From the TUC

Ratings agencies outsource blame

20 Jan 2012, by in Economics

Philip Stephens’ Financial Times column today asks why credit ratings agencies CRAs are so influential, given that they only tell us what everyone is already thinking (although their recent admission that growth is more important than fiscal austerity suggests they can also buck trends too). But this misunderstands quite how pernicious their role is.

It’s certainly true that CRAs like Standard & Poor’s, Fitch and Moody’s perform what looks like a hugely important function – deciding, in global financial terms, who is up and who’s down – and that they do appear to have huge influence (but see below) on the markets, especially at the moment the market for sovereign debt.

But the way they influence behaviour is not by revealing hidden truths to markets previously unaware, for example, that Italy or Greece have debt problems. They do have a tendency to encourage herd-like responses in the markets which ever so slightly undermines the intelligent markets hypothesis (as intelligent as, say, sheep) and more seriously, promotes bubbles and crashes.

But the main way in which CRA ratings affect markets is that their pronouncements are built into the algorithms that govern the investment decisions of hugely wealthy financial institutions, so that if a CRA downgrades a certain country’s credit rating, large numbers of major investors will automatically race to what is perceived as a safer investment. So the markets are only as intelligent as zombie sheep!

This sometimes has unintended and farcical consequences. When the USA was downgraded last year, for instance, many algorithms snapped into action and fled to the world’s reserve currency, the dollar, with the result that the downgrading of the USA actually reduced its borrowing costs!

But the reason CRA ratings are built into these algorithms isn’t because they are assumed to be the product of financial genius. It’s because the institutions want to outsource the blame for any problems resulting from their investment decisions. “I totally misread the markets” is a worse excuse than “I was doing what the CRAs said I should do”, apparently.

The solution to the problem of CRAs, therefore, is to strip them out of the algorithms. Although frankly, I’d also stop them taking money from the institutions they rate, too.

3 Responses to Ratings agencies outsource blame

  1. Mike Dever
    Jan 21st 2012, 1:57 pm

    I completely agree with the statement that “institutions want to outsource the blame for any problems resulting from their investment decisions.” Credit rating agencies exist because there is apparently a stronger need to institutional investors to be able to cover their asses more than make solid, individual investment decisions. The world’s governments institutionalized this behavior by requiring many institutions to buy only highly-rated (by one of the approved rating agencies) debt issues. And of course, the conflict-of-interest circle closes even tighter with the business model of the ratings agencies – the issuer pays THEM to rate THEIR bonds!

    I write about all this in my book “Jackass Investing: Don’t do it. Profit from it.” (the Kindle best-seller in the mutual fund category) and am pleased to provide readers with a complimentary link to the chapter where I cover the credit rating agencies “Myth #13: It’s Best to Follow Expert Advice.”:

  2. Mubaraq Tope Akere
    Jan 21st 2012, 5:36 pm

    Currency (ies) without a 100% backing of an intrinsic, abundant, and necessity commodity of food and agriculture as the least and real gross domestic product (LRGDP) as a unit of account; are worthless and cancerous currency (ies) as debt, and in trade. Also, as an inflationary tool with detriment to purchasing power of currency (ies).

  3. Owen Tudor

    Owen Tudor
    Jan 21st 2012, 6:40 pm

    Mike, many thanks for your comments and happy to provide the opportunity for a book plug! The conflict of interest issue – as alluded to in my last sentence – is clearly a major issue for Credit Rating Agencies that needs to be addressed.