Political Economy

Powerful credit-rating agencies are a creation of the government . . . what does it mean when they bite the hand that feeds them?

Aug 10 '11

Rajiv Sethi makes a point I’ve also seen elsewhere, that these credit-rating agencies are influential in large part because of fairly recent government actions:

As Ross Levine notes in his recent autopsy of the financial crisis, this is where we stood forty years ago:

Until the 1970s, credit rating agencies were comparatively insignificant, moribund institutions that sold their assessments of credit risk to subscribers. Given the poor predictive performance of these agencies, the demand for their services was limited for much of the twentieth century (Partnoy, 1999). Indeed, academic researchers found that credit rating agencies produce little additional information about the firms they rate; rather, their ratings lag stock price movements by about 18 months (Pinches and Singleton, 1978).

But then a policy shift occurred that continues to have major ramifications to this day. The SEC provided a special designation to a class of rating agencies and then proceeded to use their opinions as a basis for setting capital requirements. The selected agencies suddenly found themselves endowed with vastly increased market power and a very lucrative business model . . . This brings us to the role of the agencies in the financial crisis. The rapid growth of structured products provided the agencies with a substantial new source of demand, as well as the problem of assessing credit risk for securities of much greater complexity. Minor changes in modeling assumptions could lead to significantly different ratings for such assets. Nevertheless, there were strong incentives in place for the agencies to act as if they could make competent assessments of credit risk . . .

Sethi concludes:

Perhaps the time has come to consider a complete overhaul of this dysfunctional system. Withdraw the special designation accorded to the major agencies, so that they compete on a level playing field with new entrants. . . .

Another way to look at this is: Given all the above, those S&P dudes must really really think the U.S. is at risk of defaulting. Keeping the AAA rating would’ve been the safe default choice. Deciding to downgrade–that’s political dynamite, with a risk of losing their lucrative quasimonopoly. That’s a decision you’d only make for a really good reason. Or maybe they’re just overcompensating for all those bad AAA ratings they gave out a few years ago?