Discredited credit agencies

I’ve done another guest post over at the ABC Unleashed site, on the topic, which we’ve discussed here a few times, of the ratings agencies, their quasi-official role in regulating investment, and their recent catastrophic failures. I’ve reposted it over the fold.

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 were 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 ideological 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.

* As reader Tony G points, out the Lang government in NSW stopped interest payments on bonds during the Depression, but the Commonwealth 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.

66 thoughts on “Discredited credit agencies

  1. If the ratings agencies were offering ‘opinions’ on ‘ratings’ of Australian commercial entities I am assuming they would come under the Trade Practices provisions.

  2. pablo, to the extent that they were carrying on a business (ie. selling their services) in Australia, yes they would come under the TPA. Which invites the question: why haven’t they been sued to oblivion for failing to render their services with due care and skill?


  3. pablo, I’m no expert in this area, but as far as I know the regulation of the ratings agencies falls under ASIC rather than the ACCC. As long as they give the required warnings, e.g., “this analysis may be complete crap so you shouldn’t rely on it”, they’re off the hook.

  4. Then again, I could be wrong. Five minutes of research tells me this:

    In June 2005, ASIC proposed to continue not regulating them.

    In August 2008 ASIC started to think about whether this approach was working.

  5. I’m all for the government trying to set up its own ratings agency but that’s only because I get a lot of personal satisfaction from seeing governments embarrass themselves. I think I’ll celebrate their first major failure by writing a blog piece about how government ratings agencies are now discredited and the job should go to the private sector. I doubt I’ll have to wait long.

  6. Credit ratings agencies rate entities that pay them to be rated.

    Translation: these entities emerge from the dressing room and ask the ratings agencies “Does my bum look big in this?”

    There is only one answer to that question.

  7. I have a question: How can anybody rate a collateralised debt obligation (CDO) or any other portfolio of securities with non-linear pay-off functions (sharing rules) as an ‘investment’ grade (which allows holding to maturity), given Merton’s 1990 continuous-time model results?

    Alternatively put, the Finance industry’s line: ‘a rolling debt does not accumulate default’ seems to me to be consistent with Merton’s continuous-time model but not with any measure of the notion of an ‘investment grade’.

  8. References to post #8:

    Merton(1990) Continuous Time Finance, Oxtford, Basil Blackwell. Earlier work by Merton is referenced in this publication.

  9. In one sense I agree with Joseph Clark – anyone who has read about the performance of APRA in the HIH inquiry would know that government agencies don’t necessarily get it right either. Of course, that doesn’t justify the existing credit rating situation continuing either!

    It seems to me that the problem occurs when the agency, whether public or private, lacks the skill and/or motivation to do the task. In this case I don’t see how that motivational conflict can be eliminated for a private agency. So teh trick is to establish a public agency with the skills and motivation to do it right (culture?).

  10. Here’s a thought – require the ratings agencies to indemnify investors for the first x million dollars lost in any default on an investment rates A or above.

    Let them nominate an amount but if the amount is zero, investors will likely drawn a similar conclusion about the value of the rating.

    Of course, given recent events, the indemnities would have to be fully financed and in the form of government bonds.

  11. Katz,
    There is only one answer – yes, it is.
    A quick question. If I asked you for some financial advice and you give me some, saying things like “I think this is a good one, given what I know about it and under current conditions.” I then go and invest my entire life’s savings in it and perhaps borrow against my house to do so. The investment subsequently goes bad, so much so that I lose my house.
    Is it your fault for giving me the advice or mine for being so stupid as to put it all into one basket?
    No-one, anywhere, should ever think that any investment is 100% safe – that is why most sane investors go in for multiple asset classes across several sectors. If some idiot at a local council decides to risk everything on one turn of the roulette wheel then should we blame the maker of the wheel, the managers of the casino, the croupier or the gambler?
    The agencies are just as capable of making errors as anyone else. I do not share your evident, but seemingly heartfelt, belief that a bureaucrat is more likely to get it right than someone whose pay, and job, ultimately depends on being right more often than not – something that, for all the barbs thrown at them, the agencies tend to be. The focus through these problems has entirely been on the ones where they got it wrong, rather than the many on which they got it right – and have continued to get it right over the decades they have been doing this.
    At least in their public protestations, the agencies are also not happy with this quasi-regulatory role. In reality, I would think them less than totally unhappy as it does tend to reinforce the oligopoly amongst them.
    Your suggestion, though, seems to be to try to replace an oligopoly with a monopoly. To put it another way – you seem confident that the same people responsible for picking the agencies will be able to do a better job in picking investments. I do not share your confidence.

  12. Maybe the entities have to do their own ratings based on an internationally established standard set of rules. Similar to the energy rating of your appliances. In this way the assessment (self assessment) could be insured, and the insurer would apply the scrutiny, for their own protection. The insurer could be the government of the country in which the entities existed and the country’s own rating established by its performance accuracy. Not so far fetched with governments around the globe underwriting their banks. Furthermore the self assessor could be sued for distorting reality. It is far more likely to recover lost investment funds from the securities provider than from an agency that received a fee (small) for assessing the value of an entity. Whistle blowers in this structure would be taken more seriously as they would have an interested ear to whisper into.

  13. I’m intrigued by the soft language that has been used to smooth over the huge cracks in the world’s financial pavement. The key one being “sub prime”. Now one would expect that “prime”, being just one step removed from “guilt edged” or AuAA “gold award assured” rating, might have an AA rating. So “sub prime” being something less than “prime” might have an AB”above bad” rating, when in actual fact it should have been given a DD “downright dodgey” rating. When the wordsmiths go to work on what should be a numbers game something is definitiely wrong.

    Perhaps you economist types could clarify the commercial language so that us laymen, when sitting on decision making committees, are not schmoozed again by the brothers Leerman.

  14. AR, your quick question ended up rather long, and your use of dubious debating terms like “heartfelt” suggests you lack faith in your own conclusions. My response is that regulators paid by the public have historically done a better job than unregulated financial markets. The episode of deregulation we have just experienced, beginning in the mid-1970s managed only one decent growth cycle, beginning in the early 90s before collapsing in the heap we now observe. And the failure of the main institutions (stock markets, investment banks, ratings agencies and the rest) to allocate risk and capital sensibly was evident by 1996 (remember Greenspan and irrational exuberance)

  15. Bilb, subprime mortgages are hardly DD assets – more like single A or BBB.

    Generally speaking, over the life of a portfolio of subprime mortgages, the higher default rate is offset by the higher interest charged.

    The current crisis arose because people took those moderately risky assets, used securitisation and mortgage insurance and other gimmicks which supposedly reduced the risk and then proceeded to treat them as though the were equivalent to prime mortgages – including using them as security for further loans.

    The failure of ratings agencies and insurers to properly assess the real risks associated with CDOs and the like are at the heart of the current crisis.

  16. I don’t think this counts as a default from the viewpoint of bondholders“.

    In my view, it is, because not doing so is the equivalent of netting off assets and liabilities, which you can only do when there is so much linkage = positive correlation – that they are each always on tap for the other. The default happened, but clearly there was no tied in necessity for it to be covered, and equally clearly it showed how near the surface the potential for default was.

    With sovereign entities, there is also the question of “inflation is repudiation”, though that really only comes up at federal level.

  17. I don’t profess to know, Damocles, I was just having fun with perceptions. I do, however, seriously suggest that a self assessment of quality is the way forward. Structurally, this puts the buyer (source)on a “beware” footing and the seller (drain) on probation. [() to indicate direction of money flow which as I think about it is very similar to an electronic circuit]

  18. PrQ,
    Having been involved in the way that most of these institutions have been regulated since the mid 1980s I have a good working, as well as theoretical, knowledge of how it actually works. To say that we are in a “deregulated” system is, as I have said many times before, to show a deep misunderstanding of the system as it now is. The regulators do, in a deep and very material way, rule the roost. While this may not be in the directed credit environment we had in the 1950s – thanks goodness – there are still much more than enough ways in which they manipulate the operations, policies and procedures of all financial institutions. If you are in any doubt, just pick up the Basel II accord for example – all 400 pages of it – and read in particular pillar 2, which effectively gives the regulators the right to do anything they want. Solvency II is also on the way for insurance companies.
    To say that “deregulation has failed” is (IMHO) to make exactly the same mistake you accuse the libertarians of – deregulation has not really happened.

  19. AR,
    All very true but I think you’re missing the broader thrust of Quiggin’s argument. He wants full nationisation of the finanical sector. Anything less is unacceptably deregulated.

  20. John, if I may reply to Joseph Clark by saying government supervision is necessary where rogue entrepreneurs give a bad name to an industry.

  21. It is absurd for the ratings agencies to claim that they are mere observers. They are both regulatory and commercial players.

    The Basle capital rules provide that banks with higher ratings need hold less capital. The thinking was that if the market says that institution x is less risky, then the market must be right, and so less precaution (less capital) is required. But what is the market in this instance? It’s the opinions of the agencies who are being paid by the same organisations they are rating. If that isn’t a conflict of interest, what is?

    The local government councillors who stupidly invested money in CDOs were free to do so because state governments said that any investments they made had to be rated AA or better. So the CDO salesmen, with their products stamped AA or AAA, could say to the councils, “your backside is covered”.

    Governments have foolishly outsourced part of their regulatory responsibilities to the agencies, but the agencies are accountable to no one. The agencies can’t have it both ways. If they want to be treated merely as people with opinions, like an anonymous blog commentator, with no responsibility and no accountability, then their opinions must carry zero official weight.

  22. “To say that “deregulation has failedâ€? is (IMHO) to make exactly the same mistake you accuse the libertarians of – deregulation has not really happened.”

    Can we agree that current regulatory regime across most of the developed world which was widely described as deregulation has failed?

    Seeing as this policy was broadly supported by mainstream parties of both the left and the right, that’s hardly a partisan statement.

  23. I think the deregulation of currency values (in so far as the value of currencies was once the target of open market operations and isn’t any longer) is clearly a failure. A brutal abdication of responsibility in fact given the extent to which laws effectively prohibit any serious alternative to government fiat currencies. The flip side is that we now regulate interest rates (via open market operations). So I wouldn’t call this particular change deregulation, just a shift from good regulation to bad regulation. If the government makes the currency then the government should regulate the value of the currency. Obviously we should prefer if they did it wisely.

    In terms of investment ratings I don’t know why anybody would point the bone at libertarianism. Libertarians asserts that governments should be careful with taxpayers money. If that means doing more inhouse assessment and relying less on external advice before spending or investing taxpayers money then fine.

  24. “In terms of investment ratings I don’t know why anybody would point the bone at libertarianism. Libertarians asserts that governments should be careful with taxpayers money. If that means doing more inhouse assessment and relying less on external advice before spending or investing taxpayers money then fine.”

    But it’s transactions between non-government agents that have caused the current crisis.

    So long as governments are expected to bail out banking crises, they have a legitimate interest in ensuring the actions of individuals and corporations don’t make such crises more likely.

  25. “But it’s transactions between non-government agents that have caused the current crisis.”
    The ‘current crisis’ as you call it Ian, was simply that private entities cottoned onto the public money printing game and have ruined their monopoly. Consequently we are being cajoled that the only answer is to protect the inscrutable monopolists from such unruly predatory behaviour in future. That’s inscrutable logic I guess.

  26. JQ says “fn1. Since I haven’t checked, I’ll assume that this set of people has zero overlap with those I once debated who insisted that the supposedly superior performance of the US economy over social-democratic competitors demonstrated the superiority of free market economics.” From Crooked Timber link @ 20.

    John, I don’t believe that any of the current events actually negate this particular argument. Regardless of how much of a free market economy anyone thinks the US is, I would maintain that countries that are more social democratic than the US will not fare any better and indeed will generally fare worse in the current environment.

    For example, we can probably agree that Australia is more socially democratic than the US. And yet Australia has even worse problems in terms of average debt to incomes, over-inflated house values, etc. When our own bubble bursts, I wonder how many will be arguing that this is a failure of our more social democratic culture and policies.

    The same applies to Europe. Most of Western Europe has much the same problems as the US in terms of debt, budget deficits and troubled financial institutions. But in addition they have worse problems in terms of rapidly ageing populations and unsustainable social programs. So, in effect, they are borrowing even more against the future.

    It’s true in some ways that the US is a slightly more market-oriented economy and society. However, the extent of this is often greatly exaggerated. So the idea that everything wrong with America is proof of the failure of the free market is questionable.

    If countries that are more social democratic than the US were likely to fare better, you would have a strong case. But I don’t believe they will.

  27. John, I agree. The credit rating agencies have done an appalling job of rating securities not just in this crisis but throughout history. I personally don’t think government bodies such as councils etc should be investing in any asset that relies on the ‘opinion’ of a rating agency. They should only be allowed to invest in cash deposits at the RBA and any excess cash should be returned immediately to the taxpayer.

    I’d also be interested to see what you think of the Federal Reserve’s role in the current crises. They are a public institution and in the opinion of many credible commentators have failed miserably. I take it you are familiar with Nobel Laureate Paul Krugman’s opinion of the Fed.

    As an aside, Anna Schwartz lets fly with a few criticisms of the Fed in last weekends Wall Street Journal – http://online.wsj.com/article/SB122428279231046053.html?mod=todays_us_opinion

  28. Re the councils, the really strange thing is, once all the investment banks in the chain had had their go at clipping the tickets, the return on the CDOs was just 1% higher than a term deposit in the Commonwealth Bank.

    All that extra risk, for a measly 1% more!

  29. John, you make the criticism that rating agencies provide comparatively better ratings to corporate issuers than they do government/semi-government issuers. I have no reason to disagree with this opinion. However, the market is also fully aware of this anomaly and government debt will trade at a hefty premium to similarly rated corporate debt. For example 5 year Tasmanian Government debt is currently trading at a yield of about 5.5% and 5 year ANZ debt is trading at a yield of about 6.8%. Both agencies are rated AA. While the rating agency may have it ‘wrong’ the market knows better. As a result, the final cost to a government issuer from a biased/incorrect rating is minimal. By the way, Standard and Poors is rating AIG debt at AA. The market however thinks differently. AIG debt is currently trading at a yield of about 37%.

  30. The problems that governments face with ratings agencies rating their debt are mostly self-inflicted. Governments have convinced themselves that it would be political death to lose their AAA rating, even though the difference in funding costs between AAA and AA is minimal (10 to 20 basis points).

    This is so stupid, it beggars belief. BHP Billiton is rated AA. Does anyone think this is a badly run company? In fact, it’s a bad thing when companies are rated AAA, because it means they have a lazy balance sheet, and aren’t taking advantage of their growth opportunities.

  31. Tin Tin, I know the market discounts the ratings though I’m not sure if the discount is complete. The problem comes when ratings get embodied in regulation.

  32. Mac Bank are paying 7% on A deposits and are guaranteed by the govt for 3 years.

    What isnt guaranteed is the %

  33. Wait, so because the government, through regulation, imposes sub-optimal investment decisions on public entities (sub-optimal because they are at variance with the relatively optimal market opinion), we ought do away with the market for the provision of credit ratings? How about just recognising the obvious government/regulatory failure and allowing public entities to invest in a manner consistent with the broader market’s assessment of the riskiness of investing in government instruments?


  34. John, my experience has been that government issuers generally trade at a higher premium than ex post risk would dictate. I am talking about more than just Australian government issues. Government issuers generally receive favourable treatment under regulatory capital requirements. This makes it cheaper for regulated institutions to hold government debt for regulatory purposes relative to corporate debt. For example, APRA requires Australian Deposit-taking Institutions (ADIs) to hold no capital against assets issued by the Australian Government. However, an ADI would be required to hold a 20% capital charge against a similarly rated corporate issuer. This effectively reduces the demand for corporate issues relative to government issues. There has been a tendency for regulatory bodies to relax this bias against corporate issuers in recent years. In effect, rating agencies end up playing a bigger role in regulation. I’d be happy to see this trend reversed. In fact, I think the only asset that should be held as capital for regulatory purposes is a cash deposit at the RBA.

    Click to access APS-112-12-12-07-Final.pdf

    Btw, I did some back of the envelope numbers on the ex post risk associated with owning US municipal bonds and corporate bonds on your blog in June this year. While the default rate on corporate bonds was indeed higher, the return from owning corporate bonds was even higher again. This says that corporate issuers are being penalised more harshly than government issuers by the market despite the rating agencies bias. https://johnquiggin.com/index.php/archives/2008/06/13/bond-insurance-and-regulatory-arbitrage/#comment-212918

  35. The problem is a system of regulations built around private rating systems that were entirely in the hand of private entities.

    If we are going to require, by governent regulation, that the behaviour of fincancial entities be dependent on ratings, then the government, and indeed the entire financial sector should have some input into those rating systems. Clearly leaving them entirely to the discretion of a small number of private agencies has created some perverse incentives. I see no reason that the ratings could not be defined in a manner similar to GAAP. If the accounting standards used to manage most of the world’s businesses were under the control of a tiny handful of private companies they would probably not work very well.

    Why not a two tier system of ratings? You could have clearly defined standards arrived at from general discussion between regulators and the financial community in the same way that GAAP is produced. Ratings under this system could then be produced by a much wider variety of agencies than the current group while still being consistent with each other. This “standardised rating” system could be restricted to plain vanilla instruments with a long historical track record to compare them too. Government could regulate and audit any agency giving ratings to ensure they were adhering to the standards properly. THis approach works pretty well in accounting.

    Then to still allow for innovation you could have a separate system which works the way it does currently, with a private agencies rating however they feel like doing. This would allow products with no track record to still be rated, and everyone would understand the difference between good old fashioned stuff and newer exotic things.

    Then to tie the two systems together you would just need to specify how much of each type of ratings a financial institution could hold. For instance you could say that banks could not hold more than 10% of their assets in non “standardised rating” products.

  36. Wait, so because the government, through regulation, imposes sub-optimal investment decisions on public entities (sub-optimal because they are at variance with the relatively optimal market opinion), we ought do away with the market for the provision of credit ratings? How about just recognising the obvious government/regulatory failure and allowing public entities to invest in a manner consistent with the broader market’s assessment of the riskiness of investing in government instruments?

    That would entail removal of a certain “systemic” JQ bias. However don’t worry, many of us are beavering away on this problem. 😉

  37. BBB, if you read my final para you’ll see that you have got my point backwards. By all means, if market participants find agency ratings useful, let them use them. I’m just arguing that governments shouldn’t require or encourage reliance on these ratings, any more than they should tell the readers of magazines which astrologers they should follow.

  38. PrQ,
    I would like an answer to my #23.
    Uncle Milton,
    The ratings agencies never asked to be given any official role. They write ratings for their clients which their clients are then able to use. The government then comes along and forces (or strongly advises) government and semi-government bodies to use those ratings. How is this the ratings agencies fault if the government uses them? Should they then try to stop the government using them?
    Sorry, but I cannot see how this is a market failure – it is, IMHO, yet another regulatory failure.

  39. PrQ,
    To get back to the substance for a while. One of the problems I see with your proposal is that, to be effective, the government assessor would have to carry out more in depth assessments than S&P or Moody’s – meaning more cost per investigation. They would also probably be considered unnecessary by the issuers being assessed – i.e. they would not get the cooperation that S&P or Moody’s currently get. They would also have to cover enough instruments to give a broad spread to potential users of the ratings – i.e. it would take a lot of work over a short time.
    In brief it is likely to be expensive, untimely and ineffective. Not something I would find as being a useful way to use my tax money.
    You are right that the naive use of the ratings in policy and regulation is not optimal, but I would say that the most effective remedy would not be to try to reinvent the wheel, but to try to ensure that the wheels that are there are being used properly. Ensure that there is sufficient spread, multiple instruments and multiple industry sectors and the risks of losing any substantial amount can be much better covered.

  40. Suppose that health inspections were outsourced to private contractors who were paid by the restaurateurs. Do you reckon the risk food-poisoning would go up or down? Suppose that Choice magazine were paid by the makers of the product? Would their advice be worth anything?

    This is the current rating system and there is no reason why it should work. The only way to make it work would be to (a) develop a payment methods by which the consumer i.e. buyer of the security pays the rater (like Choice) or (b) tie trailing penalties to any products that failed. Designing (b) would be a nightmare.

    Providing unbiased information for the market to base a more informed decision is precisely the kind of government activity that even libertarians should support. But some commenters here simply oppose any government involvement in anything because they distrust organistaion not motivated entirely by personal greed. They would rather leave the lunatics to run the asylum. Great post JQ.

  41. Third, and most importantly, they have a long-standing ideological bias against the public sector.

    I presume you mean that this bias is expressed through them giving a lower rating to public sector entities than their actual risk would imply, and therefore that those entities have to pay an elevated rate for what is in fact a perfectly safe investment. Indeed it is literally safer than money in the bank, if your data are correct.

    If this is true it seems like the kind of thing that would be easily swept up by arbitrageurs. Why has it not been?

  42. mindful,
    It has not been swept up by arbitragers as the ratings agencies are not the price determiners. They are (to anyone with any brains) just another input into the mix. Arbitragers are only able to make a real difference if there is a pricing disparity. For the people who actually buy and sell these things professionally the difference never really arises.
    The reason I do not think it would work is expressed above. Before you go and ascribe motives to a strawman, how about attempting to answer the points I raised. A good example would be to try to explain why it may not “… be expensive, untimely and ineffective…” to establish such a body. This would advance the argument. Of course, if you just want to express your own prejudices, go ahead. Do not expect me to join in the process except to point out that you are making a strawman and arguing against that.

  43. AR as regards #23, I restate the same point made here by Jacob Weisberg on libertarianism.

    and which I made in the post I linked at #20

    The policies that have failed were called deregulation when they were introduced, by both supporters and opponents. If you now want to distinguish (in the argot of debates about communism) between “true deregulation” and “actually existing deregulation” feel free. I was talking about the actually existing variety.

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