HSBC and Malta's rating game

There are now new rules governing the country credit rating game, which used to be the sole playground of the world credit rating organisations, such as Moody's, Standard and Poor's, and Fitch-Ibca.

This oligopolistic structure is now fully under assault. These firms demonstrate a high degree of interdependence in their decisions. Such a situation creates uncertainty in the industry, for the obvious reason that any entrepreneur can notice in it the unmistakable, dark finger of collusion.

Any hint of collusion is unacceptable in the cutthroat world of international financial borrowing. If a country gets a good rating it means that the service charges for its foreign-denominated debt will go down. That is, a country can borrow internationally at a better rate.

The assault on the prestige and working practices of the great rating agencies has been building up for almost seven years. It has now reached an unmistakable climax with the entry into the fray of Goldman Sachs, one of the world's leading financial organisations.

The words of Goldman Sachs as recently reported by Time magazine were not uttered in a fit of absent-mindedness. They are a long-term fulfilment of an editorial in the Financial Times, which was published on Christmas eve in 1997. That editorial stated, with reference to the failure of the rating agencies to foretell the serious trouble of the economies of South East Asia, that it was time for other players to enter the credit rating game.

It was a tough editorial and it has become fully vindicated by the problems which have recently arisen in connection with the rating of Japan. These problems are by no means only foreign to the rating of Malta, which as I will show leaves much to be desired.

In the editorial entitled "Over-rated agencies" almost five years ago, the Financial Times thundered: "It does not take much expertise to see that something rotten in Asia's financial system sparked the region's economic crisis.

"What is now becoming clear is that something rotten in US markets is helping make it worse, namely the absurd reliance of investors on questionable judgments by credit rating agencies."

The absurdity of the judgments of the rating agencies was nothing new but the result of oligopolistic collusion, which is condemned by any textbook of economics.

The oligopolistic collusion between the rating agencies has enabled them to have the whip-hand in the evaluation of a country's creditworthiness. It has made it possible for them, and especially for Moody's and Fitch-Ibca, to make unsolicited ratings which could be used as a bargaining tool with a country to obtain higher fees.

A country's rating could be suitably raised after negotiations are conducted from a position of strength on the part of the rating agency. The anatomy of this unacceptable negotiating process was extensively described in Institutional Investor of October 1995. The American government had also taken action against it.

Rating Japan

The straw which finally broke the camel's back was the rating of Japan. The backlash against the rating agencies had long been accelerating in these past months, especially since the Enron crisis.

The Japan rating has forced Goldman Sachs to come out head on against the rating agencies. Time magazine stated: "Goldman Sachs became the first major bank to contest the downgrades of Japan's credit rating by Moody's, Fitch and Standard and Poor's.

"Goldman Sachs said that Japan is not a default risk and deserves an Aaa Rating instead of A2, which places it below Botswana."

Goldman Sachs was here in complete agreement with the Financial Times, which ten days before had declared in an editorial entitled "Rating Japan":

"Moreover, Japan remains the world's biggest creditor nation, boasts about ¥400,000 billion (€11,790 billion) of household financial assets, and still runs a large current account surplus.

"How can Moody's cut Japan's local currency debt rating by two notches to A2, ranking the country below Botswana, which receives development aid from Tokyo?"

Confrontation

The confrontation between the oligopolistic rating agencies and their critics has had a very important outcome. A report in the Financial Times under the signature of its capital markets editor in New York, entitled "Moody's to dig deeper in its analysis of companies", stated: "Moody's investor service is to broaden its analysis of companies' use of derivative instruments, the quality of their accounts and the transparency of their corporate governance practices."

The move reflects the extent to which investors now distrust the accounting profession after the collapse of Enron and other high-profile cases.

Instead, fund managers are asking the credit rating agencies to step in to provide the definitive opinion on a company's accounts.

It also follows criticism that the credit rating agencies missed the problems at Enron, which were hidden deep in the collapsed energy trader's accounts.

Moody's said it would "apply greater analytical focus and commit additional resources to its existing credit analysis effort". This is exactly the procedure I recommended to Standard and Poor's almost three years ago.

Standard and Poor's failure to follow a proper rating strategy is now being openly exposed by Moody's under international pressure.

Jack Paton, a director of Standard and Poor's, told me in a letter dated October 5, 1999: "You made it clear in our discussion that you feel that Malta is not fully appreciated by the rating agencies, including Standard and Poor's, and I would like to point out that credit rating is a measure of a country's ability to service its debts and is not a broader measure of a country's wealth attractiveness; as such the analysis has to be dependent on the official government figures as unrecorded funds cannot be deemed to be available to the government to service the country's obligations. As such there may often be disagreement between patriots like yourself and the more hard-headed analysis."

Half-baked judgments

In the advice I gave Standard and Poor's, I based myself on the editorial of the Financial Times of December 24, 1997, entitled "Over-rated agencies" (quoted above). Five years ago the battle had already started to make the rating agencies dig deeper in their analysis.

That editorial had stated with an explicit reference to half-baked judgments: "The nature of their work requires them to take a formulaic approach and rely uncritically on the government statistics, which may be out of date and incomplete. Because they want to appear scientific rather than subjective in their ratings, they do not have the same latitude to make independent predictive judgments as do other economists."

This half-baked judgment conundrum of the rating agencies with reference to Malta must stop. If Moody's is to make a dramatic change in its rating strategy, Standard and Poor's must follow suit. This is because Moody's is the more prestigious.

The solution

Malta has not been the only country in the world to grapple with the problem of dealing with the rating agencies' oligopoly. Malta's power to negotiate will be vastly increased if it has its own rating agency.

This has been achieved by Maalot in Israel. The Israel Securities Rating Company Ltd was established in 1991 under the initiative and support of the securities authority, which is the equivalent of our MFSC, and with the assistance of the Israeli Treasury and the Tel Aviv Stock Exchange. However, these bodies do not have any legal association with Maalot, which is owned by nine major Israeli banks and financial institutions.

Malta deserves to have its rating agency, as its government has never reneged on a single cent of its debt. Its hard currency reserves go a long way to cover its debt position. It must be said that the rating of A3 given to Malta by Moody's, A single by Standard and Poor's, and a single A by Fitch Ibca, are completely unacceptable, for they do not satisfy the present evaluation conditions as mapped out by the rating agencies themselves.

It cannot be denied that Malta's ratings are good, but the fact that they are not underpinned by adequate research will not escape a great international bank like Goldman Sachs, which is a master at the rating game. Malta does not need a rating which cannot stand international scrutiny.

This is where the operation in Malta of a great bank like HSBC could be very useful. In its three years in our country this bank must have acquired a deep knowledge of our economy. It is more than qualified to express an opinion on the accuracy or otherwise of the local work of the rating agencies.

It could also be the leader in the organisation of an indigenous rating agency on the lines of Maalot.

Malta is in a weak negotiating position with the oligopolistic rating agencies. To improve its rating it would require a disproportionate negotiating effort on its part, which it can hardly afford. Moody's rating of Malta was poorer than Standard and Poor's because of the two Moody's is the harder to negotiate with.

Doing justice

We must do justice with whom justice is due. We will not follow the ways of the financial world, who in their parlour game ridicule the rating agencies calling Standard and Poor's poor standards and Moody's moodiness. We have found the oligopolistic structure of the rating industry highly objectionable, but we must not forget that there is also an oligopolistic structure in the car industry.

Let us not expect the rating agencies to be the world leaders of ethics of economics. Small countries like Malta can do a lot for themselves to ensure the integrity of the rating process.

HSBC is unquestionably the financial leader of Malta. This island eagerly looks up to its leadership in the organisation of a local, reputable rating agency. The rating agencies will certainly welcome a local properly capitalised rating organisation.

This is demonstrated by the words of O'Neill, who was the chief ratings officer, when he stated in Institutional Investor in October 1995: "Our network has largely been developed from scratch - France is an exception.

"But going forward, alliances with other agencies will grow in importance. We don't believe we can fully understand or rate credits, especially in emerging markets, without having local input and expertise. In these markets we find agencies that want the experience and resources of a major partner.

"Initially, we'll offer technical help, but in phase two we may take equity participation. Then if it makes sense, we'll put in a much larger stake".

These words of O'Neill remind us that Malta can do something for itself as regards the rating process. This island certainly needs the work of Moody's and Standard and Poor's for the establishment of its international financial image.

We must with justice say that although the gross mistakes of the rating of the rating agencies continue to be exposed, their prestige still runs high and their ratings appear every day on the Bloomberg channel and other channels.

The rating agencies must also do full justice to the Maltese people. Malta is not a country where begrimed children go begging in the streets.

The Maltese have a vibrant democracy and a vigilant press. The technique of the rating process is in for a big change the world over, and in particular the economic education of a people must be taken into consideration.

John Azzopardi Vella is an adviser to business and has been a promoter of the Malta Development Fund. E-mail: johnazzopardivella@ hotmail.com.