Are Ratings Agencies Worth It?

Former Nottinghamshire County Council Chief Executive and County Treasurer, Roger Latham, discusses his views on the integral yet controversial role of credit ratings agenices in local authority investment. Roger is a Visiting Fellow with Nottingham Business School.

R151: You recently argued at our LA Treasurers’ Investment Forum that ratings agencies have been guilty in the past of playing “catch-up”. Do you see any change there in the wake of Iceland?

RL: No I don’t for two reasons. First, because the credit rating agencies always have to use information which by necessity is historic in nature. Because of this I pointed out that they have a long track record of playing catch up, going back beyond Iceland to the Enron situation and even back into the Wall Street crash of 1929 and the 1930s depression that followed it. I don’t see that track record changing any time soon. Indeed, a number of agencies appear in the past to have issued forward-looking analyses of specific situations – Iceland is a case in point, but there have been others – which they then don’t seem to have taken into account in their own technical assessments until much later. The second reason is I think more fundamental. I argued strongly that the activities of credit rating agencies are tied to a particular economic model that is an inadequate explanation and inaccurate forecaster of the state of the economy, and that when you look at the alternatives to that model there is an inherent uncertainty and rapidity of
change which means that the more realistic view of the economy virtually renders it technically impossible for credit rating agencies to do anything other than play “catch-up”.

R151: Arguably, ratings agencies have a regulatory role to play. Does that engender a conflict of interest?

RL: I think it’s very arguable that their regulatory role is at all valid. It’s my view that the current dependence of the regulators on credit rating agencies is a result of the desire to deregulate the financial
markets and to adopt a so-called “light touch” arrangement – which I consider to be an oxymoron. Instead of undertaking a proper regulatory role the regulators instead have relied on the activities of credit rating agencies as a proxy. As recent experience has shown this was a mistake. Credit rating agencies are operating in a commercial field and are being paid by those organisations who wish to have their paper appropriately franked. There is always the suspicion that the agencies will tend to be more compliant to the paying customer, and indeed some evidence that where their customers were reluctant to pay that they adopted bullying tactics for commercial gain. As a result, notwithstanding the technical issues that were involved, the way that the agencies gave some of the derivative instruments triple-A ratings suggest
that they are insufficiently independent to be relied on in a regulatory role.

R151: Are local authorities paying more interest than they should do to credit ratings?

RL: I would argue that if local authorities defined their policies solely in terms of credit rating agencies evaluations then they are paying more interest than they should to credit ratings. By doing so they are tying themselves to the traditional economic orthodoxy of perfect markets which are an inadequate explanation of economic activity. I argued strongly that local authorities and their advisers need to draw up not one but several strategies to deal with the different phases of the economy independent of credit rating agency evaluations. If I had to define the minimum level of strategies it would include:

– The normal cyclical activity of economic growth – a balance of risk and return over a 3 to 5-year cycle.

– The period of asset price speculation – essentially a more cautious defensive approach.

– A balance sheet recession – a more highly defensive strategy with particular emphasis on government stocks.

– A balance sheet recovery period – taking a longer-term view based on steady growth and risk minimisation.

R151: How do you rate the predictive capacity of institutions such as S&P, Moody’s and Fitch?

RL: The main argument in my presentations has always been that current economic theory is an inadequate explanation of economic activity. The new dimensions to modern economics introduced in the ideas of chaos theory, quantum theory, and looking at the economy as an organic rather than mechanical form suggest that economic forecasting is less of a mechanistic scientific prediction and more analogous to weather forecasting in the UK! In some parts of the world, such as the tropics, where climate is much more uniform weather forecasting has a greater level of certainty, although as we have seen some of the monsoon regions recently, variations from year to year are still possible. However in areas of complexity such as experienced in the UK or Japan weather forecasting is a much more uncertain proposition. Whilst there are certain regularities which mean that it is not entirely random, even short-term
forecasts are more emergent than certain. Long-term forecasts are much more problematic and sometimes only general trends are apparent. Apply this to the economy generally and it means that only when things are stable are the predictions of agencies likely to be borne out in practice. In most other
circumstances the uncertainty, emergent, and rapid shifts of basic economic pattern serve to undo the agencies’ predictive capacity.

R151: Looking at LA investment strategy, timing and product selection, to what extent do you think the ratings agencies are providing valuable support?

RL: From what I’ve already said I think that local authorities need to work with their advisers on issues of strategy and timing without particular regard to credit rating agencies evaluations. However in situations
where the economy is in one of the four more stable patterns that I outlined above then credit rating agencies individual evaluations of products do serve a valuable function in giving relative advice as to the return and risk between alternatives which should allow the specific choices to be made more
appropriately, utilising the wider information base the credit rating agencies can bring to bear compared to that available to individual authorities.

R151: We’ve seen recently how some LAs are getting their own creditworthiness rated. Do you think this will give them a competitive edge when raising capital in the markets?

RL: It might do, if there was a more mature market for raising capital directly by local government. As it is the activities of central government have virtually killed the development of a wider local authority
capital funding market. Only if local authorities are given greater freedom to raise funds on their own account and to develop the kind of bond market that existed in the past is a relative credit worthiness of local authorities likely to be valuable to them. Even then, as with sovereign debt, you need to ask
whether a credit rating evaluation of a public body which has a continuing existence and the taxation capacity to always meet its debt obligations really makes any sense. As far as sovereign states are concerned I would question whether or not a credit rating agencies evaluation is a valid exercise. There
is some argument that for local authorities as independent organisations without the taxation and money printing abilities of the state credit rating is a more valid exercise – but it has its limitations.