By Michael Hirsh
August 8, 2011
The Treasury Department and the Federal Reserve have already revealed what their strategy toward Standard & Poor's will be now that the agency has stripped the U.S. government of its AAA rating: to destroy S&P's credibility.
They can make a pretty good case. It's not just that S&P revealed its ratings process to be corrupt and deeply flawed during the subprime mortgage bubble, as it gave inflated AAA ratings to bad securities in order to satisfy its investment banking clients, according to the Financial Crisis Inquiry Commission report. It's also that the ratings agency appeared to go well beyond its ambit this time by taking it upon itself to assess, as it said in its report Friday, the "effectiveness, stability, and predictability of American policymaking and political institutions."
Rep. Brad Sherman, D-Calif., a leading voice on Capitol Hill for ratings agency reform, seconded the Obama administration's approach in an interview with National Journal on Sunday. "They did this on the theory that Washington might deliberately refuse to pay its debt because of a political impasse. But I don't know what makes them experts at this. They don't have anybody over there who has ever sat on the floor of the House," said Sherman. "S&P's main job is rating private issuers, and they have some expertise in that, although obviously they got it pretty wrong in mortgage-backed securities. But in this case you need to be a political scientist and not an MBA. And I don't know if they've got any political scientists over there."
The problem with this line of attack is that S&P is not the first ratings agency to downgrade U.S. debt. It was preceded by a much smaller but arguably more credible agency, Egan-Jones Ratings Co., which on July 16 also reduced the U.S. credit rating to AA+, although it did not include a "negative" outlook. In an interview on Sunday, the managing director of Egan-Jones, Sean Egan, said that his own decision was driven by the worrisome size of America's debt to GDP ratio, nearly 100 percent by his estimate, and by the inability of policy-makers in Washington to come to any kind of intellectual understanding about the economic causes of America's debt crisis.
Egan said he would like to see some kind of common ground, which currently doesn't exist, between the "neo-Keynesians" in the Democratic camp, who believe in more government stimulus, and the "neo-Libertarians" on the Republican side who simply want to reduce the size of government. "I don't think the political leaders have a handle on what country is faced with. They still don't understand the underlying factors," Egan said. "The economics comes first, and then the politics."
Congress and the Obama administration, he said, must arrive at some kind of "new framework" for "what will make America more competitive, such as enhancing the quality of the education system, double-checking the wisdom of spending $3 trillion on three undeclared wars, and determining whether or not sufficient checks and balances exist so the credit crisis won't recur. Of the $14 trillion or so in U.S. debt, $3 trillion was the result of the three wars, and $2 trillion was because of the credit crisis."
Egan leaves himself open to the same kind of criticism being directed at S&P, of course, which is that a rating agency is supposed to be analyzing securities, not national politics. At the same time, there is little doubt that the impasse over two fundamentally different economic philosophies is partly what underlies the political gridlock in Washington, as National Journal reported in May.
Egan-Jones, while a relatively tiny firm, earned plaudits in the run-up to the financial crisis by "warning investors about poor credit quality long before the Big Three ratings agencies," according to Fortune magazine. Sean Egan has long been a critic of those agencies, S&P, Moody's and Fitch, because their revenues derive from the fees they receive from the investment banks whose securities they rate. That creates a potential conflict of interest, in that the agencies can succumb to temptation-and often did during the credit bubble-to deliver whatever ratings their clients pay for, even if they aren't justified. Egan-Jones, by contrast, earns its revenues from investors who subscribe to its service.
The U.S. Treasury in recent days has called the S&P downgrade fundamentally flawed, attacked its math, and has sought to discredit the agency by citing its poor performance during the credit bubble. The Fed, meanwhile, has directed the banks under its supervision to effectively ignore the S&P analysis.
But the government is somewhat conflicted in attacking S&P, because one of its chief defenses is that two other agencies also considered complicit in the subprime bubble, Moody's and Fitch, have maintained their top ratings on U.S. debt. "The worst thing we could do is to be seen as railing against S&P and rewarding Fitch or Moody's," says Sherman. "To say: I don't agree with what S&P did, but I do agree with what Moody's and Fitch have not done."
Despite some moves in Congress to change their behavior, U.S. authorities are still treating the ratings agencies as linchpins of financial stability. Like many of the big banks, the agencies have been deemed too big or important to the system to fail. Their prominence in the financial landscape is an ironic result of the government's efforts to fix the system after the Wall Street mania of the '20s led to the Great Depression. As part of the era of Glass-Steagall reforms in the 1930s, regulators told banks that if they were going to hold bonds, they must be "investment grade" and a handful of agencies grew up to vouchsafe that assessment. Today the main ratings agencies continue to be anointed by the government as "Nationally Recognized Statistical Rating Organizations" or NRSROs, in other words as arbiters of what banks, pension funds, and others restricted to "safe" investing can legally buy.
Although efforts were made under the Dodd-Frank financial reform law to expand the number of NRSROs (Egan-Jones became on in 2007), the rules implementing those changes have yet to be written (the deadline is next July). Meanwhile the government must deal with the market fallout from the debt downgrade by discrediting the same ratings agency it has previously worked to enshrine in the financial system.
But the government may not have any choice now, given that the U.S. will be saddled with S&P's downgrade for years. Sylvain Raynes, a former Moody's executive who has become a severe critic of the ratings agencies, says that the S&P action has undercut the fundamental logic of the ratings system and created an inconsistency in S&P's other ratings. That's because the United States has always been the touchstone--the standard--by which all other securities are rated, he says. "Does the U.S. have less ability than, say, Pfizer or Exxon Mobil to pay its debt? As a result of this rating are we going to downgrade those companies?"
The most telling judgment will come from the markets this week, of course, and the message may well be mixed. "If you thought that maybe the U.S. might possibly default on its debt, then you'd think that things are going to hell in a handbasket," says Sherman. "But if things are going to hell in a handbasket, then you've got to buy U.S. Treasuries."
By Michael Hirsh
August 8, 2011