Why Fitch’s A+ gets a D

The credit rating of a country’s bonds is based on a group of experts’ opinions and they may well disagree.

By SHLOMO MAITAL
Brokers in the trading room of an investment bank in Tel Aviv (photo credit: NIR ELIAS / REUTERS)
Brokers in the trading room of an investment bank in Tel Aviv
(photo credit: NIR ELIAS / REUTERS)
I PLAN to give a Chutzpa + Obfuscation Award to the bond-rating agency Fitch. It recently “downgraded its outlook for Israel government’s long-term foreign-currency debt from Positive to Stable, while affirming Israel’s local currency bonds as A+.” For most people, that statement is clear as mud.
Israel’s actual credit rating remained unchanged.
This is important – it is not Israel’s credit rating that was downgraded but its “outlook.” There is a big difference.
Opposition politicians, now in election mode, jumped on this decision by Fitch to vilify the performances of Prime Minister Benjamin Netanyahu and Finance Minister Yair Lapid.
Meretz Leader Zahava Gal-On said, “The rating outlook is a result of failed economic policy.” Labor MK Erel Margalit called the downgrade a “slap in the face for Netanyahu.”
Margalit is a former venture capitalist; but I wonder how well the others understand what Fitch’s downgrade really means.
What in the world is a “rating outlook”? Who is Fitch? Why did the Fitch announcement bash the shekel? And why do these ratings matter? Let me try to shed some light on the matter and explain why I believe we should be skeptical about Fitch, S&P, Moody’s, or any other for-profit rating agency.
What are the Big Three ratings agencies? They are three for-profit companies, which make money by evaluating the credit worthiness of a company or a government based on the debtor’s ability to pay back the debt and the likelihood of default. The three largest credit ratings agencies are Standard & Poor’s, Moody’s and Fitch Ratings, and they are all based in the US. They are paid mostly by financial services companies that underwrite the bonds.
They use letters to rate credit risk, like teachers grading math exams. Each agency uses a slightly different letter system; S&P uses capitals with pluses and minuses (AA+), which it copied from Fitch; Moody’s uses capitals and lower-case letters (Aaa). One would think they could sit down together and work out one simple language to grade bonds of countries and companies. But they cannot, and the result is needless confusion. True, the credit ratings are for professionals but they affect all of us and we deserve to understand what they mean.
Arguably, we do need an objective third-party arbiter who will honestly evaluate how risky government and corporate bonds are. However, this is done at present by underpaid and overworked accountants. And because the rating agencies are hired and paid by those who underwrite the bonds being rated, this gives new meaning to the phrase, “the cat guarding the cream.” What if college students paid lecturers directly, as they did in England several centuries ago? How hard would it be to get an “A”? Each of the Big Three ratings agencies has a different system for rating credit, but none use an objective mathematical formula – all use subjective evaluation of data. So in the end, the credit rating of a country’s bonds is based on a group of experts’ opinions, and experts may well disagree. Fitch’s rating of the Israeli debt outlook differed somewhat, until recently, from that of S&P and Moody’s.
Why do we need three ratings agencies? We don’t. One solid one would do. But as former Moody’s vice president Richard Michalek once testified, “The threat of losing business to a competitor… absolutely tilted the balance away from an independent arbiter of risk.” Translation: If Moody’s failed to give a high rating to a corporate bond sold by an investment bank, the bank would go to a competitor who would. A former Moody’s managing director, Gary Witt, told the US Financial Crisis Inquiry Commission, “It’s like, well, next time, we’re just going to go with Fitch and S&P.” This suggests there is a fundamental flaw with the three competing ratings agencies being paid by those who, like students, have an abiding interest in getting straight As forever.
Why not turn over the credit rating business to a credible non-profit international body, like the International Monetary Fund (IMF)? The answer is that Wall Street apparently likes the game as it is currently played, tilted in its favor.
What do their ratings mean? Why do they cause so much controversy? Credit ratings determine how much of a risk premium bonds should pay, in other words, how high the yield, or interest rate, is. Last April, S&P cut Russia’s government bond rating to just one notch above “junk” (the lowest grade, or highest risk). The reason was the impact of American and European sanctions on Russia, after its occupation of Crimea and incursion into Ukraine. Partly as a result, the interest rate on 10-year Russian government bonds jumped from 7.8 percent to 9.5 percent this year. That may not seem like much, but it means billions of rubles or dollars in higher interest payments.
As a result, the Russian government has cancelled nine bond auctions since the S&P downgrade (it’s now too costly for Russia to sell bonds) and Russian Economy Minister Alexey Ulyukayev said the downgrade was “partially politically motivated.” China and Russia have spoken about creating their own ratings agency, just as they are creating their own versions of the World Bank and IMF.
Why are the ratings agencies so influential? Many US pension funds and investment funds, for example, are limited by law to investing only in high-grade AAA bonds. So if, for instance, Moody’s rates a bond A- or B+, it cannot be sold to some of the best customers with deep pockets. As a result, those who pay the ratings agencies are understandably upset if a bond they are underwriting (selling to investors) gets a failing grade.
Banks, too, get a credit rating, and if it is low, they may be unable to raise capital. This is now happening to some Russian banks.
Earlier this year, Fitch downgraded the stateowned Russian bank VTB, the country’s second-largest bank, to close to “junk” (highest risk). VTB’s shaky balance sheet simply wouldn’t permit anything else.
I can understand the Obfuscation Award.
But why Chutzpa? The answer is a bit complicated. The three ratings agencies played a role in the 2007/8 global financial collapse. Wall Street. found a way to enable pension funds and other funds to invest in the hot real-estate market, by packaging bundles of mortgages into what were known as mortgage-backed securities. Pension funds could not directly invest in mortgages, but they could, by law, buy mortgage-backed securities, which paid a strong rate of interest. But there was a catch. Those securities had to have goodas- gold AAA credit ratings. And the three ratings agencies supplied those ratings, even though many of the securities were backed by less-than-golden subprime mortgages whose holders had trouble making their monthly payments.
Had the ratings agencies done their job properly, they would have blown the whistle on the poor-quality mortgages that backed many of the mortgage-backed bonds. The whole house of cards toppled, when reputable firms like AIG and Lehman Brothers sold “credit default” insurance (payable if the bonds defaulted), never imagining that a AAA or A++ bond would default. But many did go into default when the mortgage holders could no longer meet monthly payments, and the result was a global crash with one bank toppling another. There is plenty of blame to go around, but the ratings agencies certainly share much of it.
That is why the fact that the credit ratings are treated as gospel is simply chutzpa.
In financial markets, once your credibility is lost, it should take a long hard road upward to regain it. For the ratings agencies, it hasn’t because they are simply part of a very profitable game.
Why was Israel’s credit outlook downgraded by Fitch? It’s no mystery. Israel’s budget deficit this year (3.3 percent of Gross Domestic Product) and next year (3.4 percent) will rise because of Operation Protective Edge, which was more costly than expected.
Budget tightening is planned for 2016, but without new taxes that will be difficult.
Fitch says “[Israeli] government debt is fairly high, at a Fitch-forecast 67.4 percent of GDP at end-2014. Progress in lowering debt toward the peer median of 48.9 percent has been disrupted by the Gaza conflict.” Peer median means the average debt ratio for countries similar to Israel.
“Fairly high?” America’s public debt is 105 percent of its GDP. Israel’s consumer debt is 39 percent of GDP; America’s is 83 percent. I don’t see Fitch downgrading American Treasury bonds.
Should Israel be concerned about the downgrade? Israel should be concerned that at a time when its economy and that of the world economy is slowing, the government could not agree on a common policy. A credit rating outlook downgrade is definitely not good for investor perceptions.
Is Israel undergoing European-style or Japanese-style deflation? Over the past 12 months, consumer prices in Israel have actually declined. This is technically deflation. But, according to Deputy Bank of Israel Governor Dr. Nadine Baudot-Trajtenberg, “We are not seeing deflation this year.” I think she means we are not seeing destructive EU-style or Japan-style deflation caused by slow consumer demand and lack of spending. Israel rarely suffers from that.
What we do see is falling prices caused by lower oil and gasoline prices, and lower commodity, import and food prices. World oil prices have fallen by almost 30 percent this year. Saudi Arabia has scuttled efforts by OPEC to boost prices by limiting oil production.
The reason: Keep crude oil relevant by making alternative energy sources less profitable.
This type of deflation is generally positive.
It lowers the cost of living and leaves more discretionary income in consumers’ pockets.
Why has the value of the shekel relative to the dollar plummeted? Actually, the shekel has been falling relative to the dollar since mid-August when it peaked at around NIS 3.40 per dollar. It is now at about NIS 3.90, a rate that will help Israel’s exports. Strangely, all of the Bank of Israel’s mighty struggle to keep the shekel from strengthening against the dollar, buying billions of dollars, did little but the statement by Fitch about Israel’s credit outlook (along with Operation Protective Edge) did succeed in bashing down the shekel – so much for rationality in capital markets.
Despite skepticism about the validity of the rating agencies’ alphabet soup, should we be concerned about Israel’s economy? I was recently in China and saw firsthand how its usually torrid economy was slowing. The same is true of Europe and, to some extent, the US. And Japan, too, is in recession. So, when the largest four economies of the world are stagnant or in decline, export nations like Israel suffer. This requires an aggressive economic policy with no room for error and certainly no room for political squabbling, walking a narrow line between controlling budget deficits (for investor confidence) and spurring demand (to prevent unemployment).
In the short term, if the 2015 budget is not passed on time, and that looks highly likely, investors may continue to vote against Israel with their feet – and their money, especially with new elections due for March. And Fitch’s outlook downgrade will prove correct. 
The writer is Senior Research Fellow at the Samuel Neaman Institute, Technion