Do Not Pass ‘GO’

The origin of credit ratings agencies was in the selling of business intelligence in the late nineteenth century. That is, investors could subscribe to an agency’s reports to guide their investment decisions.

Most smaller agencies still operate this “subscriber” business model, but not so the larger ones, in particular the “Big Three”, Standard & Poor’s, Moody’s Investor Service, and Fitch Ratings. These get their income by issuing credit ratings on companies commissioned by those companies themselves. Thus a business can make sure that the market has an impartial credit report to justify their credit rating and share price.

You might think that there would be scope for malpractice in this kind of arrangement. After all, what incentive would exist for an agency to downgrade one of their customers, and potentially lose their business? Agencies argue that it would be worse to lose their reputation for impartiality.

Dancing PigsIn fact, the agencies, especially the Big Three, could be considered one of the prime causes of the global economic crisis, since they regularly assigned a rating of AAA to businesses owning large pools of mortgage debt, even when it became clear that the individual loans had been made with reckless abandon, and many would never be paid back. These banks were typically paying one of the Big Three a fee of half to one million dollars for their rating. They would “shop around” to get that AAA.

However, in the case of rating the economies of entire nations, or “sovereign debt”, the agencies have no direct incentive to exaggerate the credit-worthiness of any country. Actually, it’s in their interest to be cautious or conservative, because investors can lose money if an optimistic valuation leads them to buy bonds that eventually can not be redeemed. An investor who decided not to buy bonds on the basis of a credit rating is making no loss of money, only of opportunity.

The real issue on rating sovereign debt is that the agencies have power without responsibility. A downgrade of a nation (even the USA, as happened in August) has zero negative consequences for the agency, even though in the real world, the probability of the US defaulting on its government debt is so low as to be in the realms of fantasy.

Obviously, the same can’t be said of Greece or Ireland, but seriously, France? And Germany? A downgrade damages a country’s economy whether it reflects reality or not, but means nothing, financially or otherwise, to the rating agency.

In order to prevent the credit rating agencies being out of control, the politicians need to implement measures which make the agencies responsible for their actions. Tight regulation might be one option, but in the spirit of capitalism, why not make them legally responsible? Make sure that they can be sued for their bad advice and see if that makes them more careful.

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