A Philosopher's Blog

S&P, The State and Credit Ratings

Posted in Business, Ethics, Law, Philosophy, Politics by Michael LaBossiere on August 20, 2011
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S&P recently downgraded the United States’ credit rating from AAA to AA+, apparently causing some problems with the market. Interestingly, S&P has been under investigation for its rating practices prior to the financial meltdown. It has been alleged that S&P’s analysts wanted to rate the mortgage bonds at less than AAA, but they were overruled. These excellent ratings led people to put more faith in these financial instruments than was warranted, thus contributing to the financial mess.

While there is clearly a need for a rating system, the current system seems to be rather problematic. One obvious problem is that the entities who are rated pay the rating fees to companies like S&P (some states, such as the US, do not pay). For example, banks paid $100,000 or more when getting their mortgage bonds rated. Rating fees for collateralized debt obligations were significantly higher, apparently seven times so (or more). Banks allegedly shopped around looking for companies that would give them favorable ratings in return for large sums of money. That this is a recipe for disaster should be rather obvious.

To use an analogy, having rating companies being paid by the entities they rate seems a lot like having college students directly pay their professors. In such a situation, students would tend to shop around for professors who would give them the best grades and would tend to avoid professors who would provide an honest assessment. Professors, being only human, would tend to be influenced by this as well. After all, it would be much harder to assign an F or D knowing that it would no doubt impact enrollment (and income) the next semester. If such a system existed, another impact would be that the transcripts of students would not be trusted by professional schools and businesses. After all, if the students are handing cash to those who grade them, the grades will generally not be accurate.

While some might suggest handing over the rating system to the state, this does not seem to be the optimal solution. The rating companies should, of course, be subject to legal regulation to keep them from doing harmful deeds. However, their independence from any specific state seems to be important in the context of a global economy.

One appealing solution that has been suggested is having the investors pay the fees. So, for example, the folks investing in mortgage bonds would pay S&P or other companies to evaluate the quality of these bonds. This would give the rating companies an incentive to accurately assess the financial “products.” After all, a rating company that rated crap as golden would soon find itself without any customers. Given that this change would give the rating companies an incentive to rate accurately, it seems like a much better system than the current one that certainly seems to encourage over-rating.

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2 Responses

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  1. T. J. Babson said, on August 21, 2011 at 9:56 am

    If S&P was indeed compromised, then perhaps they will suffer the same fate as Arthur Andersen:

    Arthur Andersen LLP, based in Chicago, was once one of the “Big Five” accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations. In 2002, the firm voluntarily surrendered its licenses to practice as Certified Public Accountants in the United States after being found guilty of criminal charges relating to the firm’s handling of the auditing of Enron, an energy corporation based in Texas which had filed for bankruptcy in 2001 and later failed. The other national accounting and consulting firms bought most of the practices of Arthur Andersen. The verdict was subsequently overturned by the Supreme Court of the United States. However, the damage to its reputation has prevented it from returning as a viable business, though it still nominally exists.

    http://en.wikipedia.org/wiki/Arthur_Andersen

  2. James Claims said, on August 21, 2011 at 12:16 pm

    I like the idea of investors paying into the investment firms. It distributes the burden of payment to those who are literally banking on the assessment to be correct. To use your professor analogy, it’s like an engineering firm paying into the university to make sure that they get truly A students and not inflated grades. It’s pragmatic and results oriented. A fine way to solve most any problem in economics.

    Personally, I believe that a separate agency associated with a better funded SEC would be beneficial since then there would be the power of subpoena involved and companies would have less ability to hide documents if they really wanted to be graded appropriately. Plus, it would be a good sign to investors that if the companies tried to dodge the subpoenas then the companies may not be entirely truthful in their documentation.


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