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What to do about the ratings agencies

August 7th, 2011

S&P’s decision to downgrade US Treasury bonds from AAA to AA+ has elicited various reactions, some of which I’ll doubtless repeat here. Obviously, S&P has no particular expertise (apparently it couldn’t even get the arithmetic right) and based on its historical and continuing performance, its opinions ought to carry no particular weight with anybody (they say so themselves, when under pressure over obvious cases of misrating, asserting that they are merely offering an opinion).

On the other hand, it’s also pretty obvious (and even more so after the Repubs successful use of the debt ceiling to force Obama to abandon any call for tax increases along with the cuts they both wanted) that the US has some fairly intractable problems in dealing with its (technically quite manageable, but still substantial) public debt. Finally, as I said last time I discussed this, a decision of this kind (including a decision to maintain AAA ratings) is inherently political

There are two reasons why S&P’s choice of rating matters more than, say, my own opinions on the matter
* First, a lot of investors still pay attention to ratings agencies, for whatever reason
* Much more importantly, agency ratings are embedded in global regulations concerning prudent management of investment. If a second major agency were to join S&P in downgrading, large numbers of institutions would be debarred, under existing rules, from investing in Treasury bonds

That’s clearly unsustainable, so what will happen?

All sorts of fudges are possible, but the only clean response is to remove reference to private agency ratings from regulations prescribing prudent management of investment. Under current rules, provided managers invest in AAA-rated assets they are normally regarded as having discharged their duty of care. On the other hand, the agencies insist that their ratings are mere opinions, and that they have no duty of care whatsoever in offering them. Dodd-Frank was supposed to fix this, but as I just discovered (H/T Anders Widebrant), the SEC has abandoned any attempt to implement this part of the law.

But what is the alternative. I (and others) have previously floated the idea of a public ratings agency, but I now think this is a roundabout and inappropriate solution to the problem of defining a safe harbor for institutional investors. What is needed, simply, is a list of approved investments drawn up by the relevant regulators. Investors who choose assets outside this list would do so on the basis of their own judgements and would have to defend that judgement in the event of default.

There are some crucial differences between this and the existing system. First, regulators take responsibility for their own decisions, rather than outsourcing them (though some may choose to use a common list). Second, and most importantly, this approach reverses the onus of proof regarding financial innovation. If someone comes up with a new financial instrument, and a theory as to why it is (almost) risk-free, they have to persuade regulators (who will carry the can if something goes wrong) to approve it. Under these circumstances, the kinds of institutions that are required to make prudent investments will be effectively excluded from investing in innovative instruments. Given the history of financial innovation, that’s a good thing.

There are still problems here. Lots of governments have AAA-rated debt and lots more would like their debt regarded the same way, even if (or especially if) they are not pursuing particularly prudent fiscal policies. Obviously they would like, and will pressure, regulators to take a favorable view, and will be particularly miffed if their debt is dropped from an approved list. There are several cases here. One is the case where the regulator is responsible to the government concerned. In that case, I think nothing can be done or should be done. The government will declare that someone who invests in its own securities has done nothing wrong – institutions regulated by that government will have to make up their own minds whether or not to do so. The second case is that of the debt of foreign governments – here a downgrading might involve some embarrassment, but as long as it is done by independent regulators. The third, and trickiest case is that of regulation in a federal or confederal system (US states or EU member countries). I haven’t thought through this one yet, so I’ll leave it for comments.

What would happen to the ratings agencies if they were cut out of the regulatory loop? I’d guess that they would continue the business of rating ordinary corporate debt, much as before, but they would lose a lot of business associated with rating innovative financial instruments (given their record of failure in this area) and government debt (given that they would be competing both with regulators and with CDS markets).

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  1. Sam
    August 10th, 2011 at 11:42 | #1

    I think it’s usually a mistake to posit a conspiracy theory when ordinary incompetence will do.

  2. Freelander
    August 10th, 2011 at 14:19 | #2

    @Sam

    There is no real conspiracy. Numerous members of the looney right have, at various times, stated that constraining government’s ability to tax is a great way to shrink the size of government. Loading the government with debt so that the only spending can be repaying the debt is simply a variation on the theme.

    Sure they are incompetent but they also have looney beliefs including that a modern economy can operate with a very small government. These beliefs underpin their lack of concern about bringing the world economy to the brink of disaster, because in their alternative reality that is not what is happening, and if it does happen, it wouldn’t be their fault.

  3. sam
    August 10th, 2011 at 14:28 | #3

    @Freelander
    I agree with that. I was replying to Mulga’s assertion here:

    And Obama is, and always has been, a loyal functionary of that global empire. His does what he is told, and the debt ceiling pantomime was simply an act put on to justify destroying Social Welfare and entitlements. Obama always surrenders to the Right, after some mock defiance, his head held high, slightly turned to one side, as if in direct contact with the All High.

    Obama may be weak, he may be too centrist, and he may have a silly obsession with bipartisanship. He is not however, in on a vast conspiracy. He is bad at being a good president, not the other way around.

  4. Freelander
    August 10th, 2011 at 16:30 | #4

    I agree Obama isn’t in a formal conspiracy but he, like other politicians, is well aware of the vastly easier path he treads by keeping in with the so-called establishment. He is just one more ‘modern’ politician driven not by principle or the desire to achieve but rather driven by the desire to be elected, in this case elected and re-elected President. The desire is too accumulate political capital not to spend it. He prefers the easy life. After all he has a Nobel Peace Prize, for which he did and has done nothing, why should he have to do anything at all?

    One factor contributing to the current riots in the London at the moment is probably the sense of alienation large sections of British society now feel after the many years of Thatcherism and ‘New’ Labour. Society is not set up to serve any of their needs let alone desires; clearly it is set up for those somewhat better off. Because society has abandoned them, it is unsurprising that they feel no allegiance to that society.

  5. sam
    August 10th, 2011 at 17:01 | #5

    Agree completely.

  6. Ernestine Gross
    August 11th, 2011 at 09:58 | #6

    What to do about the rating agencies? Start with selling McGraw-Hill Inc. securities and don’t buy their Finance texts. http://www.nyse.com/listed/mhp.html

    There is a finance war on.

    Latest examples: Warren Buffet bought 40 billion $ worth of US government paper and made a public statement against S&P. S&P respondend by down-grading the papers issued by companies associated or controlled by Buffet.

    France government paper is now under attack and French banks are ‘down-graded’.

    Hopefully the French will follow the lead of two Italian NGOs and take S&P to court for market manipulation.

    It is absurd to have a bunch of people who ‘rated’ junk bonds as AAA investment bonds and have them sold all over the world to now dictate to the world how they are to pay for their mess.

    The market manipulation is too obvious.

    This has gone far beyond debates. This is serious.

    PS: The Chinese advice to the USA government revealed a lot about China’s concern with the welfare of people. Not impressive IMHO. Either the Chinese are going to make their currency tradeable or ‘we’ will have to reintroduce tariffs. End of story.

    In a sense it is quite amusing to have two or more ‘leading’ country governments trying to pursuade the rest of the world that their problem is the problem of the rest of the world.

  7. Mulga Mumblebrain
    August 12th, 2011 at 18:40 | #7

    I read today that US banks have been ‘instructed’ not to lend to French banks. If true it gives credence to my current pet conspiracy theory (well, my favourite amongst many) that the wealth and hedge funds’ assault on the Eurozone countries’ bonds, one after the other, is part of a US campaign to destroy the Euro. After all the threat of a rival to the US as global reserve currency would be seen by the ruling US elite as a ‘New, New Pearl Harbor’ worthy of an exemplory exercise of economic ‘Full Spectrum Dominance’.

  8. Freelander
    August 12th, 2011 at 19:03 | #8

    The US has been vigorously trying to distract the world from their problems and to stop the logical dumping of their currency as the world reserve in favour of the Euro (which should have taken place at least five years ago). Who would you trust to manage the world reserve currency, the US government and their feral Fed or the ECB?

    That US intelligence agencies have had a hand in trying to undermine confidence in EU countries, the Eurozone and the Euro should come as no surprise. After all, whose intelligence agency overthrew the democratically elected government of Iran in 1953 in favor of the Shah and in favor of the West getting their hands on the oil? Who attempted to overthrow Castro and assassinate him several times? Who overthrew Allende? And who had a go at overthrowing Chaves? Why would they not purse ‘American interests’ in Europe?

    When will our traitorous leaders in the West recognise that the US is not our friend?

  9. Beau Smyth
    August 13th, 2011 at 18:21 | #9

    Tthese ratings agencies charge a bucketload for their supposedly objective opinions. How is that different a pharmaceutical company paying for ‘independent’ assessment of dodgy drugs?
    If it weren’t for the ratings agencies’ endorsement of junk securities (by an entirely different, but not-much publicised ratings methodology, ie, AAA on a sovereign is nothing like AAA on a junk mortgage security), would we even be in this economic shambles now? I think not.
    John, you are right. It is time that the spurious authority of the billion-dollar ratings agencies was submitted to the junk pile with the junk bonds they loved to death.

  10. Mulga Mumblebrain
    August 13th, 2011 at 18:36 | #10

    The answer to your question Freelander is ‘never’. We are a totally subservient vassal of the US/Israel Global Empire. Not only would an even marginally independent leader get the Whitlam treatment, with today’s equivalent of Marshall Green appointed as US Ambassador, and any number of the hundreds of US intelligence ‘assets’ in the upper ranks of our ruling class be mobilised to do ‘their duty’ for ‘Western Civilization’, but the Australian elite has also auto-selected over decades for extreme, groveling, sycophancy to the Real Evil Empire. The address by Gillard to the US Congress was just about the most demeaning and embarrassing display of obsequious and emotionally incontinent brown-nosing I have ever seen, or hope ever to see. And, according to Ron ‘Creosote’ Boswell in yesterday’s ‘The Fundament’, it came from a fully paid up (in ‘Moscow gold’ no doubt) member of the Comintern. Indeed, when you think of it, it would defeat the most inventive and sardonic comic writer to create a polity such as ours, so far does it dwell ‘beyond parody’..

  11. Freelander
    August 13th, 2011 at 19:16 | #11

    @Ernestine Gross

    The US is not our friend. The West really needs to get together to protect itself from the US because they have been robbing us blind for years. Do they really need the secret army called the CIA with a secret budget and an estimated 20,000 employees, not counting contractors. And the secret budget doesn’t count their off budget money which they have been earning for years through drugs and arms running so that they are not under congressional or presidential control. How many remember that in the 1980s the CIA successfully had newspapers reporting that the Iranians were gassing the Iraqis? Of course, the truth was in the newspapers when the US decided to go to war with Saddam.

  12. Ernestine Gross
    August 15th, 2011 at 17:33 | #12

    @Freelander

    But I have many friends in the USA.

    I hear what you say, Freelander. I am merely an economist and, to make matters worse, I am one of those who is interested in the welfare of people and in their ‘freedom’ (as understood in a social democratic framework, which I interpret to include freedom from brainwashing). All insights I could get from my studies and work in the alledgedly dreaded area of theoretical models of ‘competitive private ownership economies’ lead me to one conclusion: The existence of rating agencies is inconsistent with the idea of a market economy. The rating agencies belong to a dictatorial system.

    The good news (relatively) is that Berlisconi figured out which side of his bread is buttered. The Italian ‘austerity’ program includes a 5% tax for 2 years on incomes above Euro 90,000 to Euro 150,000 and a 10% tax on incomes above Euro 150,000 – to get funds from the ECB. (Source: smh and some EU press). I also read that Switzerland considered temporarily pegging the sfr to the Euro (apply Lucas’ notion of rational expectation to this one to get interesting implications).

  13. Freelander
    August 15th, 2011 at 18:58 | #13

    @Ernestine Gross

    They are probably victims too. It is the US establishment that is not our friend. They are hardly the friend of 90 per cent of their population either, given how their income distribution has gone. With one grandparent born there and knowing plenty of good Americans, I don’t think the entire population can be written off. Sadly, those who have been running the place may be paving the path to its destruction, and an upheaval which could be far more dangerous than the collapse of the Soviet Empire.

    I was surprised and heartened that Berlisconi (of all people) did what ought to have been done in many other countries, which is institute an austerity program targeting those how benefited most from the good times. One additional aspect of such targeting which also makes it more desirable is that the marginal propensity to consume tends to be smaller at higher incomes.

  14. Freelander
    August 15th, 2011 at 19:00 | #14

    The Swiss pegging was also a good and obvious move.

  15. Mulga Mumblebrain
    August 15th, 2011 at 20:42 | #15

    Ernestine, a ‘market’ economy, by which I assume you mean a market capitalist system, is itself a dictatorship- of money. Market capitalism operates under the principle of ‘one dollar, one vote’ so becomes, as we can see, a dictatorship of the rich. A true market system would entail equality of wealth, so that we could all have an equal go. Also, for the sake of moral hygiene, all those lovely exploitative processes by which unscrupulous capitalists rob others of their wealth ought to be banned. Then, with no avenues for pointless displays of egomania and contempt for others, most economic activity, certainly nearly all ‘financial’ manoeuvring, would cease. People would live with a decent sufficiency, and displays of conspicuous excess would become steadily more difficult. This economy would tend to a steady-state, and have the rather grand consequence that we would thwart the neoplastic ecological doom that our current system is bringing about at breakneck speed.

  16. Ernestine Gross
    August 15th, 2011 at 23:24 | #16

    Mulga M., your assumption about what I said is wrong. I do not accept an equivalence between theoretical models of ‘competitive private ownership economies’ and ‘capitalism’.

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