April 19, 2011
S&P managed to capture the headlines yesterday when it announced that it had a negative outlook for the credit rating of the United States. After all, an actual credit downgrade for the United States government would be big news. While the immediate response was a boost to the deficit hawks’ efforts to cut programs like Social Security and Medicare, it is worth asking a few questions before we surrender these programs to the Wall Street numbers mavens.
The last time S&P was in the headlines it was for giving investment grade ratings to hundreds of billions of dollars of securities that were backed by subprime and ALT-A mortgages. These mortgages were used to buy over-priced homes at the peak of the housing bubble. Many of these mortgages not only carried high risks, but were fraudulent, with lenders having filled in false information to allow homebuyers to qualify for loans that their assets and income would not justify.
Serious people should ask what S&P has done to improve its ratings systems. Have they changed their procedures? Did the S&P analysts who gave AAA or other investment grade ratings to toxic junk get fired or at least get demoted? If not, should we assume that S&P used the same care in assigning a negative outlook to U.S. government debt as it did in assigning investment grade ratings to toxic assets?
Of course it was not just bad mortgage debt that stumped the S&P gang. It gave top quality investment grade ratings to Lehman until just before it imploded in the largest bankruptcy in history. The same was true of AIG, which would have faced a similar fate without a government rescue. Bear Stearns also had a top rating until the very end, as did Enron. In short, S&P has a quite a track record in missing the boat when it comes to assessing creditworthiness.
The markets seem to recognize S&P weak track record in assessing creditworthiness. It downgraded Japan’s government debt in 2002. The interest rate on 10-year government debt in Japan is currently under 1.5 percent, the lowest for any country in the world. Does S&P think that investors are mistaken in being willing to lend Japan money at such low rates?
It is worth noting that interest rates on U.S. bonds fell yesterday, suggesting that S&P’s negative outlook did not scare people who actually have money on the line. (Not to get too technical with our friends at S&P, but it is not even clear what a default on U.S. government debt would mean. After all, the debt is issued in dollars and as a practical matter we can print as many dollars as we want. But, we’ll leave that one for another day.)
Finally, we must remember that S&P is first and foremost a corporation that is run for profit. This is why they rated hundreds of billions of toxic trash as investment grade during the housing bubble. They were paid tens of millions of dollars to do it.
S&P and the other bond rating agencies had their lobbyists working overtime in the financial reform debate. The Senate had approved an amendment by Senator Franken, which would have taken away the power of the issuer to select the agency that rated its bonds. Under the Franken amendment this power would instead be given to the Securities and Exchange Commission.
This amendment removed an obvious source of corruption. If the company issuing debt gets to pick the agency that rates the debt, then the bond-rating agency has an obvious incentive to give the debt a positive rating. Otherwise they will lose business. This likely explains how hundreds of billions of subprime mortgage backed securities got investment grade ratings.
However, the Franken amendment never took effect. In the conference committee, Representative Barney Frank, who was then head of the House Financial Services Committee, got language that delayed the implementation for at least two years. In the mean time, the current system, in which the issuer picks the rating agency, remains in place.
This should raise the obvious question: does S&P hope to influence the final resolution of the Franken amendment with its negative outlook on U.S. debt? It’s a terrible thing that we have to ask if the umpire is taking payoffs, but we do have to ask.
After all, this is Washington and Wall Street, a truly toxic combination. And we all know that S&P’s first commitment is to its bottom line, not to provide accurate information to investors. So who is S&P serving in its negative outlook on U.S. government debt?