Rating The Wall Street Ratings Agencies
Earlier this month, Standard & Poor's announced that it had downgraded the U.S. credit rating from AAA to AA+, citing political risks and the nation's rising debt burden. It was the first time in history that the U.S. credit rating was lowered.
On today's Fresh Air, law professor Frank Partnoy joins Dave Davies for a conversation about what S&P's decision means and how rating agencies acquired the influence they have in our economy. Partnoy used to work in derivatives on Wall Street and now studies the markets and financial regulation. He says that he didn't think much of S&P's decision.
"It's not a major downgrade to default levels — they're not saying the U.S. is going to default," he says. "They are saying that the chances of the United States defaulting are higher, and I don't think that that's right. I think that most investment professionals don't think that that's right."
Partnoy explains that after S&P's announcement, the bond markets reacted to the decision in the exact opposite way that one might expect.
"Instead of prices going down, prices went up. People looked at United States Treasuries and said, 'Oh, we're going to buy these, this is a good place to invest, it is still just as safe,'" Partnoy says. "And I think that is consistent with how the markets have reacted to S&P over the years. It's a great paradox of these credit ratings agencies that they change these ratings in ways that have very little informational value. It doesn't actually tell us anything about the chances of the U.S. defaulting ... It's not useful."
The History of Ratings Agencies
So how did Wall Street rating agencies like the S&P and Moody's acquire the influence they have in the economy?
It started in 1909, when an investor named John Moody was trying to determine how to tell the public which companies and bonds would be the safest to invest in. He acquired long lists of financial information about each company, but the lists weren't exactly easy for the general public to parse. Moody decided that it would be easier for his company to look at each company's financial information and credit history — and then assign each investment opportunity a rating based on a scale.
"He said, 'I wonder what would happen if I just gave people a simple mnemonic device and it would boil down to a letter — start with AAA which would be the safest, then AA and A, all the way down to D,'" Partnoy says. "It's kind of like the grades I give my students in law school — from A going all the way down to the bottom, with D being default. And this caught on."
Moody published his information about railroad investments in a book. Any investor looking to buy a railroad bond would purchase his book and then would know, based on the rating scales, which investments were safest and which were the riskiest for their investments.
After the stock market crash of 1929, the agencies began to also rate bond investments for banks — at the request of the U.S. government. But things began to change in the 1960s and 1970s. Instead of charging investors for their ratings information, the agencies began to charge the bond issuers themselves for the ratings.
"People were quite critical of this and said it could create a conflict of interest," Partnoy says. "You can imagine what the difference between ratings of restaurants and movies might be if instead of the Michelin Guide or the Zagat guide, if the restaurants or movie companies themselves were paying the raters to be rated, it's an obvious conflict of interest. And now it's very commonplace that companies and governments — anyone who wants to borrow money — they are the ones who are paying for the rating."
In addition, some regulation agencies like the Securities and Exchange Commission began outsourcing some of their work to the ratings agencies.
"The SEC had the job of figuring how much capital broker-dealers would have to set aside in order to remain safe," Partnoy says. "So they said, 'We're going to designate these [ratings] agencies ... to do our work for us. You go out and rate these bonds.' And more and more regulators [like the SEC] thought this was a good idea. They said, 'We don't have to do our job. We can get ratings agencies like S&P or Moody's to do our job for us.' ... A web of regulation grew over the most recent decades to make it so that if you're a company and you want to borrow and you want a large institutional investor to buy your bonds, you got to get a rating. There's no choice."
Rating agencies then became the official arbiters of what is safe for long-term investing. Some mutual fund investments, for example, are dictated by rules that largely depend on ratings — they can only buy bonds rated AAA or AA. Insurance companies, global banks and pension funds are also largely dictated by what the rating agencies say.
"Over time, we've created this very strange business model for the ratings agencies where, regardless of whether we think their ratings have value — whether we think this bond actually is AAA, that doesn't matter," Partnoy says. "It has to be AAA in order to be sold whether the AAA is accurate or not."
Frank Partnoy is the George E. Barrett Professor of Law and Finance and is the director of the Center on Corporate and Securities Law at the University of San Diego. He worked as a derivatives structurer at Morgan Stanley during the 1990s. He is the author of F.I.A.S.C.O.: Blood in the Water on Wall Street, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, and The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.
On the role the ratings agencies played in the financial collapses of 2007 and 2008
"The ratings agencies were absolutely at the center of the crisis. They enabled and facilitated all of the complex financial instruments that really were at the core of why the markets melted down, first in 2007 and then in 2008. What they did, basically, was initially rate mortgage-backed securities — the bundles of prime and subprime mortgages — and then in a second wave of ratings, they took those mortgage-backed securities and they rated bundles of those bundles which were called collateralized debt obligations. Basically what they were doing was repackaging things they had already rated. The reason there was such a big problem in 2007 and 2008 was they had taken subprime mortgage bundles that initially had low ratings and then when they were bundled a second time, they gave them much, much higher ratings. It turned out those higher ratings were false and they had to downgrade them and the downgrade was what caused the collapse of Lehmann Brothers and nearly many other banks."
On what would have happened had the ratings agencies said the mortgage-backed securities were risky
"If they had done what they were supposed to do, these would not have been rated AAA. They would have been rated AA or A or BBB or even further down the scale. If they were rated lower, then large institutional investors wouldn't have bought them and at the major banks, people would have seen flashing red lights that said, 'Oh, these things are risky.' The problem was, when people looked at these instruments, they saw AAA and they believed that it was actually AAA. In fact, it wasn't."
On his experience with the ratings agencies while working on Wall Street
"I think it would be fair to say that we would run circles around them. The quality of the rating agencies' models was very low and they often didn't have a very good understanding of what they were rating. ... In some ways, the mistakes that they've made more recently are tougher because they involve complicated math, very high-level understanding of the interrelationships among the subprime mortgages and the securities in these pools. So I do have some sympathy, having looked at the testimony from the rating agency employees that they were in over their heads. But nevertheless, if you're in a business and you're in over your head, I think the right thing to do is to step back and say, 'We're not willing to do this anymore.' And the employees at the ratings agencies who said, 'This is crazy, we can't put AAA on this.' They were ignored and very much ill-treated."
On the Dodd-Frank financial overhaul law and regulatory reliance
"There are two crucial changes. One is in the area of regulatory reliance on ratings. In other words, this web of regulation that depends on S&P and Moody's on the credit rating. Like the requirement that your mutual funds buy only funds that are rated in the top two categories. What the Dodd-Frank bill did on that was require that various regulatory agencies remove references to ratings from those rules. It said take them out. Get rid of them. ... The challenge has been for regulators to come up with some substitute. ... There's some pressure for a proposal that I've advocated for a while which is to rely on market prices, to look at the markets as one reference point for deciding whether or not something is creditworthy so that you reflect information and wisdom from a variety of market participants. That is showing up in some of the regulatory changes."