Down on the Downgrade?
The downgrade itself was fair. However, S&P’s timing and “partisan gridlock” rationale were questionable, as is its implicit advocacy of higher taxes. Nothing really changed for the worse since before the debt-ceiling fight, so S&P should not have waited to issue its new rating until after the issue was resolved. And it’s beyond laughable that after the U.S. was downgraded, many countries mired in the Eurozone crisis still are rated AAA.
S&P was actually a Johnny-come-lately at marking down U.S. debt, as two upstart credit-rating agencies, Egan-Jones Rating Co. and Weiss Ratings, had already done so. Unlike S&P, these firms made clear that their ratings were about long-term prospects, rather than the debt-ceiling fight, and emphasized spending over taxes.
When Egan-Jones, widely respected for its early downgrades of Bear Stearns and Lehman Brothers, changed its rating of U.S debt from AAA to AA+ on July 16, it explained: “The major factor driving credit quality is the relatively high level of debt and the difficulty in significantly cutting spending. We are taking a negative action not based on the delay in raising the debt ceiling but rather our concern about the high level of debt to GDP.”
Similarly, Weiss, which lowered its rating in April from C to C-, offered this explanation: “Our downgrade today is not contingent on the outcome of the debt-ceiling debate.”
In a truly free market for credit ratings, S&P’s fairness shouldn’t matter nearly as much. S&P and Moody’s would be to securities what Zagat is to restaurants, a rating influential because of its reputation but without undue power over a restaurant and its customers.
But that’s not how it works today with the government-protected cartel of credit-rating firms. As Kevin D. Williamson recently pointed out in “Downgrade Nation” in the pages of National Review, “The judgment of the Big Three agencies is taken as gospel by practically no serious investor; their ratings are largely of technical and legal concern.”
In 1975, the Securities and Exchange Commission (SEC) created the designation of “nationally recognized statistical rating organization” (NRSRO) for credit-rating firms. Regulatory agencies soon began requiring that banks, brokerage firms, pensions, and insurance companies carry mandated levels of securities rated AAA from an SEC-approved NRSRO.
From the 1990s until 2003, only the “Big Three” of S&P, Moody’s, and Fitch had been approved by the SEC to be NRSROs. And when these firms would rate a new security as AAA, financial firms would rush to buy it to satisfy their regulatory capital requirements. This is what helped created the bubble in AAA-rated mortgage-backed securities.
We are slowly moving away from this government-backed cartel. Prodded to increase competition by the bipartisan Credit Rating Agency Reform Act of 2006, there are now ten firms approved by the SEC to be NRSROs, including Egan-Jones. And over the weekend, financial regulators prudently waived the NRSRO requirement so that financial firms holding U.S Treasuries would not have to substitute “safer” bonds of AAA-rated countries such as France to satisfy their regulatory capital requirements.
But we still have to go further. The situation today with the credit ratings embedded in our financial regulatory system is analogous to one in which zoning authorities would give permits only to restaurants with top ratings in Zagat, whether or not customers wished to patronize them.