by the excellent John Quiggin
October 20, 2008
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October 20, 2008
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The present financial crisis is notable for the lack of high-profile villains upon whom blame can be pinned. There is no obvious Enron or Long Term Capital Management. Rather, the entire financial system has failed, and the checks and balances that were supposed to prevent such failure have proved useless.
Among the most prominent checks and balances are private sector ratings agencies, of which the most prominent are Moody's, Standard & Poor's, and Fitch. Although these agencies claim only to offer opinions, and therefore to fall under the protection of the First Amendment to the US constitution, they have long-held quasi-official status.
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There are a number of explanations for the failure of the ratings agencies. First, like most participants in global financial markets, they have shown themselves to be subject to the euphoria that is associated with a booming market, and the prosperity it brings to the financial sector. Second, they are subject to inherent conflicts of interest, since the issuers of financial securities pay to have them rated.
Third, and most importantly, they have a long-standing bias against the public sector. This is reflected in the fact that state and local governments, which rarely default on their debt, are assessed far more stringently than corporate issuers. In the last year, thousands of private-sector securities issued with AAA ratings have been downgraded to junk, and many have subsequently gone into default.
By contrast, defaults on government debt have remained rare. One effect of the differential ratings practices of the agencies is that government borrowers have been forced to seek insurance from bond insurance companies such as AMBAC that are, in reality, less sound than the governments they are insuring.
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The ratings agencies have failed to do their job. If they can persuade private firms to overlook this failure, and take notice of their opinions, that is all well and good. But they should no longer be given the backing of governments, and their ratings should not be treated as relevant information for the purposes of financial regulation or public policy.
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