Why economic advice from rating agencies should not be trusted

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The Australian government is using warnings from ratings agencies like Standard & Poor’s Global Ratings (S&P), which placed Australia on negative watch during the election, to justify taking fiscal action. In reality, S&P (and the other two credit rating agencies) have no moral or technical authority to issue such a warning.

S&P has warned that Canberra must take “strong” fiscal action to address “significant” budget deficits, which is unlikely in the near future, or risk losing its AAA rating.

However, rating agencies should not be vested with this kind of power. In fact, it is not at all clear why the rating agencies, including S&P, are still in business. These agencies helped cause the global financial crisis, but survived due to lack of political will and because ratings are required by law as a regulatory requirement.

The reputation of credit rating agencies was tarnished not only by the global financial crisis but, before that, by the Enron scandal, the Asian financial crisis and the financial collapse of New York City in the mid-1970s. agencies show the inability to detect near misses, defaults, and frequent financial disasters, as well as the inability to downgrade troubled companies until just before (or even after) declaration of bankruptcy. In fact, the rating agencies follow the market, so the market alerts the agencies in the event of a problem, and not the other way around.

During the global financial crisis, hundreds of billions of dollars worth of triple A-rated mortgage-backed securities were abruptly downgraded from triple A to junk (the lowest possible rating) within two years of issuance. the initial score. . About 73% (over $800 billion) of all mortgage-backed securities that a rating agency (Moody’s) rated triple-A in 2006 were downgraded to junk status two years later. In the United States, the Commission of Inquiry into the Financial Crisis attributes much of the responsibility for the global financial crisis to agencies, while European Union officials blame agencies for having contributed to the advent of the European sovereign debt crisis.

The failure of rating agencies can be attributed to negligence and incompetence. Starting with the negligence, there is every reason to believe that the rating agencies did not check the strength of their rating because customers were willing or coerced into buying it. Negligence means that the rating agencies were able to exercise good judgment, but did not make the effort to do a thorough job. Given the bullishness that prevailed as the crisis approached, agencies opted instead to receive big pay for lousy work.

The agencies did not have the expertise to do the work entrusted to them, particularly with regard to the assessment of the risks inherent in structured products. In testimony before the Financial Crisis Inquiry Commission, Gary Witt (formerly of Moody’s CDO unit) said that Moody’s did not have a good model on which to estimate correlations between asset-backed securities. mortgages, so they “invented” them.

Rating agencies promoted inferior products knowing the quality of these products. The rating agencies knew that the risk was high or that the securities were not really AAA, yet they upgraded them to AAA.

While credit rating agencies may be seen as “willing victims” of investment bankers and securities issuers, there is also evidence to suggest that the transparency, quality and integrity of other credit rating practices and processes agencies have been significantly reduced. This is to support the extraordinary growth of agency structured finance operations. Indeed, the agencies deliberately overlooked the possibility that the rating might have been unduly high.

For all these reasons, rating agencies should not be taken seriously. Agencies are stricter in rating countries than in rating private sector companies, as they do not charge commissions for rating countries, which is the “public relations” part of doing business. Credit rating agencies have every right to compete on a level playing field, but these agencies should not have oligopolistic power and should be forced to operate under an investor-pays model to avoid conflicts of interest. interests.

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