Saturday, 6 August 2011

Daddy, what's a credit ratings agency?

The short answer to that question is of course an organisation that gave Lehmann Brothers a triple-A rating minutes before it collapsed.  But as Standard and Poor announce that they have downgraded the United States' rating from AAA to AA+ - potentially increasing borrowing costs for the productive economy and hitting ordinary citizens, it's worth pausing to consider the role of these organisations.

Essentially, credit ratings agencies do precisely that - the compile and publish assessments of the creditworthiness of businesses and governments, to provide information that allows investors to assess the risk associated with their investments.  In traditional market theory, where market information is crucial, they perform what is theoretically a hugely important service.

But there are real questions about the way in which the big agencies carry out their work.  There's the quite obvious question of why, before the collapse of 2008, the agencies continued to give banks whose capitalisation was essentially founded on junk bonds AAA ratings right up to the moment of the crash.

After 2008 serious questions were asked about the performance and accountability of the agencies - most famously in the film Inside Job, but also by US legislators. A piece in the New Republic by Alex Klein describes how legislators sought to bring some accountability into the world of the reference agencies, but were brushed aside by the administration:

Last May and June, during the debate and mark-up process for the Dodd-Frank financial reform act, Congress saw many proposals that would have curtailed the overweening power of the rating agencies. Almost all of them were lost or ignored.
The most prominent proposal to curtail the power of the rating agencies, championed by Senator Al Franken, would have ended the longstanding practice of banks choosing and paying their own bond rating agencies, a clear conflict of interest. The freshmen senator brought an amendment to the floor that would have rotated the agencies among firms, reducing their power. On a wave of disgust for the agencies’ financial crisis failures (like giving Lehman Brothers a triple-A rating minutes before its collapse), the Franken amendment passed.
But then the Democrats turned and ran. Barney Frank and Chris Dodd said the issue needed “more study.” And the administration, for its part, stayed silent. Franken told Newsweek, “I could never quite figure it out … It was weird. Dodd gave a speech and said, ‘What Al’s done is great … But I think it could have unintended consequences.’ I said, ‘Maybe you could tell me what one of them is?’” Franken’s amendment was neutered, ultimately becoming a research study in the final bill.
And Franken’s popular proposal wasn’t the only bullet dodged by the rating agencies. There was another important provision in the final Dodd-Frank bill, originally proposed by Representative Paul Kanjorski, that would have labeled the agencies “experts” and therefore capable of being held legally liable for their ratings. But the agencies lined up against it, refusing their expert status even after the bill’s passage. As Sue Allon, CEO of the credit risk management firm AllonHill told me, “They came together and said they wouldn’t do it. Because all of them refused, there was very little choice.” And so the SEC, reporting to Treasury and the president, nullified the liability clause. Just a week ago, the House Financial Services committee approved a bill that would reverse it altogether.
Finally, Congress and the president never orchestrated serious and extended oversight hearings into the specific role played by the rating agencies in the 2009 crisis. The Federal Crisis Inquiry commission, the ten-member body tasked with investigating the financial crisis, asked too few questions of the rating agencies, adds Ornstein, and unintentionally served to shield them from Congress. “There should have been a much deeper investigation.”

The implications are horrendous.  If I wanted a loan from my bank, and I went to my bank manager claiming that I'd slipped my mate Fred down the pub a couple of tenners and he's offering an assurance that I'm creditworthy, I'd get a fairly dusty response.  Yet that caricature appears not to be so very far from what credit ratings agencies are doing.  They're clients of the people they're assessing and they bear no accountability for their conclusions, and on this basis decisions are taken and things happen that fundamentally affect the economic well-being of people and states.  It's a form of ideological strong-arming that is an absolute antithesis of democracy.

BBC Newsnight blogger Paul Mason's description of the thinking behind the agencies' response to the debt ceiling crisis seems to give an all-too-plausible insight into the blend of ideology and economic irrationality behind the agencies' reaction.  It shows how these decisions are political as well as economic.

In the specific case of S and P, there appears to be a certain amount of posturing.  They said they would downgrade if the deal on the deficit ceiling contained a commitment to cut of less than $4 trillion the next decade - in the event the deal required cuts of $2.1 trillion.  That's bad enough for the average American on medicare, but evidently in the macho irresponsible world of the credit rating agency, face has to be saved at the expense of increasing the economic misery.  The US treasury is already challenging the numbers, a source suggesting that S and P's analysis contained errors amounting to a mere $2 trillion.  The fact that Sarah Palin is claiming the downgrading as a Republican victory says much for the bizarre non-logic surrounding the whole affair.

It seems clear that the real function of the credit ratings agency is ideological - the secret police of the shock doctrine, wielding vast power without accountability.  They got it disastrously wrong in 2008, and may do again now.  Sensible economics seems to require that their power is broken.

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