Explainer: Why Do We Listen to S&P?

Tuesday, April 19, 2011

Yesterday Standard & Poor's downgraded the outlook for U.S. sovereign credit ratings from 'stable' to 'negative.' That prompted It's a Free Country readers to ask one question over and over again: after the worst economic disaster since the Great Depression, why do we even listen to credit rating agencies like S&P anymore?

The scrutiny is warranted. Prior to the crisis in 2008, S&P gave adequate ratings to many of the same financial institutions that eventually imploded. As late as June 2nd of that year, Lehman Brothers was given an 'A'—S&P's median mark out of five possible rankings. If Lehman Brothers' risk rating was "satisfactory" a mere fiscal quarter before its collapse, we can be forgiven for our shaken faith in S&P.

Where did that faith come from in the first place?

"They've been in business a long time," says Dr. Richard Sylla of credit rating agencies. Sylla is a professor of Economics at New York University; anyone confused about what these agencies do should read his "Historical Primer on the Business of Credit Ratings." He compares the reputations of S&P, Moody's, and other big credit raters to that of our oldest universities: "Harvard is an old university and everyone thinks it's good and it probably is."

Credit rating agencies first started to appear around the turn of the 20th century, consolidating the functions of credit-reporting agencies, the financial press, and investment bankers—insiders, in other words, who were trusted sources of information that investors could turn to when determining whether they could expect a return. Despite obvious foul-ups, which always glare brighter than successes, Sylla said that rating agencies' track records are, on the whole, pretty good for a near-century of operation. "It seems that when they rate something at tops," he says, "it does in fact have a low probability of default after the fact."

Did we forget 2008?

'Low probability' isn't 'no probability' though. However many times S&P gets it right, crises like the one in 2008 cast a shadow over every rating the agency hands out today.

But Richard Sylla says that rating a corporation is not the same thing as rating a country. Agencies like S&P are private entities that get paid by other private entities to give them a rating; accurately scoring the United States and other sovereign nations is part and parcel of their stated obligation to investors, and nobody pays them to do it. As such, there's less chance of a conflict of interest.

Richard Sylla explains, using the subprime mortgage crisis as an example:

[Credit rating agencies] use historical materials. When people came in and said, 'Rate these CDOs,' which didn't have much history, some people said, 'We can't really do that with our standard techniques.' But each deal paid ratings agencies $200,000 or $250,000, and so somebody there said, 'Find a way to rate them so we can make that money.'

By comparison, there is no shortage of history on sovereign debts, which means there's more to back up S&P's numbers this time around than there was in 2008.

What can we do when they're wrong?

As Sylla said, part of the reason we still pay attention to what S&P says is the extensive track record backing them up. It's that same track record that led the federal government to designate certain of the most proven credit rating agencies "Nationally Recognized Statistical Ratings Organizations" in the 1970s. This effectively sanctioned the activities of Moody's, S&P and others, enshrining them in the federal regulatory process without being federal institutions at all. Now, issuers have to pay an agency to rate their bonds, and that rating (which comes from a private entity, remember) is referred to by federal oversight authorities.

Because they aren't a part of the government, it's harder for government to hold them accountable. "It's like freedom of the press," says Dr. Sylla. "[They say] they're only offering an opinion, not a guarantee—so they don't guarantee that they're always right, but they have the right of free speech to express their opinion."

The excuse is unsatisfactory, but as long as the federal government relies on these private companies to do regulatory legwork instead of conducting its own ratings, perhaps our frustration could be better directed at Washington.


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Comments [3]

Peter Baxter from Brighton

President Obama Slave of wall street
Posted on August 20, 2011
Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple “tranches” that are issued by special purpose entities and collateralized by debt obligations including bonds and loans these were sold as triple A investments when the sellers knew they were Bad debts.

Credit Default Swap (CDS) is a form of insurance that protects the buyer of the CDS in the case of a loan default. If the borrower defaults (fails to repay the loan), the lender who has bought traditional insurance can exchange or “swap” the defaulted loan instrument (and with it the right to recover the default at some later time) for money – usually the face value of the loan.

The lenders used CDS to insure themselves against any CDOs defaulting

All the money gained by using the CDS went in the pockets of the banks

I think a legal case should be brought against the finance companies becuse these CDS should have been paid to the homeowner because they had paid for them within their mortgage repayments.

This matter should be resolved in court .

Put simply bad debts where sold as triple A investments when people who sold them knew they were bad debts. They insured themselves against any loss.

This insurance was by the borrower, and the financiers pocketed all the money paid out by the insurance company for the borrowers subsequent loss.

This is the biggest scam in the history of the world. This led to the collapse of the Worlds Markets. It makes the rioters who followed this fraud look like altar boys.No one has been brought to Justice for this, their punishment was to be rewarded with tax payers money and even bigger bonuses.

There is an estimate that these Bankers spent over 10% of their considerable incomes on vice , drugs, and prostitution and this was all paid for by their companies on company credit cards and I think if the serious crime squads worldwide seek the truth, we can still get some justice from these crooks remember it was tax evasion that brought down Capone. We can get them for expenses fraud. unfortunately I understand the head of prostitution was given immunity from prosecution provided she kept dumb. However a team of auditors can correct this.

This corruption of the banks can be compared to the Capone era.

President Obama came to power promising to bring the villains to justice so far he has just reappointed the people who were in financial power under Bush and it is more of the same.

President Obama has become the slave of Wall Street. Why?

Aug. 20 2011 09:51 AM
Peter Baxter from Brighton

How to solve or Worlds Economic woes.

The problem with all our world economic problems was the collapse of the housing market brought on by corrupt banks swindling their customers.
This can never be solved by governments pouring Taxes to prop up these Banks.

What we need is a stimulus to the housing market and I would do this in two ways.
First give tax incentives to builders and make land available from government land for redevelopment.

Secondly; we need mortgages which guarantee the buyer that in the event of a collapse in his house price, the difference will be paid upon sale of that property to the buyer from an insurance company. A new type of insurance of protected mortgage also the availability of work protected mortgages.

This can be government protected like the Banks are government protected and I would make these mortgages available throughout all the banks.

Any costs involved could be paid for by selling off all social housing.

This scheme will within five years have the economies of the entire world growing again.
It will also bring confidence back to the financial markets.

It is possible to build eco friendly houses for around 50,000 and if government land is freed up for this, we can look forward to prosperity for everyone.
Because every ones homes will start inflating and not just bank profits

Peter Baxter

Aug. 19 2011 08:54 AM
Peter Baxter from geo:lat=50.80593472676908 geo:lon=-0.1318359375

Rob a bank and you get 10 years The Bank robs you and they get a seven figure pension.

Factors that contribute to rioting are population size, the breakdown of respect for social order, poverty, the lack of opportunities for personal advancement and Debt.

Today the people that led the world into debt by their corrupt practises within the Banking, Insurance, and Financial sector have been reappointed by President Obama to head his financial team. No one has been brought to justice for the debt all the world is now paying and rioting about.

All the banks had AAA status just before they collapsed from Standard and Poor the same people who have just downgraded USA economy?

University Professors who advised the governments were working without declaring their paid interest for these corrupt banks etc. just before the crash.

If you check the facts you will find a transfer of wealth from the poorest to the top one percent and these crooks are still running all our economies.
This was achieved by getting companies like standard and poor to give false assessments of bad debt which was then sold to our pension funds as triple A.
Whilst ever these crooks go unpunished and are rewarded by huge golden handshakes and top government jobs, riots will get worse.

We all have a remedy it is our vote and a free press.
Make sure you give your vote wisely and all the politicians who supported crooked bankers, insurance companies, are swept from power.
To the press it is time to expose these crooks. Name and Shame

Aug. 14 2011 09:58 AM

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