“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
James Carville, Wall Street Journal (February 25, 1993, p. A1)
There has been a lot of discussion recently about the possibility that the United States might lose its triple-A bond rating as a result of the standoff between President Obama and House Republicans. For press coverage see here, here, here, and here. For blogosophere reaction, see here, here, and here.
Speculation about the results of a rating downgrade was fueled when Mohamed El-Erian, chief executive of bond trading giant Pimco, said that the debt-ceiling political crisis in the United States has hurt that nation’s reputation in the financial markets and that the loss of the triple-A credit rating would have dire consequences.
El-Erian wrote:
America’s already-fragile economic psyche and its global standing have taken a material hit. Forget about “animal spirits” for now. Instead, worry even more about an economy that is already having tremendous difficulty sustaining an acceptable growth momentum, and that already suffers from an unemployment crisis that is increasingly protracted in nature. Analysts will now scramble to again revise down their projections for growth, and up those for unemployment… America’s friends and allies are bewildered at what is going on here (and its enemies rejoicing).
Read more here.
El-Erian’s piece in the Huffington Post generated lots of discussion. There has, however, been relatively little discussion of the history of the agencies that issue these ratings.
An excellent paper by Richard Sylla on this subject is available online. Sylla is the Henry Kaufman Professor of the History of Financial Institutions and Markets and Professor of Economics at the Stern School of Business in New York. Anway, here is the first paragraph of his paper.
When the business of bond credit ratings by independent rating agencies began in
the United States early in the twentieth century, bond markets—and capital markets
generally—had already existed for at least three centuries. Moreover, for at least two
centuries, these old capital markets were to an extent even ‘global.’ That in itself
indicates that agency credit ratings are hardly an integral part of capital market history. It
also raises several questions. Why did credit rating agencies first appear when (1909)
and where (the United States) they did in history? What has been the experience of
capital market participants with agency credit ratings since they did appear? And what
roles do agency ratings now play in those markets, which in recent decades have again
become global, to an even greater extent than previously in history.
As Sylla shows, it is entirely possible to have a lively bond market without rating agencies. Like many people, I am skeptical of the predictive value of bond ratings because they come from for-profit companies that have conflicts of interest that undermine their credibility. The 2008 Global Financial Crisis destroyed much of the reputational capital of these agencies. As we all know, the credit rating agencies granted very high ratings to dodgy subprime mortgage securities. As one observer pointed out, “a primary cause of the recent credit market turmoil was overdependence on credit ratings and credit rating agencies.” Read more about the role of the rating agencies in the subprime crisis here.
If the rating agencies turn on the United States government and downgrade its credit rating at this critical moment in the history of the American empire, it would be a rather ironic turn of events, since the global political clout of the bond rating industry is largely a creation of regulations put in place by American officials during the New Deal era. These regulations were strengthened in the 1970s, after which an increasing number of financial professionals were forced to use the ratings produced by a small group of government-approved ratings agencies. These agencies are known as “National Recognized Statistical Rating Organizations”. Read more here.
The NRSRO business is rather uncompetitive with considerable barriers to entry. As of 2011, American companies are allowed to use the ratings produced by just ten such agencies. See here. To the credit of the US SEC, which licences the NSRSOs, not all of these agencies are American. There is one Japanese firm and one Canadian company on the list, which shows that the Americans aren’t being protectionist here. In other ways, however, these agencies are remarkably homogenous in terms of their corporate structure and underlying business model. All are in the private sector. All of them are for-profit businesses. In all ten cases, the agencies make their money from payments from bond issuers rather than from the people who make decisions based on their ratings. (Holy conflict of interest Batman!) None of these agencies is a non-profit organization and it is unlikely the US SEC would designate a non-profit agency staffed by disinterested volunteers as a NRSRO. For one thing, such an agency wouldn’t have the money for the required campaign contributions to members of Congress.
I have nothing against homogeneity in an industry if the industry is functioning properly. But it seems to me that in the NRSRO business, it would be beneficial to have some heterogeneity. Why not have a mixture of non-profits, profitable companies, and government departments issuing bond ratings?
Very few people actually believe that the rating agencies have much predictive power, so by themselves their ratings wouldn’t have much impact on investor behaviour. What makes the ratings produced by these agencies so damn important are US laws that require financial institutions to take the bond ratings produced by these agencies into account.
Here is an analogy. Suppose there was a notoriously unreliable weather forecaster who worked for a particular TV station. In the normal course of events, nobody would trust his forecasts. They make decisions about travel plans, clothing choices, bringing umbrellas, etc based on the weather forecasts on competing TV stations or some other method. But if the government passed a law saying that only the predictions of this one forecaster could be used to make decisions about, say, when it was unsafe for a scheduled flight to go ahead, then this forecaster would have a captive market in the country’s airport and airlines. Moreover, if the weather forecaster had a financial stake in say, a particular airport, he or she might be inclined to say “Yeah, it’s ok to fly today” than would otherwise be the case. At the very least, there would be an obvious conflict of interest, since an airport loses money every day it is closed.
Image of a weather forecaster randomly selected from the Wikimedia Commons
At this point in the crisis, it would be worthwhile for all players and commentators to pay more attention to the history of the rating agencies and to financial history more generally. We should also think long and hard about why the ratings issued by these NRSROs matter so much.
Further Reading
Flandreau, Marc, N. Gaillard and F. Packer, (2009), “Ratings Performance, Regulation and the Great Depression: Lessons from Foreign Government Securities”, CEPR Discussion Paper 7328.
Goodhart, Charles A.E. (2008), “The Financial Economists Roundtable’s statement on reforming the role of SROs in the securitisation process”, VoxEU.org, 5 December 2008.
Partnoy, Frank (2001), “The Paradox of Credit Ratings”, UCSD Law and Economics Working Paper.
Partnoy, Frank (2006), “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers”, in Yasuyuki Fuchita, and Robert E. Litan (eds.), Financial Gatekeepers: Can They Protect Investors?, Brookings Institution Press and the Nomura Institute of Capital Markets Research.
Portes, Richard (2008), “Ratings agency reform”, VoxEU.org, 22 January 2008.
The Past Speaks 