“A faulty condom is worse than no condom at all,” my sex education teacher intoned before a befuddled classroom decades ago. I’m not sure that any of us sixth graders really understood what she was saying at the time. Students today, however, have a more poignant example to draw from: The three global ratings agencies.
In the two economic mega-crises of the twenty first century so far, the 2008-2009 Great Recession and Europe’s sovereign debt debacle, the protection offered by these supposed sentinels of risk has been defective, at best.
Indeed, there is a good case to be made that the three agencies, Standard & Poors, Fitch and Moodys, have earned a junk rating themselves as they doled out AAAs to the likes of Ireland, Spain and others now looking less sovereign and more like wards of the Bundesbank. As late as 2010, Moody’s issued a AAA bill of health for Spain. All three had Ireland rated AAA for most of 2009. Today Ireland’s at Baa3. How’s that for clarity?
This week, S&P has made news again by putting 15 nations in the euro zone on notice of a possible downgrade – i.e., announcing a negative outlook for their sovereign debt, including that of AAA performers Germany, France, the Netherlands and Finland. While many will view this merely as the agency catching up with reality – no matter how prudent a euro zone nation is right now, the costs it will pay to borrow money almost certainly depend on a credible longterm plan emerging from Friday’s EU summit – both the credibility and the basic business model of ratings agency have been so debased in recent years that only a serious reform can salvage their role in the global economy.
The fact is, the three ratings agencies all blithely continued to issue AAA stamps of approval very late in the game to the very instruments of disaster that caused both the 2008-2009 Great Recession and the euro zone crisis.
The problem is not their understanding of sovereign balance sheets or the questionable value of mortgage backed securities. Instead, there is a basic conflict of interest inherent in their business model. Currently, it is the issuer of debt – banks, brokerages, municipal governments and other entities – who pay for the privilege of the particular bond or offering being rated.
In effect, this allows issuers to shop around for the highest rating (and to develop a longterm, cozy relationship that benefits everyone – except, perhaps, the investor and the taxpayers that eventually bail them out). The obvious reform here is to forbid these agencies from accepting money from market makers, and instead have investors fund the cost of risk assessment. Dissidents within the ratings agencies would thus be empowered, and investors would ask questions when noted experts from the outside raised issues. This change would eliminate a serious risk of “false positives” in the global economy like, say, the idea that an investment bank can survive lending out $395 billion with just $11 billion in the vault (as was the case at AAA rated Bear Stearns in 2007).
It isn’t as if no one else noticed these things coming, after all. The human harbingers of the 2008 disaster – economists like Nassim Taleb and Nouriel Roubini, regulators like Brooksley Born – warned years ahead of time that ratings agencies had lost their souls. Ahead of the euro zone crisis, Roubini again and his fellow dismal scientists Bernard Connolly and Kenneth S. Rogoff again questioned the AAA consensus.
Again, the usual players were wired to ignore them. Central bankers and politicians wore ideological blinders; investment professionals happily served up any Kool-Aid that would keep capital flowing.
The ratings agencies, however, allegedly exist to provide a clear-headed view into these problems. That is much harder when the people paying your salary are the same ones you’re rating.
Exacerbating their poor performance as coalmine dwelling canaries, the agencies have also managed some astounding errors given the sensitivity of their writ. S&P deserves credit, in my book, for being on the leading edge of well-deserved downgrades. But it has damaged its credibility with dumb errors.
Last month, S&P issued an accidental downgrade of French sovereign debt – Excuse moi? The EU is asking, with good reason, what “accidental’ means. This followed that agency’s infamous $2 trillion gaff when it downgraded the United States last summer. Again, as richly deserved as the downgrade may have been, S&P essentially discredited (no pun intended) the gravest decision the firm ever took with sloppy math.
Some reform is brewing, thankfully, but not here in the land of deregulatory delusion, and not enough to address the conflict at the heart of this problem.
The European Union, which never liked these three private-sector US firms holding such sway over its economy anyway, reacted with typical parochialism to the first round of downgrades of the PIIGS sovereign ratings by ordering the creation of a European ratings agency (as if it were the rating agency’s excessive zeal, as opposed to their internal contradictions and European profligacy, that caused the EZ crisis). Wisely, this plan was dropped in favor of new rules insisting that bond issuers switch agencies every three years (presumably to prevent apathy or misplaced incentives from setting in). The EU also plans an audit of each agency’s sovereign debt ratings methodology.
Tepid as these actions may be, this is a good deal more than the US Congress managed: it dropped plans for changes just like I’ve described above after administering a good televised tongue lashing and, no doubt, realizing the entire financial lobby opposed the reforms.
And don’t blame the Republicans here, either: the ratings agency victory occurred during House – Senate negotiations in 2010, when the Democrats controlled both chambers, with opposition led by New York’s Sen. Charles Schumer and the venerable Rep. Barney Frank. Just as in an earlier scandal, when Congress considered an overhaul of credit agency rules when the agencies failed to properly rate debt from reckless companies like Enron and WorldCom, a bipartisan tide rose to carry Fitch, Moody’s and S&P out of harms way once more.
Speaking of conflicts of interest …
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