either too little too late, or too much too soon. It is a debate that highlights the very different responses that our rating opinions can sometimes elicit--and the need for us to reiterate the reasons for our actions and our broader role in the market.

First and foremost, we recognize that our views are sometimes unwelcome to the issuers we rate--and in this case to EU officials--but we believe our focus has to remain firmly on serving investors.

This is clearly a difficult time for the Greek government, the Greek people, and for the Eurozone as a whole. But as an independent provider of credit research and opinions, our primary duty to investors is clear: we have to communicate our view about relative credit risk as we see it, without fear or favor.

Greece is a good example of this principle in action. Our recent decision to lower its sovereign rating to 'BB+' was prompted by downward revisions to our economic growth assumptions for the country. In our view, the size and scope of the fiscal retrenchment required to stabilize Greece's debt burden are likely to further depress Greece's medium-term growth prospects. Under our new assumptions, we do not expect nominal GDP to regain its 2008 level until 2017.

At the same time, like many others, we see the Greek government facing a growing challenge to implement its fiscal reform program. We now estimate that stabilizing the government debt burden implies a reduction in the primary fiscal deficit (excluding interest payments) in the order of 13% of GDP-?a tough target compared with what other sovereigns have been able to achieve in the past.

In short, Greece's longer term fiscal prospects have led us to conclude that the sovereign's creditworthiness is no longer compatible with an investment-grade rating.

Some have suggested we should have suspended judgment until the EU/IMF bailout was finalized. We think not. We have repeatedly pointed out that a bailout, while addressing Greece's near-term liquidity problems, does not necessarily secure its longer term solvency-?as examples of sovereign bailouts in other parts of the world have shown.

In our view, Greece should be able to roll over its maturing debt for the remainder of 2010, as a result of the official financial support it is receiving-?and which we have repeatedly said would be forthcoming. But our reservations about Greece's credit standing are focused on the political and economic challenges its government is likely to face over the next three to five years?-challenges that, in our opinion, the bailout cannot easily resolve.

A faster return to fiscal balance may, in time, help market confidence recover and lead to an improvement in the sovereign rating on Greece. However, in our view, the success of this strategy ultimately rests on one factor the Eurozone authorities and the IMF can try to influence but cannot control--the willingness of the Greek people to embrace fiscal austerity on a scale never before attempted in the country. And that willingness is only now being tested.

As our 'BB+' rating implies, we do not see Greece in imminent danger of default (the historic 10-year default rate of 'BB+' rated sovereigns is 14%), but we do see increasing risks to its credit standing over the longer term.

Some have suggested that our ratings have been driven simply by market sentiment. In fact, as our record on Greece shows, the contrary is true. For much of the last 10 years, until the financial crisis, the market valued Greek debt nearly on a par with 'AAA' rated sovereigns like Germany and France. Yet our first downgrade was in 2004, when we lowered the rating on Greece to 'A' from 'A+'. For over a decade, in fact, our views on Greece's credit standing were contrary to the market consensus.

During the past year, investor sentiment has clearly swung in the opposite direction, but we have continued to take a more balanced view of Greece's creditworthiness. That remains the case today, even after our recent downgrade.

There is little evidence, in other words, that we are driven by the market. The reality is that we provide an independent view that investors may or may not choose to consider. Ratings are one of many inputs that investors look at, and they are only one of many factors that may affect movements in the market. While credit markets regularly overshoot and undershoot depending on the ebb and flow of sentiment, ratings take a longer term view of fundamental credit risk and tend to steer a middle course.

The market benefits from competing views on credit risk, whether from ratings firms or others. Currently, for instance, it is digesting three different ratings on Greece from the three major credit ratings firms. We welcome this debate and are committed to contributing to it by providing our independent view. We do so on the basis of rigorous research, local knowledge, criteria that we apply consistently worldwide, and transparency about our rationale and assumptions, which enables investors to take an informed rather than uneducated view of our ratings.

This principle of independence is a crucial one. It is enshrined in the EU legislation governing ratings firms, which comes into effect in September. This regime introduces day-to-day oversight of ratings firms' activities by EU securities regulators and is expressly designed to promote the independence and integrity of ratings?-in particular, to ensure they are not unduly influenced by debt issuers or other external parties. We strongly agree with this principle and believe that our recent rating decisions on Greece, and other EU sovereigns, demonstrates its application in action.