Economics

Credit ratings: Where ‘least wrong’ is the best we can hope for

U.S. regulators think they can do better than the major credit ratings agencies. As part of the Dodd-Frank Act, U.S. regulators are no longer allowed to use ratings from independent companies to judge the appropriateness of bank capital levels. Under the newest proposal from the Fed, the Comptroller of the Currency, and the FDIC, ratings would instead be assigned based on OECD classifications, which are even worse than the ratings agencies’ diagnoses.

This week, the U.S. Congress will hold hearings regarding the major credit ratings agencies’ supposed inability to predict the collapse of MF Global. Despite the fact that both Moody and S&P downgraded the brokerage prior to the collapse and “did not have any understanding” of the firm’s bets on European sovereign debt until less than a week before the collapse, expect lawmakers to crack down harshly on ratings agencies yet again.

This comes amid accusations that ratings agencies are, apparently, being too harsh on European nations thanks to a spate of downgrades in sovereign creditworthiness over the past months. These accusations piggyback on prior claims that the ratings agencies failed to anticipate the wave of defaults in subprime mortgages that precipitated the U.S. housing crisis. (Never mind that U.S. regulators didn’t anticipate them either.)

Surely the OECD ratings can’t be worse?

Except that they can be. The OECD currently rates all of the troubled countries of the Eurozone as entirely riskless investments and has done so since they started producing ratings. This stands in stark contrast to the ratings agencies. See below for a breakdown of ratings, and notice how the OECD has totally failed to grasp the magnitude of the current crisis.

By cutting out ratings agencies, regulators have correctly sensed the conflicts of interest in the status quo, but they have merely replaced one set of conflicts of interest with another. The OECD is a collective of governments who are leveraged to the hilt with sovereign debts they are struggling to service. In this instance, the ratings agencies are right to say these countries are in trouble. It appears that in this instance, least wrong is the best we can hope for.

2 thoughts on “Credit ratings: Where ‘least wrong’ is the best we can hope for

  1. This analysis is incorrect. The OECD does not rate high-income OECD countries. Thus, a zero rating classification means that the country has not been rated by the OECD, not that it is riskless.

  2. Rate This

    Rating agencies collect annually 4 billion US$

    The interest rates countries pay on sovereign debts are determined largely by the credit rating agencies (CRA). Three major rating agencies are; S & P, Moody’s, and Fitch, and in 2011 their income came to 4.3 billion U.S. dollars.

    Apparently this amount of 4.3 billion US$ was worth to be paid, for the information analysis they provided.

    Oddly enough if we look at the following chart representing Greek debt rating by S&P and Moody we can see, that until end of 2009 both agencies ranked Greece very highly. Moody’s even rated Greece until November 2009 as A+, meaning “High level of feasibility to honor its obligations”. Is it possible that at the beginning of 2010 something fundamental has changed, which suddenly reduced the evaluation value of Greece?

    What exactly happened? Was it sudden change in the current account?

    If we look carefully at the chart above, we find surprisingly that the Greek current account deficit as percentage of GDP reached its peak of 15% at 2008 and in spite of negative GDP growth since 2008 its current account deficit as percentage of GDP started to decrease since then. According to this the Greek economy was definitely not in better shape at the beginning of 2009 than at the end of it. So how is it, that S&P and Moody did not change their evaluation of Greece economy in the year 2006-2008, when obviously (see the chart above) the Current account deficit started to be out of control in this period?

    Assuming that these agencies employ the very best professionals, probably something very basic vent wrong. And if so, can we trust their new evaluations. Don’t they do mistakes, that can have additional serious consequences in the future?

    If we check the latest development in credit rating of G.I.P.S. countries we find the following charts;

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    Looking the charts above you can get the feeling that the credit rating agencies are few steps behind the reality.

    Following the crisis and very much influenced by the Maastricht criterions, the public discussion about the economic strength of the states is focused mainly on the relation between the GDP and governments budget deficits, GDP and accumulated debt (public and private) and the GDP and the current account. Yet these indicators gave very partial picture; The government debt represents the annual cash flow between the government and private sector, current account represents the annual cash flow between the state and its commercial partners, and the accumulated debt represents the total liability of the state and the government compared to the GDP.

    In this presentation we are obviously missing the asset value of the state and the annual rate of its accumulation, even though the main part of the economic power of the state is in the property, including real estate, potential franchise rights of infrastructure utilities in transportation, communications, education and health, and state-owned activities that indirectly help increase the profitability of businesses. The other major factor representing the economic strength of the state is the capacity of entrepreneurship of its residents, based on innovation of new technologies and start ups of new ventures. This is strongly influenced by the education level of the state, the supportiveness of the government and legal system to new ventures and peoples alertness to new economic opportunities.

    As an additional index to follow the economic strength of the state, i would add evaluation of all these above mentioned factors, and compared it to total liabilities. This method has of course many deficiencies, like the asset value has to be evaluated according to its market price, while that can be reduced substantially in times of crisis and over valued in times of prosperity not to speak about creating a methodology of a accurate accounting of these national assets. But in any case I think it is worth to try to create such an index, in the worst case at least it will create many new jobs to many young economists.

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