Last week’s downgrade of the US AAA rating (to AA-plus) by Standard & Poor’s begs a look at S&P’s own definition of what its ratings are. Quoting from its website: “A Standard & Poor’s Issuer Credit Rating is a current opinion of an obligor’s overall financial capacity (its creditworthiness) to pay its financial obligations … it is not a statement of fact or recommendation to purchase, sell, or hold a financial obligation issued by an obligor or make any investment decision. Nor does it comment on market price or suitability for a particular investor.” [Emphasis mine.]
In other words, it is simply the opinion of an organisation that is dedicated to studying credit risk — similar, in a sense, to Mecklai Financial’s opinion about the likely movement of the rupee.
There are two key differences, however. First, if we are wrong consistently, we lose clients (money); S&P doesn’t. (Incidentally, when I speak of S&P, I include other credit rating agencies, like Moody’s and Fitch.)
Second, pompous as I may be, the impact of our opinion is relatively limited, driving, perhaps, as it does, decision-making on about $50 billion a year of foreign exchange exposures, largely in India. The impact of S&P’s opinion is there for all to see.
And while I cast absolutely zero aspersions on S&P’s capabilities, the problem, as has been loudly apparent for nearly ten years, is the manner in which S&P is structurally inserted into the global financial system. This issue burst into prominence back in 2002, when the Enron scandal exploded, painfully displaying the structural flaw in the business model of credit rating agencies (as, indeed, audit companies), whereby they get paid by people whom they rate.
There was, at that time, some talk and discussion on fixing this fundamental flaw. However, finding that unwinding the role of credit rating agencies would require restructuring the fundamental framework of global finance, which would be extremely difficult and costly, the situation was glossed over by burying Arthur Andersen and opting for a tighter (ha ha) self-regulation.
If, however, the political will could have been mustered (ha, ha, ha, in the face of financial sector lobbying), it seems possible that there would have been no US-centred credit derivative crisis, and, as a counterpoint, substantially slower economic growth over the 2003-07 period. Net net, the US budget deficit would have been substantially lower, since the impact of slower growth would have been minuscule compared to the estimated $4-trillion expansion in US debt as a direct result of the crisis.
I recognise, of course, that “if” is, perhaps, one of the largest words in the English language, but let me persist. Clearly, since a key element of the solution would be to remove the credit rating agencies from ALL regulatory prescription, their opinions on Greece or Portugal or Ireland would carry approximately the same weight as mine; as a result, the European Union would have much more time to address and fix their problems, which, of course, were partly created by the US-centric credit crisis, which, in turn, was partly created by the continued insertion of credit rating agencies into financial decision making.
Incidentally, it is worth noting that while the credit rating agencies are paid by companies to rate them, sovereign ratings are done without charge, thank you very much. The storms created in Europe and now, possibly, globally, suggest very pointedly that if the rating agency business model for private companies had been changed from “issuer pays”, as had been recommended by several analysts (self included) at the time of Enron, it is fairly certain that, even if the AAA-rated CDS/CDOs did come into existence, they would have been downgraded much before they could do the substantive damage they did.
Most importantly, of course, if regulators did not prescribe capital requirements based on private company ratings – boo to Basel 2 – financial markets would be substantially safer, albeit supporting slower economic growth, a higher cost of capital and much lower profits for the financial sector.
So, is it time to shoot the messenger?
Well, given the high trauma that currently afflicts the global economy, which requires faster growth and a lower cost of capital as critical medicine, it may, perhaps, not be the best move at the current time.
However, it is crucial that the world’s regulators focus on the issue. Dodd-Frank is a start, but with US politics having turned into a tasteless circus, change could become even more glacial there than in other poorly-governed countries.
Perhaps, this is an opportunity for the Reserve Bank of India to take the lead and bring India back into the spotlight by proposing and driving a global panel to fix the credit rating problem once and for all.
