Discredited

by John Quiggin on October 20, 2008

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.

{ 19 comments }

1

SPayne 10.20.08 at 1:26 am

Jason Hackworth has a good chapter in The Neoliberal City on the credit rating agencies using their power to push for neoliberal austerity measures in U.S. cities.

2

HH 10.20.08 at 1:44 am

Today’s Sunday NYT has a front page article on the FBI lacking sufficient agents to investigate white collar crimes committed in the mortgage market disaster. In the business section of the SAME NEWSPAPER is an article by a reporter solemnly explaining that nobody was at fault because the crisis was so big and unexpected and all-encompassing that nothing could have averted it.

The ratings agencies betrayed their trust, and they should be punished through lawsuits that put them out of business. Even a cursory investigation would reveal deliberate decisions to relax rating standards to win more business. The makers of those decisions should be fired and prosecuted under any applicable laws.

3

PatS 10.20.08 at 1:53 am

Why would a bond buyer trust a government agency certifying the credit-worthiness of another government agency? I can see how your proposal works for a central government that wishes to regulate the behaviour of local governments, but could it perhaps be supplemented by some sort of private rating system funded by bond buyers (who, after all, have a considerable interest in getting an accurate view of the risk in any particular bond)

4

MarkUp 10.20.08 at 1:55 am

~In the words of former President George Bush, “[A]sset forfeiture laws allow [the government] to take the ill-gotten gains of drug kingpins and use them to put more cops on the streets.” New York City Police Commissioner Howard Safir invoked deterence when he said, “We believe that … the threat of civil forfeiture and the possibility of losing one’s car, have served to reduce the number of motorists who are willing to take the chance of being caught driving drunk.”

Right idea, wrong industry?

5

Rich Puchalsky 10.20.08 at 4:27 am

“In the business section of the SAME NEWSPAPER is an article by a reporter solemnly explaining that nobody was at fault because the crisis was so big and unexpected and all-encompassing that nothing could have averted it.”

Same newspaper? Try same blog.

This idea is a good one, though. The ratings agencies were convenient fictions, but there’s no reason why people should let them continue now that the whole system is being propped up with public money.

6

Andrew 10.20.08 at 7:27 am

Yeah it’s really funny how differently they treat public agencies and private companies. In the Seattle area, our big transit agency, Sound Transit, has had to struggle to get a AAA rating, after years of getting a AA or just an A rating, while WAMU, which has gone bankrupt on the same sort of dodgy mortgage securities, got AAA the entire time.

7

shannonr 10.20.08 at 7:58 am

That’s a superb introduction. Kudos.

8

jsalvati 10.20.08 at 8:04 am

Huh, have there been studies on rating agency bias against government entities? It seems bizarre to me.

9

John Quiggin 10.20.08 at 8:42 am

jsalvati, this practice is the subject of current litigation

http://www.ct.gov/ag/cwp/view.asp?a=2795&q=420390

the complaint shows how the bond insurers lobbied for the maintenance of discriminatory ratings

10

PHB 10.20.08 at 12:50 pm

If a government agency rates a bond as AAA that is going to be taken as an implicit guarantee. So I don’t quite see how you could have a government agency rate non-government bonds.

At the end of the day, ratings are bogus unless the rating entity has skin in the game. FDIC has a pretty good idea what its banks are doing. A government bond rating agency makes little sense, and insurance agency makes much more sense. But then you have the issue of political control. There is a real risk that if Republicans gained control of the insurance agency they would politicize it like they did with the DoJ.

11

Alex 10.20.08 at 1:25 pm

*Somebody* setting up a major public credit rating agency would probably have a salutary impact on the whole market. It’s true that the agency would be conflicted WRT some public-sector orgs, but hey, there are commercial ones. But if OzRate’s note on ANZ Bank or whoever is substantially different to S&P’s, people will want to know the reason why.

12

HH 10.20.08 at 2:21 pm

Another approach would be to establish a regulatory procedure for random review, by government auditors, of selected ratings, with penalties assessed against firms that deviate from accepted practices. Regulators could also have the final word on approving new risk measures and models for new types of securities. The same spot-check approach could be taken for private sector auditing of public companies. Regulators need not be ubiquitous in order to be effective.

13

John F. Opie 10.20.08 at 3:05 pm

Hi -

It’s actually worse than you think. The Rating Agencies helped their clients – who pay their bills – game the system, and indeed the system was gamed. This is one of the core aspects of the events leading up to the Panic of 2008: those who were to have been telling the public that something was very risky colluded with those holding those risk instruments to hide the fact that those instruments were so risky that giving them a risk rating was impossible.

This should be the basis for criminal inquiry. The rating agencies have fundamentally abused their position of trust – they are certified by the SEC as following proper statistical methods for determining risk – and should be, at the very least, de-certified.

If that puts them out of business, it is something that they dearly deserve.

14

Suther 10.20.08 at 7:36 pm

“In the Seattle area, our big transit agency, Sound Transit, has had to struggle to get a AAA rating, after years of getting a AA or just an A rating, while WAMU, which has gone bankrupt on the same sort of dodgy mortgage securities, got AAA the entire time.”

Not to let facts get in the way of a good story, but Wamu has never been AAA, ever.

I think the real challenge is separating the two issues of the mortgage bubble – fraud and collusion on the part of investment banks and rating agencies – that is bad and folks should go to jail and companies should be sued – and the separate issue of whether a gov’t agency would have done any better.

Just like you said – “In Australia, despite the fact that no state or national government has ever defaulted” … that was similar to the preface in the US mortgage industry – prior to this crisis, real estate prices had never, ever gone down nationwide in the US since the Great Depression. If you assumed the last 60+ years meant something, any postal service type rating agency would have been hard pressed to say that the risk of a 10-20% decline in US real estate prices was anything but fantasy…

15

John Quiggin 10.21.08 at 8:37 am

Suther, in the case of Australian governments, I don’t need the qualifier “since the Great Depression”. Even then, and despite Lang’s best attempts, Australia paid up.

16

J Thomas 10.21.08 at 5:25 pm

If you assumed the last 60+ years meant something, any postal service type rating agency would have been hard pressed to say that the risk of a 10-20% decline in US real estate prices was anything but fantasy…

This is the central problem.

When you’re in the middle of a three-year boom, or a ten-year boom, or a sixty-year boom, it’s simply not credible that the boom could ever end. The very idea seems like a fantasy.

We see this in lots of context.

I don’t see any way to fix it.

Here’s a limited idea that I thought was interesting, from a Heinlein novel: Collect real estate taxes based on the value the owner places on his property. The value gets published and anybody who wants to buy the property at that price can do so.

Never mind the problems, I just liked the idea of that kind of valuation. You set a price you’re willing to sell at, and that’s what the property is worth to you. You pay taxes for the price you set so you don’t overvalue it too much. But you don’t want to undervalue it either. If it’s worth more to somebody else then you get your price and they say what it’s worth to them.

It seems so elegant at first thought. If only it would work.

17

Suther 10.21.08 at 8:34 pm

“Even then, and despite Lang’s best attempts, Australia paid up.”

Well, puts Australia in a tie with Iceland, which hasn’t defaulted on any debt either … and it has been continually inhabited 700+ more years than Australia. Which country should be AAA?

18

derrida derider 10.22.08 at 2:19 am

J Thomas, that method of assessment was first suggested by Henry George – the 19th century Californian advocate of land taxation.

I know it was actually used in one Australian state (South Australia) but was repealed after a few decades (I’d guess after some especially well connected tax minimiser lost his property). Given how influential George’s writings were I’d be surprised if it hasn’t been tried somewhere else in the world.

19

Joshua Vincent 10.23.08 at 11:47 am

Land Value Taxation is still the norm for most Australian states, as well as many US cities, New Zealand cities, Danish cites. Estonia has a national land value tax. It is applied spottily that’s for sure, but the advent of computer analysis makes implmentation clearer and easier, as well as making the positive outcomes for the citizenry that much clearer. The self-assessment aspect is in place in, I believe, Estonia. that would make the whole H. George program work much better, IMO.

Most of the above named places still have many other taxes that “drag” the impact of the land value tax, but they generally are economically healthier places than a similar neighbor that does not use the program.
Cheers, Josh

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