The truth about Credit Rating Agencies and speculators

2012-07-17

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“Ban Credit Rating Agencies!” is the kind of call we hear every time there is a downgrade of the creditworthiness of an ailing Euro zone economy. Uttered by demagogues or other “socially conscious” opinion-makers who think that downgrades per se cause the crisis, this cry against “the speculators” is supported by masses of European citizens. Their principal idea is that these downgrades worsen the position of hardly-pressed Euro area member-states; and as such something should be done to mitigate such a potent threat to our institutional order and social fabric. It is alleged that if we ban or stringently regulate these sirens, then our countries will no longer fall victim to “market attacks”. We are made to believe that controlling credit rating agencies will offer EU policy-makers the chance to implement their agenda with greater ease; and therefore the European citizens will not have to experience untold suffering.

After all, as the President of the European Commission, Mr Barroso, once said in an infuriated reply to some credit downgrades: “our institutions know better […] our analysis is more refined and complete”. Since it is somehow established that the EU’s omniscient bureaucracy knows better, it would be reasonable to prohibit or drastically diminish the scope of action of credit rating agencies; and perhaps replace their function with some Euro-wide board that will feature objective descriptions and detailed ratings of each and every country in the euro zone; always based on “our own” more credible information and “refined” analysis.

This view is widespread as it is expressed by top-ranked EU officials and other policy-makers, while it enjoys the support of newspaper editors, political parties, NGO’s, quangos, do-gooder groups and other activists. In fact this idea is so popular that even the most absurd of libels against credit rating agencies in particular and the “markets” or the “speculators” in general, is thought of as a self-evident truth.

While it would be safe to go along with the trend and replicate the tissues of misunderstandings and fallacies peddled by the media and the political elite, each time there is a credit downgrade; I shall instead state my objection to the above account. My disagreement will be delineated in two parts. Namely: (i) core fallacies, (ii) cronyism. My conclusion is twofold: (1) the real problem is the inability or unwillingness or cautiousness of European leaders to proceed with determined banking/fiscal/political integration, (2) the set of perverse policies, support, pampers and other favoratist governmental edicts needs to be revised so that credit rating agencies (and megabanks) will no longer enjoy an official oligopoly status, but will instead be subject to the forces of the market, and the potential losses therein.

Core fallacies

At first let us unearth the two core fallacies that underpin the above-mentioned fancies:

The markets are treated as ontological entities

One only needs to open almost at random a newspaper, magazine or website critical of “the markets” to observe a truly unique and spectacularly chimerical conceptualization: namely that the “market” is “deciding”, “acting”, “thinking”, “conniving” etc. Markets are treated as if they were beings of their own. One may say that such phraseology is but a mere poetic representation of complex phenomena and is only used for conveniency in writing. Though in general such a justification would indeed be legitimate, I nevertheless contest such an argument. I do not think that such phrases are only used as mental shortcuts, since it is crystal clear to anyone who is aware of social sciences that there always is a tendency for generalized aggregations, simplifications and stereotypes in thinking, writing and researching. In particular disciplines such as macroeconomics, sociology and certain strands of political science and history, have as their subject of study the “society”, or the “economy”, or the “nation”, or in general any other arbitrarily defined group.

To such disciplines the individual does not really exist, as they are only concerned with the given group. These group concepts are fallaciously treated as if they were distinct agencies with faculties of acting, thinking, feeling and discerning in and of their selves. For example the macroeconomist is concerned with the economy as a whole and develops elegant mathematical models and theorems that depict and even predict the “behavior” of this fictitious entity.

Yet the plain fact is that there is no such thing as “the economy”, which can be observed in the real world. The concept of “the economy” is but a mere mental tool we humans use to conduct thought experiments, or in other words to conceptually divide things that in the real world are inextricably bound up together. An independent entity named “the economy” does not exist and can never be observed as such. Despite that the devoted macroeconomist continues to follow his chimera and draws several conclusions out of his study, which are in most cases mechanistic and misleading since the very premise is false.

In truth all that exists are individuals who have established their own imaginary institutions and who live together in what we call “societies” or “communities” (for more see: Castoriades, Cornelius. “The Imaginary Institution of Society”). These individuals are the only beings who possess faculties of acting, thinking, feeling and judging. The groupings that politicians, theoreticians or scientists might make, such as “the nation”, “the economy”, “the team”, “the party”, “the society”, are nothing more than mere concepts and/or imaginations, which certainly lack any capacity of acting, thinking, feeling and judging in and of their selves. To speak therefore of a group mind, or a national character, or indeed of “markets attacking nations”; is but a crass misinterpretation of reality. Such fictions and figments cannot possibly be accepted if we are to make any serious discussion.

Utopian authors of such kind can be found on both sides of the spectrum from the nationalists who think of “the nation” as if were a real being of its own; to the marxists who have on one hand “discovered” some irreversible constant of history, while on the other have been treating people as mere automatons that only operate in accordance with their “class interest”; whereby the concept of “class” receives a mystical understanding as it were an ontological entity.

To make it clear, groups of all sorts are but imaginary constructs. The truism is that only individuals think and act; and individuals is all we have in this world. As such the whole debate of “the markets”, “the states” and “the nations” being at odds with “one another” is but a mass of fantasies at best and egregious fallacies at worst.

The warfare-like language is misleading and inappropriate.

As stated above, there is no such thing as “the market” with powers of thinking, acting, feeling and judging; and a fortiriori the idea that “markets” attack is from the very outset completely absurd and meaningless.

Markets do not attack. First because they do not exist at all, as distinct agencies that could “act” against (attack) someone or something, in this case our nations; and second because the whole concept of “attack” relates to situations that have nothing to do with the decisions of (economically) acting individuals.

When for example Greece has to pay 25% interest in order to borrow money, it is not because of some metaphysical voracious appetite of a fictitious being called “the market”; but the consensus among individual investors who have taken into account their implicit and explicit costs, together with any other available information they might have; and have reached the conclusion that Greece cannot possibly repay its debts, thus the risk premium is significantly greater than the rest, hence the higher interest rate.

This is not anything like an attack and can never be considered as such. Only governments, army generals and despots may launch an attack against people. Investors can only invest or abstain from investing in a given security, or in a given country. Investors are of course individuals, and individuals have the freedom to act freely. Thus no one has the right to say that an individual or a group of individuals who abstain from investing in say Greece, is somehow “attacking” Greece. The same can be said for all those who choose to withdraw their savings from Greece in search for safer destinations for their property.

Moreover the concept of an attack implies that it is the unwillingness of investors to invest which causes the crisis; that it is because of these “attacks” that the euro area can actually disintegrate. If we strip away any absurdities of conspiracy theorists and focus only on the argument of well-meaning people; such a mode of thinking is erroneous as it puts the cart before the horse, by completely neglecting the very reason investors changed their behavior in the first place.

In particular an investor will be more risk averse in case the circumstances change; if for instance the political system becomes volatile, or the state imposes taxes and arbitrary cuts every few weeks, or the legal framework is constantly revised, or political leaders keep dithering about the solution to the crisis etc. Investors will abstain from putting their money in a country if they feel that their money is at greater risk; conversely they will be perfectly willing to invest if they expect higher returns. To be sure there is nothing related to the kind of warfare language we always come across in such cases. Investors only act in accordance with their incentives and their expectations (whether those are correct or not is irrelevant).

Therefore if we really want to be precise and specific in our discussions on the role of credit rating agencies and/or speculators in the eurocrisis, we need to abandon such rhetoric. Only in doing so, will we comprehend the issue and find the solution to it. Misleading parlance is but a gift to demagogues, despots, misanthropes and others who may only do more harm than good.

Credit rating agencies and cronyism

From the more theoretical we may now proceed to the practical. Ever since the Great Recession commenced, the three established credit rating agencies (Standard & Poors, Moody’s, Fitch) have lost the “credibility” they once enjoyed. Their excellent ratings for financial derivatives and other assets that proved to be toxic, effectively forced investors to reconsider their methods in calculating risk and in pricing assets. These agencies proved to be utterly oblivious in predicting the crisis, as their ratings suggested that the market was rather robust, when in truth the bubble was becoming increasingly unsustainable. The grand failure of these agencies (and their regulators) to calculate risk is to a large extent rooted in bad regulations and the perverse incentives these engendered. Though it is commonly believed that credit rating agencies are byproducts of unregulated markets, the fact is that the exact opposite is true.

Economist and fellow blogger Vuk Vukovic trenchantly argues that Credit Rating Agencies enjoyed an official oligopoly status for several years. In his research paper titled “Political economy of the US financial crisis 2007-2009”, he states the following:

The rating agencies were, like Fannie and Freddie, privately owned companies that enjoyed large government benefits. A large amount of institutional investors such as retirement funds, insurance companies and banks were forbidden to purchase securities with a lower rating than BBB as determined by the recognized rating agencies. The regulator in certain cases allowed only the purchase of highest AAA rated securities creating thus a favourable market for credit rating agencies. In 1975 a government regulating agency, Securities and Exchange Commission (SEC), gave an oligopoly status to three rating agencies in the US. Standard & Poor’s, Moody’s and Fitch became the only agencies that had the right to give out official ratings to various market securities. They were set as NRSROs (Nationally Recognized Statistical Rating Organizations) and they were the only ones good enough to comply with SECs regulatory requirements in order to evaluate the riskiness of a security.

Such a decision brought about a large distortion of the financial market as the impact of the decision had severe consequences on fi nancial stability. The regulators restricted the supply of ratings, empowering only the NRSROs to provide ratings to which the rest of the fi nancial industry needed to comply. They also increased the demand for rating agencies services as the entire fi nancial industry that was under regulatory supervision had to use the NRSROs ratings in order to determine their capital requirements. The government was also using the same ratings, as all the securities issued by the government, including its GSEs, were rated with the highest investment grade. Companies that would not use the NRSROs ratings faced a limited market for their securities. The system became much too dependent on the role of the rating agencies.

“The rating agencies faced little market discipline, had no significant regulatory oversight, were protected from competition by regulators and enjoyed a burgeoning market for their services” (Levine, 2010). In a situation with limited competition due to a restricted access of entry to the market the agencies had no incentive to use up to-date methods and no incentive to reveal their credit making process creating thus a lack of transparency. There was no market-correcting mechanism to ensure accuracy. In addition, the agencies operated in a particular business model where the “issuer pays” for the rating. Before the 1970s the agencies were operating in an “investor pays” model where if one agency was giving out bad ratings the customer would simply buy the rating from one of its competitors. The new model of “issuer pays” automatically implies the problem of a conflict of interest. Companies prefer favourable ratings as this can lower their costs of capital. They care less about the accuracy of the rating. Since the rating agencies depend on revenue from the securities issuers, who wish for the best ratings possible, the desire of the agencies to please their customers may result in sub-optimal ratings.

I find the point of Vukovic crucially important. But in case someone thinks that this was some “American disease”, I have to point out that the European Central Bank followed a similar path, as it officially used the ratings of these three agencies to evaluate the condition of the European banking system, within the context of “External credit assessment institution source (ECAIs)”. In a reply to the Commission, dated February 2011, the ECB makes the following remark (emphasis mine):

The Eurosystem has a keen interest in the policy debate concerning possible measures addressed to reduce overreliance on external credit ratings, in consideration of the important effects that the perceived existence of shortcomings in the rating activity performed by CRAs [Credit Rating Agencies] may have on market confidence and the possible adverse effects on financial stability.

Understandably the reference to the need of reducing “overreliance on external credit ratings”, implies two things: (1) not only did the ECB/Eurosystem used the evaluations of the rating agencies in their assessment of the European monetary system, but they also “overrelied” on them, (2) the reliance on the credit rating agencies needs to be reduced but not be completely interrupted.

This means that the crocodile tears against “the speculators” only obfuscate the fact that regulators do not really wish to chop away the oligopolistic status of these agencies and to put an abrupt end to the cozy relationship with their cronies. Moreover this eventually raises concerns about the validity of Mr Barroso’s claim that they “know better”; while it also makes us question the very practices of EU/Eurozone regulators. The fakery and humbuggery that characterizes the whole story, seems to suggest that in truth officials are not willing to dismantle the crony capitalist system that has been created over the last decades; but instead they are seeking ways to perpetuate its existence, by refining the perverse capital adequacy criteria, or by “better regulating” credit rating agencies, state-sponsored private megabanks etc.

Concluding remarks

Today the impact of credit ratings on the decisions of investors has been drastically reduced, because credit rating agencies are no longer thought of as the omniscient gurus of risk assessment. Moreover because of their grand failure to price risk prior to the crisis, they themselves have become much more conservative and austere in their evaluations. As we have seen time and again ever since the crisis started in the euro zone, credit downgrades always come after a given period of stress in bond markets. Downgrades are therefore ex post confirmations of what investors have already decided to do; and only to the extent that there is a correlation between the downgrade and increasing interest rates.

However as I have noted before in several articles, investors in the Euro area are greatly influenced by the actions of the ECB and the decisions of EU leaders (for example see here). It would not be an exaggeration to say that the ECB and EU regulators are to a certain extent manipulating the allocation of capital. Credit rating agencies and their ratings are largely irrelevant, both because investors no longer trust them and because the crisis in the euro area is influenced by different factors.

In a nutshell the crisis in the euro zone continues to spiral because the euro lacks essential institutions and mechanisms to mitigate asymmetric shocks. The monetary union needs a banking union, a fiscal union and a political union, for the single currency to be viable in the long run. The absence of this institutional framework creates problems as it prevents decision-makers from acting quickly and effectively. Moreover the problem is exacerbated by the enervating indecision of EU leaders and their self-contradictions throughout these last two years, which have created the impression that the euro zone can be dismantled in part or in total, therefore sustaining and invigorating the confidence crisis that has gripped the euro.

With all of the above in mind, I find the entire discussion on credit rating agencies as largely irrelevant; or rather as an attempt to misdirect attention and to obfuscate the fact that European leaders are facing great difficulties in making the two basic compromises for the survival and integrity of the euro: (1) make transfers politically acceptable, (2) make loss of sovereignty possible, by strengthening EU democratic legitimacy.

Concerning the call for the prohibition of credit rating agencies, I may say that it is misplaced. The point is that only once we fundamentally revise our approach to the financial sector, will we be able to make real progress. In particular the Basel Accords which effectively strengthen the collusion of big government and big corporations, need to be discarded; while the whole monetary system needs to be reconsidered so that:

1. the arbitrariness of central banks and regulators is diminished
2. the privileges to the financial sector are withdrawn
3. competition and the profit/loss system is restored so that reckless financiers may be allowed to go bankrupt
4. the whole regulatory framework be simplified, so that systemic crises be avoided (systemic risk is the byproduct of complex and multi-faceted regulation)
5. private corporations no longer be able to abuse loopholes in the system to create fictitious (toxic) private money

Within this context credit rating agencies need to be left to open competition and to the forces of the market, whereby bad decisions may lead to bankruptcy. The solution is not to prohibit/restrict credit rating agencies nor to refine the system that brought us here, but to put an end to crony capitalism and corporatism.