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Credit-Rating Agencies Themselves Seen As Not Making The Grade

Nobel Prize-winning economist Paul Krugman called Standard & Poor's "the last place anyone should turn for judgments about our nation's prospects."
Nobel Prize-winning economist Paul Krugman called Standard & Poor's "the last place anyone should turn for judgments about our nation's prospects."
Credit-rating agencies were heavily criticized for their role in the subprime mortgage crisis of 2008.

The U.S. Financial Crisis Inquiry Commission reported at the start of this year that the three main credit agencies -- Standard & Poor's, Moody's, and Fitch -- were "key enablers of the financial meltdown" that began in 2008.

The commission concluded that credit-rating agencies grossly underestimated the risk of mortgage-related securities at the heart of the subprime crisis. It said those securities could not have been marketed and sold to the extent they were without a seal of approval from the three main credit-rating agencies.

Fast forward to today.

Concerns about Standard & Poor's downgrading of the credit rating of the United States last week, and the global stock sell-off that has occurred since then, have sparked calls for investigations into the credit-rating system and have reinvigorated efforts to reform credit-ratings agencies.

Officials in the U.S. Treasury Department have accused Standard & Poor's of presenting a judgment about the credit rating of the United States that was based on a $2 trillion accounting error. U.S. Treasury Secretary Timothy Geithner accused Standard & Poor's of showing "terrible judgment" by downgrading the U.S. credit rating for the first time ever.

"S&P has shown really terrible judgment and they've handled themselves very poorly," Geithner said. "And they've shown a stunning lack of knowledge about basic U.S. fiscal budget math. And I think they drew exactly the wrong conclusion."

In his column for "The New York Times" this week, Nobel Prize-winning economist Paul Krugman called S&P "the last place anyone should turn for judgments about our nation's prospects."

Astonished At Turnaround

Standard & Poor's has defended its decision by saying the downgrade was the result of political paralysis in Washington over how to reduce the public debt. It says it was measuring not just the ability of the United States to pay its debts but the political will among partisan lawmakers to do so.

Timothy Sinclair, an associate professor at the University of Warwick, has been writing for more than a decade about the changing role of credit-rating agencies in global finance.

He says he is astonished by how a credit-rating agency like Standard & Poor's could be formally blamed for the 2008 financial crisis but still move global markets to the extent it has with its downgrade of the United States.

"I think it is an absolutely astonishing situation to go from such criticism, and then to flip over within 18 months or so to their power being clearly more salient than ever," Sinclair says. "Their pronouncements seem to have more impact and to be more feared than at any time in their approximate 100-year history."

At the heart of the debate is the system that investors rely upon to determine the riskiness of bonds -- in this case, government bonds.

A government bond is a contract between a government and an investor that is seeking to borrow money on the sovereign debt market. By purchasing a government bond, an investor essentially agrees to lend money to the issuing government. In exchange, that government agrees to pay back the funds with interest according to a specified schedule of payments.

Credit-rating agencies claim that their ratings provide investors with an indication of the ability and willingness of a bond issuer to honor the terms of that contract. Such ratings gauge the probability that the money will be returned to the bond purchaser with interest according to the agreed schedule.

Credit ratings also can indicate -- in case the bond issuer defaults on its debt obligations -- how much of the funds will be returned to the bond purchaser and when.

Judge And Jury

The major credit-rating agencies -- Standard & Poor's, Moody's, and Fitch -- distill a whole range of economic and financial information: a country's income, its reserves, its growth prospects, its level of debt, as well as political factors, into one easily digestible grade.

They then assign a rating as a measure of how likely a borrower is to default on its debts.

Sinclair concludes that the rising powers of the credit agencies as the judge and jury of the creditworthiness of sovereign debt is a natural result of the way the global financial system has been evolving in recent years.

"That's a reflection of the changing banking system we have -- moving from a bank-intermediated system to a system where banks are just participants in financial markets like other players -- and not very competent ones either, it appears," Sinclair says. "You need some institution to make judgments. And guess what? It's Moody's and S&P. And until somebody comes along with a couple of better outfits to do the job, I suspect they're going to make a lot of money."

There is also anger in Europe at the fact that the ratings agencies are able to act as judge and jury of countries that some say were forced to run up high debts to prevent financial collapse when their banks, crippled by financial instruments that were rated golden by the agencies, needed bailing out.

Peter Levene, chairman of the Lloyd's of London insurance market and a former senior adviser to Britain's chancellor of the Exchequer, said recently: "The ratings agencies failed the world economy in spades in the past. Their track record has not exactly been stellar."

European Union leaders and politicians, including European Commission President Jose Manuel Barroso, have made no secret of their frustration at decisions by the three ratings agencies to lower the credit ratings of countries currently being bailed out of debt crises.

'Stiff Measures'

So far, three eurozone countries getting bailout money -- Greece, Ireland, and Portugal -- have had their ratings slashed.

The commissioner in charge of the EU's single market, Michel Barnier, plans to announce what he says will be "stiff measures" in November to rein in the agencies' power. He says he wants "to have transparency regarding their methods, especially when they are rating countries."

His comments followed criticism from fellow EU commissioner Viviane Reding, who says the ratings agencies' "cartel" should be "smashed up" because they are trying to determine the fate of Europe and its single currency.

But the chairman of the House of Lords' EU Economic and Financial Affairs and International Trade Subcommittee, Lord Harrison, recently told the BBC that the agencies offer useful "educated guesses" and their assessment of the debt crisis in Europe should be considered valid.

The latest issue of "The Economist" also defends the agencies' role in the global economy, citing a 2010 study by the International Monetary Fund that concluded that "ratings were a reasonably good indicator of sovereign-default risk."

The weekly also notes that "all countries that have defaulted since the mid-1970s had their grade cut to junk by ratings agencies at least a year beforehand."

Gyrating Markets

For most countries, a ratings downgrade of sovereign debt would trigger a sell-off of government bonds by investors.

Not in the United States, however.

The August 5 credit-rating downgrade sent nervous investors fleeing riskier assets like stocks and seeking safety in U.S. Treasury bonds, which have held onto their reputation as a safe place to put money.

This week, as the markets gyrated wildly -- dropping and rising by hundreds of points each day -- bond prices rose.

The reason, as Peter Morici, business professor and former chief economist at the U.S. International Trade Commission, explains, is that "global investors have little alternative but to continue to do business in dollars and store wealth in [Treasury bonds]. The bonds denominated in other reserve currencies -- the yen and euro -- are simply unavailable in suitable quantities."

For foreign buyers looking for a place to safely invest hundreds of billions of dollars in liquid assets, there are few alternatives. The United States has $14 trillion in outstanding bonds, while the next highest issuers of AAA debt have less than $2 trillion.

On August 11, bond prices dropped as investor confidence returned slightly in the wake of encouraging government employment reports. Investors rushed back into stocks and the market ended another wild day up 420 points.

Whether it will last is anyone's guess.

Heather Maher contributed reporting from Washington

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