The credit rating agencies would have you think that they are about God's work on earth--just doing their job to see that people have the "God's Truth" information they need to determine where to invest, whether they are rating corporate debt, equities, or sovereign debt.
Me? I think there's a lot of hocus pocus going on.
When I worked at Cleary Gottlieb in New York, I didn't deal directly with credit rating agencies. But any debt deal we were working on would be rated, and that rating was treated as "God's Truth" as a primary factor in doing the tax analysis (is it debt or equity?). In my first year, most of the stuff I was doing was capital market dislosures. So I'd read the draft of the offering document and any other deal documents, and then put together a tax dislosure statement. I remember asking a more senior associate at the time how one could feel confident one had acquainted oneself well enough with the company information to think about the myriad factors that go into a "debt or equity" analysis. After all, in most corporate tax classes a prof will spend class or so on the 'capital structure' topic, noting that the more subordinate the debt is, the less collateralized, the higher interest it pays, the more it starts to look like equity rather than debt. If you add in thin capitalization, low cash flows, inability to borrow from other markets, technical defaults or late payments on other debt, a close correspondence of shareholder and debtholder ownership and similar factors, you are likely to conclude that it isn't debt at all but just being labeled that way to get the tax deduction for interest paid. In publicly traded companies, the main thing you have is the financial statements. I used to look at them really closely, trying to assess the financial state of the company. But my colleague laughed my worries off.
"We tax lawyers don't need to do that kind of due dilligence," he said, "that'd be a waste of your and my time. The credit rating agencies are supposed to be looking in detail at all that financial information, and they can review the debt, look at the loans, see the history. They've got good quantitative models for assessing that stuff. So we just take the credit rating agencies' evaluations into account, and otherwise look primarily at the interest rate (is it so high that it looks like a yield from equity) and maybe the amount of real equity capital in the corporation." (paraphrasing, of course, from a conversation some years ago)
That attitude continued even as financial innovation took off and left credit rating agencies, regulators and in some cases even the bankster themselves behind in terms of fully understanding the products being rated and sold. Even if the ratings 'opinions' weren't hocus pocus before, they surely were when they failed to understand the products, didn't review the loans adequately, and scrambled to provide the desired ratings to their banker masters so that they would continue to get the business. So we ended up in a financial crisis, with too big to fail institutions locked in intangling webs of counterparty transactions that sometimes weren't even recorded on paper except as to expected result.
With the Dodd-Frank mini-reform, a few changes were made, but the credit rating agencies generally have gotten off, so far, without even a slap on the wrist, for the devastation wrought on ordinary Americans who have lost their jobs and their homes at least in part due to the hocus pocus paucity of real assessment behind their bought "opinions" that had so much influence on who bought what and how it was treated for tax purposes.
So now comes the European debt crises and the US debt ceiling fiasco (and US downgrade by S&P). What to make of it? Michael Hudson's guest post on Naked Capitalism, The case against the credit ratings agencies, Aug. 19, 2011, is worth reading.
The takeaway point: credit ratings agencies serve as 'gatekeepers' to credit by acting as "guard-dogs ... to the world's bankers", putting pressure on countries to pursue creditor-friendly policies--including privatization of their most important public assets-- no matter the impact on their citizens and with considerable attention to the credit rating agencies' own bottom lines.
Localities are pressured when their rising debt levels lead to a financial stringency. Banks pull back their credit lines, and urge cities and states to pay down their debts by selling off their most viable public enterprises. Offering opinions on this practice has become a big business for the ratings agencies. So it is understandable why their business model opposes policies – and political candidates – that support the idea of basing public financing on taxation rather than by borrowing. This self-interest colors their “opinions.”
Hudson realizes this sounds somewhat polemical, but he offers the example of Dennis Kucinich's fight to save Cleveland's public utility from the privatization dreams of its bankers and their credit rating agency enforcers.
The banks and ratings agencies told Mayor Kucinich that they would back his political career and even hinted financing a run for the governorship if he played ball with them and agreed to sell the electric utility. When he balked, the banks said that they could not renew credit lines to a city that was so reluctant to balance its books by privatizing its most profitable enterprises. This threat was like a credit-card company suddenly demanding payment of the full balance from a customer, saying that if it were not paid, the sheriff would come in and seize property to sell off (usually on credit extended to customers of the bankers).
The ratings agencies chimed in and threatened to downgrade Cleveland’s credit rating if the city did not privatize its utility. The financial tactic was to offer the carrot of corrupting the mayor politically, while using the threat of forcing the city into financial crisis and raising its interest rates. If the economy did not pay higher utility charges as a result of privatization, it would have to pay higher interest.
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[I]n saving Muni Light [Kucinich] had saved voters hundreds of millions of dollars that the privatizers would have built into their electric rates to cover higher interest charges and financial fees, dividends to stockholders, and exorbitant salaries and stock options. In due course voters came to recognize Mr. Kucinich’s achievement [and] have sent him to Congress since 1997. As for Mini Light’s privately owned rival, the Cleveland Electric Illuminating Company, it achieved notoriety for being primarily responsible for the northeastern United States' power blackout in 2003 that left 50 million people without electricity.
Looking at the way credit agencies have destroyed states' ability to rein in mortgage fraud (the Georgia statute discussed in Morgenstern's book, Reckless Endangerment) and the way that push for privatization and support for financial innovation no matter the cost to the public is now operating at the national level to push the federal government towards the same destructive policies, Hudson suggests the country is foolish to create such a platform for greedy for-profit companies to dictate public policy.
The basic conundrum is that anything that interferes with the arbitrary creditor power to make money by trickery, exploitation and outright fraud threatens the collectability of claims. The banks and ratings agencies have wielded this power with such intransigence that they have corrupted the financial system into junk mortgage lending, junk bonds to finance corporate raiders, and computerized gambles in “casino capitalism.”
Even if they are doing their job without paying too much attention to their own self-interest, credit rating agencies don't have the right priorities in mind for making policy decisions and should be dethroned from their 'god of the marketplace' pedestals. They don't like anything that means debt might not be paid back, and that includes things like consumer protection, anti-trust legislation, tort penalties, and anti-fraud legislation. That doesn't mean we should go along with that attitude. Citizens, after all, don't like being ripped off: we do want consumer protection and anti-fraud legislation.
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