My column from yesterday’s Fin is over the fold
At the beginning of October 2007, the Standard & Poors rating agency maintained a AAA rating on a set of notes managed by the Credit Suisse bank under the name Adams Square Funding 1, a hybrid CDO issued a year or so earlier, and backed by mezzanine tranches of subprime RMBS. (It doesn’t matter much if you’ve forgotten, or never understood, the meaning of these terms – no such securities will ever be marketed again, at least while anyone now alive can remember them).
On 20 November, the securities were drastically downgraded, and by early December they were in liquidation. The holders of A-grade, AAA notes got a payout of zero – not a cent back on a security they had been told a few months earlier was as safe as a US government bond. This was one of literally thousands of similar cases, notably only for the fact that it occurred early enough in the financial meltdown to surprise people.
It is in this context that we need to evaluate the announcement by Standard & Poors that Queensland government bonds have been downgraded from AAA to AA+, and Anna Bligh’s nearly simultaneous announcement of an early state election. At any time in the twenty-five years preceding the meltdown of 2008, such a sequence of events would have been inconceivable.
In the decades when ratings agencies ruled the roost, a government facing the possibility of a downgrade might well have rushed to the polls in the hope of beating the bad news. Once the downgrade happened, the only option would have been to hold off as long as possible in the hope that the electorate would be distracted by some other event.
More importantly, in the face of a threatened downgrade, governments would have, and did, implement whatever economically irrational policy the ratings agencies might demand. Assets were sold at prices far below their true value, private firms like Macquarie Bank and Babcock and Brown were given huge returns on monopoly infrastructure investments, and essential services were sacrificed to the demands of “the markets”. As late as last year, Michael Costa and Maurice Iemma were still pursuing this strategy.
Instead of following this well-worn path, the Bligh government put out the bad news about the government’s finances in a mini-Budget statement, waited for the inevitable downgrade and then went to the polls. The hope, obviously is that the public will recognise that the state’s financial problems are the product of circumstances outside the government’s control, notably including the massive failure of Standard & Poors and other agencies entrusted with the task of assessing the riskiness of investments of all kinds.
Importantly, and correctly, State Treasurer Andrew Fraser observed that the measures required by Standard & Poors to maintain a AAA rating would have been economically crippling. These measures would have included the abandonment of infrastructure investments needed both to soften the impact of the crisis and to lay the foundations for growth.
As advisers to bondholders, it could be argued that Standard & Poors do not, and should not, care about the people of Queensland. Their only responsibility is to ensure that bondholders get paid in full and on time. But such an excuse rings hollow in view of the treatment of CDOs and similar financial toxic waste. Buyers of these assets who trusted the ratings agencies lost their shirts.
The difference, quite simply, is that private issuers paid for the ratings they received and were rewarded accordingly. Issuers of sovereign debt get much less favourable treatment. US states and municipalities have sued the ratings agencies for giving municipalities lower ratings than comparably risky corporate securities, costing taxpayers millions. Studies done by the agencies themselves show that public bonds default far less often than corporate bonds with similar or higher credit ratings.
If financial markets functioned as they were supposed to, institutions with a record of failure like that of the ratings agencies would be out of business. But much of the blame for the survival of these agencies must rest with governments, which have enshrined agency ratings in official investment guidelines, effectively outsourcing the crucial public role of prudential regulation’
Among the many challenges in reconstructing a sustainable system of global finance, the replacement of ratings issued by for-profit agencies with an alternative system, in which AAA ratings actually mean something, is among the most important. The Rudd government could make a useful start by ensuring the financial soundness of state governments, guaranteeing their liabilities, and transferring nationally important assets, with the associated debts, onto its own books.
John Quiggin 
Standard & Poors do have form for OVERSTATING a entity’s creditworthiness.
Hmmm……
shout it from the rooftops JQ – a wonderfully clear and perceptive column.
(I think QLD Labor have a task ahead of them in the election though, even given the weakness of the opposition)
But John, you’re saying that the market doesn’t function efficiently.
And look how wonderfully wealthy a market economy has made us!
Ergo…
Well I’ll be a monkeys uncle. Of course I’d go much further and say that much of the blame for much of the sinificant crap that goes on in the market place rests with governments. Governments who far too often provides a safe harbour for those that behave stupidly. What we ought to have is a sizable separation between the economy and the state. In the same sense that the church and the state should be separate.
Terje, we’re probably closer than you think on this. I want to get the government out of the business of regulating, or guaranteeing, or assisting in any way, firms like Citigroup, S&P, ASX and so on.
When governments foul up deregulation, economists call it “government failure”. Likewise when they bend to the interests of private-sector “rent seekers” generally. But if markets corrupt governments, shouldn’t this be called a market failure?
One could argue that Rudd should be backing (funding) Keynesian stimulus by the States. Surely the time to invest is while resources in construction and skilled workers are in lower demand. Earlier, States were playing catch-up with infrastructure (ports etc.) during a boom. This maybe deserved more criticism from S&P than deficit spending now.
Still, after so many boom years, it would have been nice if the Qld government had put more funds aside for rainy days. Sure, the private sector broadly has been even more reckless than the State governments, but the government really think that the assets boom and the mining boom would just keep going?
Good.
However I’m still not sure how close we are on bank nationalisation. You used the term preprivatisation the other day which suggested to me that you may see it merely as a largely equivalent route to bankruptcy. I prefer the latter because it transfers equity directly from shareholders to creditors (eg deposit holders) under the supervision of an administrator. However I can see that nationalisation might, if done properly, amount to much the same thing (the “done properly” bit is where my doubts occur). However I’m not clear if this is really your position or if you just think banks should be owned by governments full stop. Which in my book is nowhere near a separation of economy and state.
Markets have no such effect. Market participants may seek to corrupt governments, and succeed, but that is another matter entirely. Typically we call them names like “rent seekers”. If government is corrupt then it is government that needs fixing or purging.
Obviously comment #7 is addressed to JQ.
Some news from the SMH website:
Moody’s puts Qld AAA rating on review
February 27, 2009 – 2:39PM
Ratings agency Moody’s has placed Queensland’s AAA credit rating on review for possible downgrading.
Queensland’s credit rating with Standard and Poor’s was last week lowered from AAA to AA, with the agency predicting the state’s net financial liabilities would surpass its operating revenue.
Treasurer Andrew Fraser will hold a media conference in Brisbane at 1.30pm (AEST) to discuss the issue.
I’ll let others be clever with “Moody”.
Re 8 TerjeP
So if the Mafia corrupts the government, it’s the government’s fault? I’d say that the badder guys were the Mafia.
John Says:
It’s not a case of “as late as last year”, it’s actually “as late as this week”. Nathan Rees is determined to learn nothing and take no notice of changing circumstances, because on Monday this week Rees was still spouting the same nonsense.
No-one has replaced John Pierce as Treasury Secretary yet (Pierce quit just after Iemma did) so maybe Rees isn’t getting any sensible advice, but in the meantime Rees is determined to follow Pierce’s zombie privatisation plan.
Not only that, but he’s proposing to spend all of the proceeds and more on the “Sydney Metro” project, which is a light rail system running from Central Station to Rozelle. Hasn’t someone told this moron that there’s already a light rail link between Central and Rozelle?
Markets certainly don’t prevent failure, neither among private banks or ratings agencies, not to mention auditors in the past. As such Govts have a right to tell such agencies to go and take a jump along with some of their past clients and let the market decide what return they want for Govt borrowings. I’m quite sure the market will work it all out satisfactorily.
‘What we ought to have is a sizable separation between the economy and the state.’
That’ll be the day! I just shook my head at all those outraged pollies queuing up to bag Pacific Brands for raising exec salaries to the tune of $15mill last year, when they were the same ones that handed out a similar amount to the company in assistance over the last couple of years. Keynesian economics at its scintillating best and they want me to believe they can all be trusted to handle our communal emission rights. There never was an honest gathering of tax deducters and deductibles.
This is no doubt the Victorian government did the right thing selling stuff into an inflated market, they could buy the whole lot back for less now if they wanted to. You would have to have rocks in your head to sell into a depressed market. NSW missed the boat.
As to the rating agents, is the federal government going to let a state default on it’s debt. Given the rating record what can one say, they really are a bunch of morons and their 3 letter editorials are worth about as much as an opinion piece in the Australian.
Here here.
There have been many regrettable consequences of this corrupt practice. The one I have experienced relates to the funding of PPPs. This absurdity has fueled the borrowing binge for them, by artificially lowering the borrwing costs of the SPVs who fund them, and raising the cost of the alternative public borrowing.
I think there is a huge semantical issue involved in how “government” that makes this long and tiresome culture wars between a certain type of libertarian, and others in requirement of a push forward.
What is “government”?
If it’s eseentially the locus of decison -making; what Quiggin seems to be proposing as a more holistic view of “government”, the “government” as in Bligh or Rudd, is really just an innefectual appendage to a larger obscured mechanism long taken over by vested interests.
Under this sort of insanity, people like Pac Bons executive can remain outside the laws of conduct agreed to by the rest and paid lip service to by such as these until it suits them to dispense with that, to the extent of giving themselves massive pay increases at the very time they beggar their workforces.
A trip back in time to Walpole’s England, with its pocket boroughs and rotten boroughs, may be warranted. The unelected Murdochs, etc of their time got to impose their misery unimpeded on the many thru precisely a perversion of, the very notion of “government”, that may be played out in these times.
The US states and municipalities ought to take the ratings agencies to the cleaners. Those SOBs (rating agency execs and management) deserve to end up walking the streets wearing rainbarrels and lunchboards.
Issuers of democratic government debt (sovereign debt) on behalf of the people should never have to put up with being rated by those liars in the corporate commercial world.
The rating has been going on in the wrong direction. Governments ought to be rating commercial agencies. The notion of private enterprise in any way rating democractic government economically or socially is risible. The current disaster proves it so.
If one good thing comes out of this crisis it will be the huge stake driven through the heart of that kind of unfettered corporate capitalism. May it never rise again.
You cannot outsource any of a democratic government’s proper functions to the corporations. They seek only their own corporate good not the wider public good.
I’m losing significant amounts of super money despite moving as much to cash as I could. (The vehicles many workers were forced into lacked sufficient flexibility.) Despite this, I don’t care. I’m glad it’s happening. Crash and burn baby, burn. Our system has to change, change radically and soon or our society and our planet are dead anyway.
The disaster had to happen before the new course could be set.
For Terje. You cannot separate economy and state. The subject area is called Political Economy for very good reasons. Economy and state are entwined at all levels.
At the most basic level, the economy and the state both deal with physical things, things centered around production and consumption.
Even the separation of church and state is much overstated; though possible to a degree and beneficially so.
Could someone tell this to Costa who has until very recently in the Australian still been praising himself, his views and his committment to the NSW rating, along with the rest of the misinformed NSW State Government?
After that can we ask university Vice Chancellors why they need US accrediation ratings, and ask the ABC management why it needs consulting advice from US based Boston Consulting Group on whether to merge with SBS. Then ask why Telstra hired Sol Trujillo and finally ask why we are still toddling and cant stand on our own two feet as a nation?
re “Pierce’s zombie privatisation plan.”
Dont underestimate the agenda to bring State Treasury and NSW State govts unfunded superannuation liability on to the books.
Under consumer protection law a firm can be got for “deceptive and misleading conduct”. Time for the rating agencies to get the ACCC blow-torch. If only…..
Re: The AAA rating on CDOs: FT: Time to expose those CDOs
ACCC has not enough teeth.
Ratings must be given and charged for like books. Why else would McGraw Hill want to own S&P and then put McGraw Hill bigwigs in to run it? Put the ACCC blowtorch on McGraw Hill first.
SJ @ 12
That’s not quite correct. The “Sydney Metro” being built by the NSW ALP government is a $4+ billion in-tunnel, automated heavy rail line.
It’s purpose is to:
a) take away from CityRail the last remaining north-south underground rail corridor, thereby blocking CityRail from being able to expand capacity to service communities north of the harbour.
b) draw away any and all discretionary funds that could be allocated to maintain and improve existing CityRail services. A corollary is that this will lead to a further deterioration of CityRail to the point where no one will object to its privatisation. This is the basic Treasury view which wants the costs and liabilities of CityRail off its balance sheet altogether.
c) Transfer said $4+ billion of taxpayer funds to the construction and engineering companies that are among the largest contributors to the ALP.
d) Having sent $4+ billion on a line to an area that is already well served, the metro megolmanianics in the NSW transport bureaucracy and their private sectors backers/parasites will argue that NSW should continue tunnelling until they reach somewhere useful. In effect resurrecting the discredited $12+ billion North West Metro plan.
There is a proposal for extending the existing light rail service from Lilyfield to Dulwich Hill. The cost is less than the rounding error of the Sydney Metro’s cost estimates.
It’s got to the point that I feel NSW needs a Phillip Game-like governor. The dysfunction, irrationality and utter moral and intellectual bankruptcy of the ALP government is that bad.
In answer to your question an emphatic yes. Corrupt governments are faulty. If you betray your duty for a bribe from the Mafia you are at fault. The existance of temptation does not exhonerate the thief or the rapist and nor does it exhonerate governments.
However my main point is that markets can’t corrupt governments. Markets are just a process not a personality or thing. If anything I would say that the lack of markets is the quickest way to create temptations. It is the lack of markets or the restriction of markets that puts temptation on the table.
“Standard: Poor”. Great heading, important content. I hear this article attracted
interest in some chat-rooms with drinking facilities around Bond Street in Sydney.
Just to emphasise how badly these guys got it wrong, here is an article on some of the latest settlements of mortgage backed CDOs. The best are now beign settled for 32 cents in the dollar; sub-prime backed ones are now worth 5 cents in the dollar:
http://www.ft.com/cms/s/0/2970532c-0421-11de-845b-000077b07658.html?nclick_check=1
I should add to 26 that all of those CDOs, held mostly by Merrill Lynch, UBS and Citi, were AAA.
TerjeP Says:
February 28th, 2009 at 1:01 pm: #24
Just as “markets” are made up of individuals who make choices, in many important ways so are “governments”. Of course ‘the gov’t’ is not blameless, and bribes may even be actively solicited from the very top. Severely punish everybody involved, I say.
In reality, of course, we get the Burke pantomime in WA. And we get traders saying that it’s the government’s fault for not properly regulating them: if the music is playing you’ve got to dance, it was said. Well, no you don’t, actually.
There might just be 30 people who care about credit ratings, and they may have all commented here. The rest of us will make our decision on the Qld. election based on things that really matter.
Chris
I couldn’t care less about the Queensland election; I live in Adelaide. But the point of JQs article (I hope) is that these rating agencies are one of the causes of the harm. They must be removed from the process.
Re 32
In today’s AFR (p.1) someone has suggested that the States’s emergency borrowing should be done via/backed by the Commonwealth, which would help protect credit ratings. Why weren’t these protocols in place 20 years ago? (Rhetorical question: we all know why.)
Company directors who have failed in their responsibilities under the Companies Act are often prohibited from being company directors again. Given that the ratings agencies have so clearly failed in their duty not to provide false and misleading advice, why are they not prohibited from giving investment advice in the future. Would we let a financial planner continue to trade if they had deliberately given false and misleading advice?
Really? Do you have a link?
I’m very glad to see some commentary on the role of the rating agencies. At a recent economics talk at the CIS, I asked the speakers how much blame for the GFC can be ascribed to S&P et al, or possibly the regulation thereof, and it was casually dismissed as “above my pay grade” by one and with a waffle by the other. Elsewhere, an economist I respect said they shouldn’t bear much blame at all, but didn’t (or couldn’t) explain why.
Frankly, I’m astonished that a risk management failure and bad debt crisis of this magnitude does not have far more condemnation of the role played by the rating agencies. And where are the calls for radical change to the oligopolistic privileges given to them by government regulation?
So thanks again, Professor. I hope others take up the argument as well.
Others do at least seem to be stiring the pot.
http://www.catallaxyfiles.com/blog/?p=4255#comment-120981
One of my frustrations with this whole fiasco is with the fact that the principle market price for risk, the rate of interest charged for a loan, is not a price that fluctuates freely. Central banks use interest rates as their primary day to day target for open market operations. In my book this represents a massive distortion to the natural price signal. And at exactly the moment when the market should be signalling that credit is in short supply and lenders are concerned about risk the central banks move to lower interest rates.
I outlined my views in some details in the following article last september:-
http://blog.libertarian.org.au/2008/09/22/price-fixing-and-credit/
Terje, if you want to launch an attack from this angle, you should at least try to understand two concepts: (1) risk-free rate, (2) risk premium.
Otherwise, you may as well start ranting about gold standards again. It will get you just as far.
SJ – it wasn’t an attack although I know from past encounters with yourself that this is your prefered way of framing every comment you disagree with so I suppose I shouldn’t be too surprised. If you have a point to make why not just make it.