I did a guest post for the blog site of the Australian Broadcasting Corporation on the topic of ratings agencies, their quasi-official role in regulating investment, and their recent catastrophic failures. I’ve reposted it over the fold – the examples are Australian, but many of the points are more general.
The present financial crisis is notable for the lack of high-profile villains upon whom blame can be pinned. There is no obvious Enron or Long Term Capital Management. Rather, the entire financial system has failed, and the checks and balances that were supposed to prevent such failure have proved useless.
Among the most prominent checks and balances are private sector ratings agencies, of which the most prominent are Moody’s, Standard & Poor’s, and Fitch. Although these agencies claim only to offer opinions, and therefore to fall under the protection of the First Amendment to the US constitution, they have long-held quasi-official status.
All sorts of bodies, such as local councils, are required by law, in Australia and other countries, to invest only in assets rated as AAA (or sometimes as A or above) by these agencies. In effect, we have outsourced a large part of our financial regulation to foreign companies that offer no guarantee of their own reliability.
As councils in Australia, and many others investors have found, relying on a AAA rating can be a road to disaster. For example, Wingecarribee Shire Council in New South Wales, operating under rules that specifically enshrined Moody’s and Standard & Poor’s ratings, invested in AAA-rated collateralized deposit obligations sold by Lehman Brothers. The investments are now just about worthless, and the Council’s attempts to recover its money seem doomed, now that Lehmans itself is bankrupt. Thousands of AAA-rated investments and tens of thousands of investors have experienced similar outcomes.
There are a number of explanations for the failure of the ratings agencies. First, like most participants in global financial markets, they have shown themselves to be subject to the euphoria that is associated with a booming market, and the prosperity it brings to the financial sector. Second, they are subject to inherent conflicts of interest, since the issuers of financial securities pay to have them rated.
Third, and most importantly, they have a long-standing bias against the public sector. This is reflected in the fact that state and local governments, which rarely default on their debt, are assessed far more stringently than corporate issuers. In the last year, thousands of private-sector securities issued with AAA ratings have been downgraded to junk, and many have subsequently gone into default.
By contrast, defaults on government debt have remained rare. One effect of the differential ratings practices of the agencies is that government borrowers have been forced to seek insurance from bond insurance companies such as AMBAC that are, in reality, less sound than the governments they are insuring.
In Australia, despite the fact that no state or national government has ever defaulted*, the agencies regularly threaten the withdrawal of AAA ratings if governments invest in infrastructure assets. One result has been the push to rely on private financing, through Public Private Partnerships (PPPs). It seems likely now that many of the private partners in these deals will fail, and that the government will be left to clean up the mess.
In the current environment, assessing the soundness of public investments, and certifying the security of public debt, is too important a task to be left to private firms. The Australian government should establish an independent body to undertake these vital regulatory tasks for the domestic markets. As part of the new financial architecture that must emerge from the current crisis, a similar body needs to be established internationally, through co-operation among central banks.
The ratings agencies have failed to do their job. If they can persuade private firms to overlook this failure, and take notice of their opinions, that is all well and good. But they should no longer be given the backing of governments, and their ratings should not be treated as relevant information for the purposes of financial regulation or public policy.
- The Lang government in New South Wales stopped interest payments on bonds during the Depression, but the Federal government stepped in and made the payments. From the point of view of bondholders, this episode shows that state governments are even better risks than their balance sheets would indicate.