Credit raters need a downgrade

The failure of rating agencies to predict defaults helped lead to the economic crisis. They need more than a slap on the wrist.US-based credit rating agencies helped cause and accentuate the current economic crisis. Yet in President Barack Obama’s plan to overhaul the nation’s financial system there are almost no provisions to firmly regulate these offenders.

Under Obama’s new plan, the shadow banking system will finally be regulated. However, the new regulations fail to recognise that investments structured by the shadow banking system were all rated with high marks by the credit rating agencies. When a rating agency gives an asset an AAA rating, the asset is supposed to be fairly default proof. The failure of the rating agencies to adequately assess creditworthiness led to the failure of the financial system.

The rating agencies have serious conflicts of interest, face little-to-no competition, constantly fail to predict defaults and accentuate the financial crises they’ve played a big role in creating. These issues need to be addressed to put this crisis behind us and prevent the next one.

It used to be that the users of credit ratings had to pay the agencies for the research they do. Now the agencies are paid by the owners of assets that ask to be rated. This creates fundamental conflict of interest problems. The New York Times put it this way: “It is as if Hollywood studios paid movie critics to review their would-be blockbusters.”

What’s more, there is little or no competition among agencies. Standard and Poor’s, Moody’s and Fitch’s comprise more than three quarters of the entire market for ratings. This concentration is locked in by US rules that make it difficult for new firms to enter the market. The new Term Asset-Backed Securities Loan Facility (Talf) accentuates these trends. The TALF was created to help financial firms supply credit to households and small business through the issuance of asset-backed securities. The TALF only accepts collateral that has been appraised by the big agencies.

In his book, The New Masters of Capital: The American Bond Rating Agencies and the Politics of Creditworthiness, University of Warwick professor Timothy Sinclair documents how the agencies failed to predict the east Asian and Enron crises. And of course they missed this crisis even though they knew better than anyone that the underlying assets of the securities they rated were packed with toxic assets. When pressed on this, they escape any liabilities because they are protected by the first amendment of the US constitution.

Agencies can be worst in the aftermath of a crisis. Because they fail to predict a crisis they downgrade a rating after a crisis hits. This prolongs and accentuates crises because nations often need to issue bonds to finance recovery. The more risky those bonds are rated, the higher cost of the financing for the issuing government.

Worst of all, when nations embark on expansionary monetary and fiscal policies to get out of a crisis, they are penalised with a downgrade. This shocked the rich world in June when the UK rating was threatened, despite the fact that the UK has never defaulted on a loan. And the UK warning was meant to be a shot across the bow to the US.

India, one of the countries on the planet the least worse off in this crisis, due to its prudential policies, is the most recent casualty. India received numerous warnings of a downgrade during its electoral campaign season. India just elected Prime Minister Manmohan Singh to another term, in part to bolster efforts to alleviate poverty there.
Yet in June, when the finance minister announced a plan to expand power, roads and aid to the poor, credit agencies threatened a downgrade. Bloomberg reports: “Rating agencies are likely to watch closely.”

The Obama administration’s financial package needs to put credit rating agencies at the centre of its reform proposals, because the agencies were and remain at the epicentre of the crisis. The raters should do business only with those who buy their services, more agencies should be allowed to operate in the market (the creation of government or UN-based agencies should also be considered) and all agencies should be audited on an annual basis and be penalised if they continuously fail to predict defaults.

Part of the reason why we are in this mess is that the agencies got a slap on the hand after the Asian and Enron crises. Let’s not make the same mistake three times in a row.

guardian.co.uk © Guardian News and Media Limited 2009

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