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The whole world in their hands: the unchallenged power of the rating agencies. By AlexWard.

by on February 24, 2012

In this bleak era of economic paralysis, the only constants that have prevailed throughout the entirety of the global financial crisis are risk and uncertainty. On January 12th, Standard and Poor’s downgraded France – joint-chief compere of the Eurozone’s economic horror show and its second largest economy. The very same day, the economies of Spain, Italy, Portugal and numerous other members of the Eurozone suffered a similar fate. More recently, Moody’s changed the UK’s outlook from ‘stable’ to ‘negative’, prompting Chancellor of the Exchequer, George Osborne, to reaffirm that the state’s commitment to austerity measures was not likely to fall by the wayside anytime soon.

In the current state of affairs, it is beyond doubt that the ratings agencies wield an astronomical level of power over governments, often cajoling them into implementing profoundly unpopular austerity measures under the threat of a downgrade. Yet, their status as the arbiters of the global economy is rarely put into question. It bears repeating that the role of these agencies is the secret to their power; they provide a sense of order and clarity to a world imbricated with uncertainty, providing impartial estimations of financial strength and creditworthiness for would-be investors.

At face value, this arrangement seems both logical and desirable. At a deeper level however, the ratings agencies can act capriciously, precipitating the disorder that they are supposed to counterbalance against. Defendants would claim that the agencies solely serve as the messenger, not in any sense the architect of all the mayhem that characterises the contemporary financial system. To counter, I would draw attention back to the original source of the current economic misery, the subprime mortgage crisis, wherein many securities rated highly by the credit rating agencies were swiftly and vastly devalued at the onset of the crisis, bankrupting countless investors and heavily contributing to the downward spiral that eventually became the global depression.

Thus, rather than mitigate uncertainty, ratings agencies amplify it. They fan the flames of speculation, impacting upon business confidence and stifling innovation as decision makers sit on capital rather than risk losing it. What’s more is that whilst risk and uncertainty propagate, the demand for the ratings agencies to impose order upon the system also mounts, entrapping the economy into a positive feedback mechanism of unpredictability.

Overreliance upon the rating agencies follows, and that’s exactly what situation we’re in currently. Worst still, the duopoly of the rating agency market, with both S&P’s and Moody’s appropriating roughly 80% market share between them, raises further concerns. In particular, in the absence of competition, transparency issues and flaws in the actual ratings themselves are pervasive. The sub-prime mortgage blunder aside, the ratings agencies’ inability to predict crises (the Asian financial crisis, Enron’s bankruptcy and deteriorations in both AIG’s and Lehman’s creditworthiness, to name a few) has raised significant criticism.

Nevertheless, there remains no panacea to replace the ratings agencies. As uncertainty becomes more of a definitive tool for understanding and framing the developments of the international economy, rating agencies will only gather more influence. They also cannot be silenced, as ratings are mere opinions, protected by free-speech laws. One option would be to reverse the outsourcing of risk judgment from governments to ratings agencies. It seems improvident to place the fate of whole currency zones at the whims of two or three private firms, who’s past record of judgment is hardly unblemished. However, nationalizing the role of ratings agencies would open a can of worms that is simply incompatible with the neoliberal model of western capitalism, rendering this option wholly unfeasible. One glimmer of hope lies in increasing competitiveness. This would ideally rectify transparency issues, whilst ensuring a certain level of prudence and diligence in the formulation of ratings. Overall though, there are no substantive or substantial signs that the ratings duopoly is to face more competition anytime soon and governments continue to act upon the vicissitudes of Moody’s and S&P’s. As such, the global economy is sure to feel the squeeze as overawing uncertainty tightens its grip. For this writer, this dreary situation calls for a downgrade of my own – from ‘outlook: negative’ to ‘outlook: bleak’.

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One Comment
  1. Edmund Robins permalink

    Alex, I have a few problems and questions of your above piece.

    1) In what way is the global economy ‘in paralysis’? Also, how can you say the only constant themes of the financial crisis are risk and uncertainty? For instance there continues to be great innovation in this sector and that the banks’ sea-change in their capital controls have made their businesses much safer – both points I feel you overlook in your sweeping judgement

    2) Would you not say that the ratings’ agencies opinions only reflect the mood and confidence of market investors, and so in the first instance the disorder that is precipitated would emanate from market forces rather than the agencies themselves? In addition I feel you downplay investors’ role in viewing the agencies’ ratings as simply opinions, as the investors who will survive in this era of rife uncertainty & risk will be those who have an idea for themselves of what they are buying, rather those who bought the CDOs and CDSs during the boom with much faith placed on the agencies’ ratings (AIG’s bust being a prime example).

    3) Could you clarify how the agencies were the ‘architects of the mayhem’ surrounding sub-prime mortgages? Was it not that the mortgage CDOs were being shown to be rotten, as the housing market took a turn in 06-07, which prompted the ‘mayhem’ you refer to. This is evidenced by Goldman Sachs and other major banks taking out Credit Default Swaps against the mortgage packages they were selling themselves.

    4) Also, how would a ratings agency bankrupt investors by downgrading the value of their CDO purchases, as their capricious (and as you indicate, fallacious) opinions are not linked to homeowners’ abilities to meet their interest payments.

    5) What is your reasoning behind saying agencies ‘stifle innovation’ by giving bad credit ratings and prompt investors to sit on their cash? Do they not, surely, increase innovation as the investors allocate their capital to the best investment options (who represent the best innovation) rather than wasting it on toxic deals?

    6) How do you envisage more competition ensuring greater prudence and diligence in the formation of ratings, where the agencies themselves are funded by the banks’ commission, where the Nash’s equilibrium would see more favourable asset ratings as the institutions themselves choose who they get to rate them? In other words, the banks’ would cherry-pick the agencies with the highest ratings for their assets, and so those agencies would be incentivised to give irresponsibly high ratings more so than now due to incresed competition.

    I look forward to reading your thoughts.

    Kind Regards,

    Edmund Robins

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