The Tyranny of the Bond Markets
from Kevin Gallagher
Credit rating agencies played a big role in creating the financial crisis. Now they are slowing the recovery. Financial regulatory reform legislation in the US has finally put the agencies on the radar screen, but the proposals don’t go far enough.
It is now legendary that the mortgage-backed securities structured in the shadow banking system all had AAA stamps of approval by the rating agencies. Of course when the mortgage bubble that propped up those assets burst, we learned that such assets were indeed “toxic” and unworthy of such high grades. The world couldn’t handle the truth and spun into the worst financial crisis since the Depression.
In addition to getting the prices wrong and triggering crises (credit rating agencies were behind the Asian and Enron crises as well), there isn’t a competitive market for rating agencies. Just three US-based agencies, Standard & Poors (S&P), Moody’s, and Fitch have all but a tad of the market. What’s more, the agencies are paid by the owners of assets that ask to be rated, creating conflicts of interest.
The US government was quick to take the most toxic of these assets off the balance sheets of the banks that were too big to fail. Households who held pensions that were stamped by the agencies weren’t as lucky.
Credit rating agencies literally made a killing by stamping approvals on toxic assets during the run-up to the crisis. According to the Ohio attorney general, agency revenues from structured financial products in 2006 ranged from 50-75% of all revenue for these firms. Moody’s raked in $887m that year, over half its revenue. Ohio is suing the agencies for $457m in alleged losses to Ohio pension recipients alone. Problem is, rating agencies have never lost a case because they claim that they are mere opinion writers and are protected by the first amendment. Moreover, suitors have to prove that the agencies that get it wrong are doing so as an act of “actual malice”, which is a high bar in a courtroom.
No one stepped in to regulate the agencies in the aftermath of the crisis. So they’ve reared their heads again, this time zeroing in on government debt. Many of the hardest hit governments, rich and poor alike, have borrowed funds in the bond markets to stimulate their economies into recovery.
Well, the rating agencies grade these bonds too. Many economists shake at the deficit fetishness that has overtaken the press and some members of the US Congress, warning that a fragile recovery from the crisis will do more harm in terms of investor confidence. Spending when times are bad, cutting spending when the economy is performing well, is good economics.
Regardless of the economics, the rating agencies are tyrannising governments for doing the right thing. It was Moody’s downgrade of Greece that pushed that country over the edge, and last week Fitch’s downgraded Portugal’s debt. Is Portugal next? In December all three agencies downgraded Mexico for not sufficiently raising taxes and that country has had its worst year since the Depression. Most strikingly, credit rating agencies have threatened to downgrade the debt of the UK and the United States – two countries that have never defaulted on their debts.
The good news is that the Obama administration and Congress is set to regulate the rating agencies through financial regulatory reform legislation currently pending in Congress. The Senate bill would create an Office of Credit Ratings at the SEC to watch the agencies and the office would have the power to shut down agencies that continue to make mistakes. The House bill would create liability windows for investors to file lawsuits whereby suitors would only have to prove “gross negligence” rather than “actual malice”.
However, neither bill changes the “issuer-pay” model for compensating agencies that is rife with conflicts of interest. Neither bill deals with the competition problem: the big three rating agencies’ stronghold on the market will hold. Perhaps most concerning is the fact that there is much less in these bills about how government debt ratings should be regulated. Foreign governments that go bankrupt and spin into crises can’t sue US ratings agencies to compensate their workers who lose their jobs.
Bond raters should do business only with investors who buy their services, not the issuers who want good ratings. More agencies should be allowed to operate in the market. The creation of public agencies for corporate debt, and UN-based agencies for government debt should also be considered. The legislation idling in the US Congress takes some solid steps forward. But these bills will need to get tougher in order for the world economy to escape the tyranny of the bond markets.
Published in The Guardian Friday 9 April 2010 14.30 BST