Standard: Poor

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.

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40 thoughts on “Standard: Poor

  1. So if the Mafia corrupts the government, it’s the government’s fault?

    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.

  2. “Standard: Poor”. Great heading, important content. I hear this article attracted
    interest in some chat-rooms with drinking facilities around Bond Street in Sydney.

  3. 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.

  4. 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.

  5. 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.

  6. 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.)

  7. 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?

  8. we get traders saying that it’s the government’s fault for not properly regulating them

    Really? Do you have a link?

  9. 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.

  10. 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:-

  11. 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.

  12. 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.

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