May 21, 2020
Credit Rating Agencies and the Lessons of 2008
In a new essay on Medium, AAF President Douglas Holtz-Eakin examines the role of credit rating agencies in the current crisis and compares the current situation to 2008. He concludes that the agencies have learned the lessons of the last financial crisis.
Get ready for another controversy over credit ratings. The Federal Reserve, with backing from the Treasury, has opened the financial spigots and is extending loans to every corner of the economy struggling from the fallout of the coronavirus pandemic — except firms like Macy’s and Kohls that do not carry investment grade ratings. Once again, the assessments of credit rating agencies (CRAs) are crucial in a crisis, echoing the financial crisis of 2008.
But this is not 2008. While the information we are receiving on the creditworthiness of firms right now is painful, all signs indicate it is correct — and that means the CRAs learned the lessons of 2008.
Since the onset of the COVID-19 pandemic, hundreds of downgrades have taken place across industries. The CRAs have an obligation to convey to financial market participants the changed credit worthiness of firms and the likely diminished performance of securities. According to a recent report, “The pace of downgrades over the last two weeks was the fastest on record in one major corporate-bond index going back to 2002, according to BofA Global Research.” Thus far, about 80 percent of the ratings actions have been in speculative grades, but “Credit-ratings firms downgraded a net $560 billion of investment-grade corporate bonds in the index last month.”
Here’s the problem: Since the rules governing access to Federal Reserve facilities require participants to carry an investment grade rating, these firms will not be able to benefit from the over $500 billion support available from the Coronavirus Aid, Relief, and Economic Security (CARES) Act. And that means they could go under. In other words, the CRAs are involved in yet another economic meltdown.
The 2008 financial crisis was a man-made event, an economic maelstrom born of multiple, interlocking forces at the center of which were toxic derivative securities built upon a foundation of risky mortgages. CRAs erroneously rated mortgage-backed securities and their derivatives as safe investments. They were not. (Buyers also failed to look behind the credit ratings and do their own due diligence.) The subsequent downgrades reflected the underlying poor health of the mortgages — the CRAs were effectively fixing their mistakes by downgrading these derivatives. As the financial structures crumbled, credit froze, and the financial dysfunction dragged down the Main Street economy.
This year’s downgrades are not part of the crisis; they are an essential part of conveying information about the fallout of the crisis throughout the economy. The virus struck, and virtually overnight customers and cash flow disappeared in large swaths of the U.S. economy. As UBS senior credit strategist Barry McAlinden put it: “Downgrades are a normal part of an economic down cycle.” Here CRAs are accurately reflecting the changing nature of the securities they scrutinize — vital information for the market — not redressing any errors made by any market participants in the original health of these investments.
The CRAs are not sympathetic figures. Their role in the 2008 crisis is well established, and they continue to be viewed with some skepticism; one report from late last year wrote, “Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist.” But their reforms since 2008 — increased transparency regarding the development of rating models and the performance of ratings, firewalls between analytic and commercial activities, beefed up compliance and internal control staffs — should not be ignored, either. And the criticism that the CRAs are inflating ratings for a profit cannot simultaneously be reconciled with the criticism that they are downgrading too quickly.
More important than the reputations of the CRAs, however, is the information they provide to the economy. The CRAs did not decide that companies such as Macy’s cannot receive federal help — it is a policy decision that Congress made in the CARES Act. Indeed, if the CRAs didn’t issue downgrades in this environment, it would be a real indictment of a too-cozy relationship with issuers. The fact that the CRAs are the bearers of bad news to these firms means that they are doing their job.