Explainer: Why Do We Listen to S&P?

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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.