A certain percentage of the US financial community smiled late last week when they read, “Italian authorities seized documents from the Milan offices of ratings agencies Standard & Poor’s and Moody’s Investors Service. The seizure was part of an investigation that the two agencies were allegedly engaged in dubious movements in domestic share prices.” The raid is seen as the Eurozone government’s way of getting back at ratings agencies, which recently downgraded the credit rating of Greece, Portugal and Ireland (Italy and Spain are said to be on the list of nations due for a downgrade).
But on Friday afternoon Standard & Poor's notified the US Treasury that it was about to downgrade the U.S. government's "AAA" sovereign credit rating which impacts the $9.3 trillion in US government debt. S&P cut its top-notch long-term credit rating for the U.S. Treasury's debt to AA+ with a negative outlook. But it wasn’t without warning: in July S&P warned that if the U.S. government didn't approve a credible medium-term plan to shrink its fiscal shortfall, it would downgrade the rating even if Congress approved a debt deal that raised the Treasury's borrowing limit. As we know, Congress did, but not enough to S&P’s liking, and also increased the debt limit, which some liken to “raising the maximum blood alcohol level so that you’re not really considered drunk.”
Fitch Ratings and Moody's Investors Service both affirmed their top-notch ratings of the U.S. during the week, although Moody's assigned a negative outlook to its "Aaa" rating. The S&P news was pretty much anticipated by the market. The downgrade by S&P generated anxiety in the global equity financial markets, but others point to the fact that investors don’t really have anywhere else to put their money, even with the yield on our 10-yr T-note down to 2.34%! Now only four major countries have the AAA rating: Canada, Germany, France, and the United Kingdom. Is US debt now the best of the worst?
Some investors may be forced to sell Treasury securities as they are required to hold only AAA-rated assets. But what, exactly, does a rating agency’s opinion matter? They’d like investors to believe that the source of their power is the accuracy of their opinions, but what seems to matter to a greater degree is the extent to which their ratings have been embedded in various rules and regulations across the financial world. In 1975 the SEC began to use such ratings to calculate how much capital broker-dealers should be required to hold, and designated a few firms as "nationally recognized statistical rating organizations," or NRSROs. Now NRSRO ratings are embedded in thousands of regulations and private contracts, if not more, determining what securities money-market funds would be permitted to own, how much collateral counterparties would have to put up in trades, among countless other matters.
Rating agencies have been viewed by many in the mortgage banking world as miss-rating hundreds and thousands of mortgage-backed securities, therefore contributing to the credit crisis in which we find ourselves. The “whip” has come down on brokers, lenders, servicers, banks, and to some extent investment banks, but rating agency’s business models have not changed much. And given how often their ratings appear in rules and regulations of banks, federal agencies, money managers, etc., it may not be feasible or practical to eliminate ratings. But there is an inherent conflict of interest when a security issuer pays the rating agency to rate one of its securities.
The detrimental role of credit rating agencies Moody’s, S&P, and Fitch was noted in the U.S. Financial Crisis Inquiry Commission’s report said “the three credit rating agencies were key enablers of the financial meltdown." A European Parliament report highlighted three key problems in the industry: lack of competition, over-reliance on external ratings in the regulatory framework, and no liability for ratings by the agencies. Further, ratings changes are lagging indicators: downgrades or upgrades mostly reflect information already analyzed and digested by financial markets. In response, regulators and legislators on both sides of the Atlantic drafted new rules to reduce the intrusion of rating agencies in the regulatory framework. New entries into the business such as Kroll or Rapid Ratings, are trying to address that issue.
If the changed rating leads to hundreds of billions of additional borrowing costs, it will become a self-fulfilling prophecy for the US government (instead of spending on improving our economy, it will spend more on interest payments to debt-holders) and the consumer (who will pay more in taxes to cover the increased expense – some believe that the government merely takes money from one group and gives it to another, and the average consumer will bear the brunt).
At this point, S&P’s reasoning about the inability of politicians to address the real issue of fiscal sustainability is generally viewed as correct, and most traders think that the short-term effect on Treasury yields of S&P’s decision will be small. But is it really the role of the rating agencies to influence or determine political strategy? Perhaps - there is no inducement for politicians to be fiscally responsible, and it seems that fiscal responsibility is not a path to reelection.
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