Blogs > Liberty and Power > Rating the Rating Agencies

Jul 27, 2011

Rating the Rating Agencies

Marc Joffe, a former employee of Moody's, has just posted an outstanding explanation, entitled "US Debt Ceiling Crisis: Rating the Rating Agencies," of why the rating agencies have strong incentives NOT to accurately downgrade government issues.

As Marc points out: "since rating agencies are regulated by the United States, European Union and other sovereign authorities, they may have reason to fear retaliation from their regulators. While such fears appear to have a basis in Europe where official criticism of the agencies has been frequent, we have yet to see a similar problem in the United States.

"Second, sovereign rating changes may impact other ratings in ways that create commercial challenges for rating agencies and investors. Given the dependence of numerous bond-issuing entities on the US government, a Treasury downgrade may trigger a large number of municipal, corporate and structured finance issuer downgrades as well. This cascade of downgrades would impose challenges on a rating agency’s internal systems, staff research skills and relationships with affected issuers.

"To the extent that certain institutional investors are restricted to investing in AAA securities, a Treasury downgrade would result in the forced liquidation of many assets. Institutional investors – who often purchase research, data and analytics from ratings firms – may react negatively to such a scenario. Moreover, such portfolio changes could substantially impact interest rates. If these interest rate changes are blamed on the rating agencies, they may suffer reputational consequences."

He concludes: "In short, the leading credit rating agencies are belatedly awakening to the fact that a dysfunctional political system and long term fiscal imbalances have created significant risks for Treasury investors. . . . That said, investors would ultimately be better served by measures of advanced economy sovereign risk that react more quickly and are less burdened by potential conflicts."

Go here for David Henderson's comments.

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