S&P downgrades the US and their own importance

So Standard and Poor’s has stripped the USA of the AAA rating for its federal debt. A lot of media attention is paid to this fact and legions of experts are being asked by serious-looking news presenters: Is this really the end of the world?

Fortunately it is not.

My initial reaction was that if Standard and Poor’s put the same good analysis into the US government debt as they put into the analysis of Sub-Prime Mortgages, we are probably fine. Readers are reminded that Standard and Poor’s together with Moody’s and Fitch were caught pants down having essentially eschewed even a minimal research effort in order to maximise revenue when CDO’s were all the rage at 5 years ago.

Since then, the three US government chartered ratings institutions have done quite some work to re-establish their tarnished image and - one presumes – their revenue. They have not really succeeded.

It is a fact that the ratings institutions are home to a series of conflicts of interest that would have clients run away screaming. Their business model is that they are paid by the issuers of the bonds to be rated. They cannot be sued for damages in case they are mistaken, since they simply get away with invoking the First Amendment to the US Constitution: Their expensive analyses are simply expressions of the right to free speech. They have a government-approved monopoly on the rating of nearly anything. Like auditing companies it is considered suspicious if an issuer terminates the contract with them. They do not shy away from rating a whole “production chain” of derivative products, including the insurance companies.

Despite an appalling track record, these institutions still hold considerable power. It is because pension funds and other institutional investors across the globe have given themselves internal guidelines that essentially dictate the portfolio composition on the basis of the ratings of the bonds.

Doing so of course frees the institutions of the responsibility for having an informed opinion about the assets they hold. That reduces the cost of running an investment department considerably.

It is not because of the quality of their analysis that ratings matter. They matter because they have become a convenient replacement for independent thinking. And because of the way huge amounts of money may move as a result.

The US government and congress of course now protest: S&P are wrong. So did the Greek government and parliament as the ratings downgrades fell thick and fast over Greece the past 15 months. They know very well that money may move out of their assets as a result, pushing up interest rates in the process.

Fortunately there are signs that the financial markets have learnt to take the ratings with a pinch of salt. After some noise, investors probably will conclude that there are no compelling reasons to reshape portfolios on the basis of the downgrade alone.

The only alternative is of course to modernise the ratings institutions. They should be made liable for their own mistakes (well, not exactly in fashion in the financial sector these days). More ratings agencies should be established. Government licensing should be withdrawn and new entrants should be given easier access. Government or supranational institutions should get involved. That would be the only way of putting an end to the political meddling and abuse of monopoly powers so blatantly displayed by the ratings institutions.