The Ratings Game

Martin Mayer

Seventy-eight years have passed since the publication of Frank Knight’s Ph.D. dissertation Risk, Uncertainty and Profit. Knight made a categorical distinction between risk, which can be measured, and uncertainty, which can’t. Ever since, investors, speculators, hedgers, and academics have searched far and wide for the alchemist’s stone that would allow them to turn the “dross of uncertainty” into the “gold of risk.”

Among those who sell this magic, rating services like Moody’s Investors Service and Standard & Poor’s (S&P) are the most prestigious and longest-lived. The letter grade assigned by these ratings agencies to the debt issues of nations, financial institutions, and corporations are taken so seriously by the buyers of debt instruments that it’s the debt issuers themselves who pay for the rating: A debt issuer cannot sell its paper without one. Likewise, many institutional buyers like insurance companies and pension funds are forbidden by law to buy paper rated below Baa (Moody’s) or BBB (S&P).

Market researcher Alfred Politz, a physicist by training, used to scoff at pollsters who made their reputations by predicting elections: “If you have the intelligence of a dime,” he liked to say, “you get it right half the time.” By the same token, it might be said that ratings agencies have a much simpler job than securities analysts. A ratings agency’s primary task, despite widespread belief, is not to evaluate whether countries, companies, or banks are well-run and will prosper. Instead they concern themselves firstly with a fairly black-or-white judgment call: Will (or can) a country or a company pay? All ratings agencies agree that a debtor is in default when it either misses a payment beyond a grace period or seeks to renegotiate the loan—anything, says S&P’s Marie Cavanaugh, that is not “timely service of debt according to the terms of issue.”

Though Citibank’s Walter Wriston famously liked to say that countries don’t go bankrupt, there is a long history of sovereign default. Max Winkler found the earliest record of a sovereign default in the fourth century, B.C., when ten of thirteen municipalities in the Attic Maritime Association defaulted on a loan from the Delos Temple Fund. (Thereafter the fund preferred to lend to private borrowers.) In the 1840s, Barings Bank extended its reach across the Atlantic to help elect those gubernatorial candidates in Maryland and Pennsylvania who had promised to resume payments on the defaulted debts of their respective states. And in the 1930s, notoriously, whole bunches of sovereign bonds defaulted.

Back in those days, there was nobody for an aggrieved foreign bond-holder to sue. Nation-states enjoyed “sovereign immunity” and could be sued only in their own courts. Under such circumstances, only the brave would buy foreign official securities, which made it difficult for state-owned enterprises in the developing countries to raise money in the capital markets. Lobbying by the nations themselves and by the U.S. State Department produced the Sovereign Immunities Act of 1976, giving bondholders a right to sue foreign governments in American courts.

One of the first lawsuits under the new law was brought in 1981 against Costa Rica, which had imposed exchange controls. Supporting the plaintiffs, the Solicitor General argued that American support for International Monetary Fund (IMF) programs was conditioned on the beneficiary’s recognition that the underlying debts those programs relieved were enforceable. Through the long Latin debt agony of the 1980s, American banks and the U.S. Treasury insisted that IMF assistance could be given only to those countries that were negotiating a resolution of the debts owed to private creditors. And in Argentina v. Weltover in 1992, the Supreme Court strengthened the hands of creditors even further by ruling that borrowing in the United States was a commercial transaction subject to the jurisdiction of American courts even if the borrower was a sovereign state.

Until recently, all this legal prestidigitation made it easier for ratings agencies to assess a country’s “sovereign” debt. Debt denominated in the country’s own currency could always be paid by printing money, and the belief was that bonds denominated in a foreign currency would be protected from default by the IMF or the “Paris Club” of creditor states simply because a mess of time-consuming lawsuits would be unacceptable.

Moreover, there was no way to renegotiate a bond issued under the laws of New York State. A bond’s terms were cemented into a trust indenture unless every bondholder agreed to a change. In the 1980s, bonds were paid off in full, coupons and principal, while bank loans were eventually renegotiated and reduced in value at the insistence of the creditors’ governments. After 1989, when the U.S. quietly approved a proposal allowing the IMF to “lend into arrears” (send money to countries that had not resolved their bank debts), and bank loans were converted to “Brady bonds,” more and more borrowing in dollars was done on a bond chassis rather than through banks.


But shifting debts from the banks to the bond markets only covered over a wound. John Williamson of the Institute of International Economics warned in 1993 that “while it was possible for distressed debtors to maintain service on bonds when these were a minute fraction of their total obligations, it will be impossible to do the same if difficulties arise in a country with a large proportion of its debt in the form of bonds. These creditors are living in something of a fool’s paradise.”

Bonds still rate better than loans to banks. “Banks don’t take sovereigns to court,” says Vincent Truglia of Moody’s, “because they’re relationship oriented, they hope to do business here in the future. Also, they’re few in number and their own supervisors twist their arms to make a deal.” Unwinding a bond, especially a bond issued under American law, remains a headache. But in the fall of 1998, the IMF asked the Ukrainian government for assurances that it would not use IMF proceeds to pay off the holders of expiring Euronotes. And the Paris Club told Pakistan that the willingness of official creditors to reschedule debt interest payments was contingent on the country’s negotiating “comparable” arrangements with private creditors, including bondholders.

Moody’s put out an alert warning that the Paris Club decision “may signal the beginning of a new phase in the world financial system.” S&P announced that in the future it would consider “incentives to honor particular instruments,” and might give properly secured bonds a higher rating than the country that issued them. The Institute for International Finance, which fought every effort to ease conditions on Latin debt in the 1980s, warned that changes in the documentation of sovereign bond issues—permitting the formation of bondholders’ committees to renegotiate terms in an emergency—might lock developing countries out of the bond markets forever; and the changes would certainly mean higher rates for borrowers.

The banks, of course, hold most of these bonds themselves: Trading in Brady bonds is among the most profitable activities of the international banks. Reporting on a meeting in Bahrain in May by representatives of nine U.S., European, and Middle Eastern banks, the Financial Times wrote that one of the purposes of the meeting was to avoid a rescheduling of Pakistan’s bonds, “as this would establish an unhealthy precedent.”

But the Rubicon has been crossed. The IMF Interim Committee a year ago proposed “extending the IMF’s policy of providing financing to members in arrears to include sovereign bonds,” and this spring the Executive Board suggested “modifying sovereign bond contract terms to encourage collective action in addressing distressed debt.” In one of his last speeches as Treasury Secretary, Robert Rubin firmly said that “there is no reason why one category of unsecured private creditors should be regarded as inherently privileged relative to others in a similar position. Where both are material, claims of bondholders should not be viewed as necessarily senior to claims of banks.” Of course, nobody knows how an American court will respond to a government rewriting a trust indenture. Moody’s Truglia believes it might be helpful if some little country did default—nothing large enough to upset the system—and somebody sued. Many think Ecuador is a suitable candidate to play the sacrificial lamb.

How well the ratings agencies performed under the old system is a matter of some dispute. Users complain that the agencies were cheerleaders when times were good and morticians when trouble came. (“The function of a ratings agency,” said a very senior man at a large investment house in spring 1998, “is to visit the field at the end of the battle and shoot the wounded.”) But Moody’s had downgraded Thailand a year before the crisis, and S&P warned against the Russian “MinFin” bonds (payable in rubles in Moscow, giving the holders, who should have known better, no venue for a lawsuit). Lenders to Asia and Russia had enough information to know they were taking large risks. They simply did not want to hear about it especially their trading desks.

Moody’s Truglia points out that low-rated sovereign bonds have indeed traded to yield more than high-rated bonds, and it’s not the agencies’ fault if the market looked to ratings for pricing bonds rather than for measures of real risk, which has in fact been remote. Now it’s less remote. Both the agencies and their customers are entering a timid new world.