Wednesday, July 27, 2011

Rating Agencies Causing the US Debt Crisis?

The Wall Street Journal's Holman Jenkins Jr. see a problem in Rating Agencies (Moody's, S&P, Fitch) actually anticipating default:
But now we have a new problem. The rating agencies, especially Standard & Poor's, have decided to join the politicians in turning an artificial crisis into a real one. S&P says it plans a U.S. debt downgrade, regardless of any debt-ceiling outcome, unless it sees a "credible" plan to reduce future deficits by $4 trillion over the next 10 years.

This has become the real worry for Wall Street, but why? America's spending debate does not remotely make it any more of a default threat than it was a week or month or year ago. America's IOUs are still completely acceptable to the markets.

Rating Agencies generally rationalize market opinion the way politicians rationalize whatever talking points are popular with their base. They aren't leaders, rather focal points who artfully persuade many who don't follow or trust markets, that the market is generally correct. When I worked at Moody's, we took a beating from KMV because this firm showed that their purely quantitative 'distance to default' outperformed Agency Ratings. A distance to default metric is basically a simple function of market cap (higher is better), volatility (lower is better), and debt (lower is better), which is basically a market cap metric (volatility and market cap are positively correlated). All I can say is that the ratings agencies said they ratings were not comparable, and then Moody's bought KMV and such embarrassing information is not mentioned much (yet never repudiated).

So, ratings agencies are symptoms, and when things trade at AAA they get those kinds of ratings. As the markets are now questioning the AAA rating of the USA, it's only reasonable the Ratings Agencies too would ask these questions. Jenkins remarks that
There's a reason the monumental unfunded liabilities of Social Security and Medicare are not counted as part of the federal debt—they don't have to be paid

Which is what many said about the obligations of Latin American before the 1980 debt crisis, or what Russian investors said before the 1998 default. They don't have to pay these obligations, but given the incentives to pay senior citizen and public employees, or foreign debtholders, I would bet on them defaulting. Debt payment is based on priorities, and often governments choose to pay others before their debt holders.

For Jenkins to imply that rating agencies should, as a rule, wait until the market trades debt at a certain level to downgrade or even discuss a downgrade only makes the ratings purely redundant. Without the option to draw a line proactively, the charade is over and Ratings Agencies lose whatever meaning they have.


Mercury said...

Gotta love the government and it's appologists crying: "Wah!, my duopoly isn't playing ball!"

How about fostering a lower barrier to entry, competitive marketplace for the debt rating industry fellas?

PF2 said...

Mercury, more raters means a lowering of standards as each issuer can go to many more places to get rated.

This is one world in which opening barriers of entry lowers standards. The solution is to create incentives for raters who provide accurate ratings, or punish continuously poor ratings.

See the following for ways to achieve this:

Mercury said...

Competition, track record and professional reputation ARE incentives to provide accurate ratings. Few are fooled into thinking that a BS from MIT is interchangeable with a BS from the University of Phoenix.

Your article doesn't mention anything about public pension funds (and others) being required to get a stamp of approval from government protected NRSROs.

PF2 said...

Mercury, I think that's the whole point. While the two BS degrees are different, a rating from an NRSRO is just that - a rating.

The collateral rules don't say where the rating needs to come from, and so the market will seek out the cheapest or softest option.

Anonymous said...

how about removing any restrictions on the legal requirement to use ratings?

dmfdmf said...

The real problem is that the rating agencies are not actually independent of the financial/banking system. More importantly, the banking system is nominally a private system but is in fact a branch of the USG. The way it works is through the threat of audits and regulatory harassment and other means to coerce "cooperation" from docile and obedient bankers and credit rating agencies. The pronouncements by these agencies are just rationalizations and whitewash of the obvious fact that the USG no longer deserves its AAA rating. This will end badly just like the mortgage crisis only much much worse.

E Hines said...

The problem I had with the Jenkins article was the implication that the ratings agencies should sit down and shut up and stop rating the holy government.

The ratings agencies, for good or ill, and with greater or lesser skill, are in the business of rating an entity's current situation so that investors can have a measure (one of several, unless the investor is an idiot) of the quality of entity he's getting into.

A free market will allow claptrap to enter and drool onto their keyboards. The competition of that free market will weed out that claptrap in relatively short order. That competition is fostered by government not mandating this or that rating agency as a standard whose ratings must be met by certain types of financial institutions. It is the government that should sit down and shut up. The choice of investigative information to use, including none at all and trusting to a Mk IV Dart and Ouija board target, is itself a market decision, not a government one.

Eric Hines

kerwin said...

I always wanted to go to a third world country, but thanks to Obama I don't even need to move. :)

Anonymous said...

"As the markets are now questioning the AAA rating of the USA..."

There's a lot of chatter about this, but where do you see evidence that the market doubts the U.S.'s AAA rating? Yields have not gone up, despite the endless claims that they will.