Lynne Kiesling
On Wednesday morning Planet Money’s Jacob Goldstein was on NPR’s Morning Edition discussing the role of credit rating agencies in the economy, in the wake of the signal earlier this week from Standard & Poor’s regarding their assessment of the quality of U.S. Treasury debt. The statement itself had only a fleeting negative effect on U.S. equity markets, and has not translated into changes in bond yields, despite the widespread acknowledgment that their perception of U.S. government debt is consistent with the beliefs and expectations of other observers and analysts.
But what I really appreciated in the story was an exchange between Goldstein and host Mary Louise Kelly that reflects the first question that popped into my mind on hearing of the S&P statement: why does anyone even place any weight on their pronouncements?
KELLY: And why should we pay attention, generally speaking, to pronouncements from S&P or the other rating agencies – the other big two being Moody’s and Fitch. I mean, they turned out to be incredibly inaccurate in the financial crisis, lots of mortgage-related bonds that they rated very highly turned into junk. Why trust them?
GOLDSTEIN: That’s a great question. They certainly got a black eye in the financial crisis. But despite whatever their performance may have been, the big ratings agencies, they’re still written into the laws and the regulations that govern our financial system. So, for example, if rating agencies lower their rating, that can force banks and insurance companies and other big financial firms to sell off that country’s bond. So the rating agencies still do matter.
KELLY: You say that their influence is written into the law, but these are not government agencies. How is it, exactly, that they work?
GOLDSTEIN: They’re private companies. And when they rate corporate bonds and mortgage bonds, it’s actually the companies that they’re rating that’s paying them. So it is this very strange hybrid, right? On the one hand, they’re private. They make a profit. But on the other hand, the law gives them this special position in the financial system.
Where I’m from we call that “special position” a conflict of interest that creates perverse incentives.
After all of the putative attention to increased financial regulation, the purported increase in consumer protection in retail financial transactions, I am still flabbergasted that the “special position” of the credit rating agencies has not been modified. They have managed to dodge what I think is some very well-deserved criticism for their role in perpetuating the unrealistically optimistic expectations about returns on mortgage instruments and their derivatives. Some of the best critical analyses I’ve read come from Gillian Tett at the Financial Times (the article is an excerpt from her book Fool’s Gold).
In a similar vein as the TSA’s “security theater”, all of the sound and fury of the financial regulation of the past two years is “regulatory theater” as long as these deep, perverse incentives are not addressed. Regulatory theater may make some financial consumers and their elected representatives feel more secure, but it’s window dressing compared to core perverse incentives such as those under which the rating agencies operate, and it’s therefore a waste of our money and resources.
“and has not translated into changes in bond yields, despite the widespread acknowledgment that their perception of U.S. government debt is consistent with the beliefs and expectations of other observers and analysts.”
Lynne, not “despite” but “because”.
EMH: only new information moves the market. If everyone already thinks this is so then the new announcement isn’t in fact new information and so doesn’t move the market.
The “why should we pay attention” question was my response too. I have just finished reading Michael Lewis’s The Big Short, and let’s just say that the ratings agencies don’t come out looking very good in the book.
But the “written into law” aspect is part of it. I’m sure a host of laws and regulations governing state and local government borrowing, and pension fund investing, and various contracting practices, make passing reference to S&P or Moody’s or Fitch’s ratings. Even when the companies are not mentioned by name, credit standards probably reference the ratings and in effect lead all sorts of companies to continue to do business with the ratings agencies whether anyone believes them.
Just an absence of a credible alternative source of the information.
Lynne,
While Jacob Goldstein is correct about the current state of affairs, I wouldn’t be too hard on the financial regulatory reforms (at least for this reason), because the “special position” of the NRSROs is actually currently being addressed as a part of those reforms. Section 939A of Dodd-Frank has Federal regulators writing the NRSROs out of their regulations:
“Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review… any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and… any references to or requirements in such regulations regarding credit ratings… Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations…”
Best,
Matt
Does anybody know of any data that can be used to test this? Something along the lines of firm entry dates, ratings, and possible bankruptcies?
Good observations!
Matt (hi! how are you?), thanks for filling us in on that detail, which makes me marginally more sanguine. I’m skeptical about the retail customer-facing regulatory changes with which I’m most familiar, and I extrapolated more from that than I should have.
I’m most interested in the institutions used as reputation mechanisms, and in this case I’m convinced that the “payment for rating” institution is perverse. Life is full of formal and informal reputation mechanisms, most prone to varying degrees of manipulation or bad incentives.
Well, the federal government isn’t paying them to rate government debt, right? So presumably they are more disinterested than when a bank pays them to rate some new package of its mortgages.
The greater danger may be that they won’t want to make the same big mistake twice in a row, and will compensate for having been too complacent by being too risk-averse.
Lynne,
I’m well, thanks! I agree entirely that the pay-for-ratings system is perverse, and I’d go so far as to say that it was one of many contributors to the crisis. And I also agree that both bad incentives and manipulation were occurring— at one conference a few months back, one of the speakers was describing how MBS originators had figured out that the residential mortgage group at one of the NRSROs was far less sophisticated than the financial products group, and… well, classic venue-shopping story, really. I also recall reading a study a while back that indicated that jumps in CDS spreads tended to indicate increases in default risk well before they were reflected in ratings downgrades. There’s a story there about markets as an efficient information-discovery tool, I think? At any rate, I’m hoping that more people, over time, look towards other indicators than credit ratings. While there’s no way to (and no sense in) preventing firms from voicing their opinions on default risk, I do think that getting them out of banking regulation is a great first step. Unfortunately, the question of what alternative to use is a really tricky one…
Best,
Matt