Think Globally, Rate Locally

Moody’s has downgraded Portugese and Irish bonds as the countries’ debt increases – and contributed to market skepticism. But would a European rating agency solve the problems? We need to reduce our reliance on ratings – and we must not sugarcoat poor economic performance.

Many developed countries are in the midst of financial turmoil, if not crisis. Moody’s has downgraded Portugal and Ireland to below-investment-grade levels, and more downgrades may very well occur. These downgrades have spurred calls for a European rating agency that better understands European concerns. “Better understanding European concerns” implicitly seems to mean not downgrading now, at least below investment grade, because of the effect downgrading has on an economy.

Such an agency would be a bad idea. The criticism of Moody’s is not that its downgrades are inaccurate but that their effect on the market exacerbates the crisis, for example by raising borrowing costs. But the market reaction comes at least as much from the obvious fact that the economy is bad as from the fact that someone powerful is saying so. Ultimately, the agencies’ power is limited. They can’t make people treat troubled economies as untroubled simply by saying nothing (or by saying that the economies are untroubled). Nor is this their job – their job is to accurately indicate the prospects of timely repayment.

This is not to say that rating agencies should not take into account the effects of their ratings actions. They should never downgrade precipitously, especially below investment grade. But if they delay, reasoning that a downgrade will cause an already weak economy to deteriorate, and the economy does not recover, they may be rightly criticized for inaccuracy.

What should be done? The role of ratings should be de-emphasized. And the quality of the rating agencies should be improved, through increased oversight and accountability, and by encouraging vigorous quality-based competition for rating agency business. Efforts to these ends are being made, but more needs to be done. Given market participants’ entrenched practice of using ratings (from the best-known raters, Moody’s, Standard & Poor’s, and Fitch), de-emphasizing ratings will be difficult, especially with no ready replacement; the entrenchment also suggests difficulties in increasing quality.

More regionally-based agencies, or agencies with specialized expertise, would be welcome new players in the market, as would agencies with business models other than issuer-pays, the model which caused such difficulties in the subprime crisis. Such agencies are already coming into being – using them needs to be made acceptable to market participants. But none of this will happen quickly.

The downgrades are a message no one wants to hear. There are probably better ways to craft and deliver the message – to better explain and time downgrades. That the rating agencies cannot observe financial conditions without changing them, in a Heisenberg-like dynamic, is unfortunate and presently unavoidable. But, critically, their role in Europe’s current turmoil is far more attenuated than their role in the 2008 crisis. If securitizing subprime loans into securities with AAA ratings had not been possible, far fewer of such loans would have been made. The housing bubble wouldn’t have inflated as far and the damage would have been far milder: the crisis might even have been avoided.

Whatever we may conclude as to how their misratings in the preceding decade contributed to the crisis now, Europe’s current turmoil will exist whatever the rating agencies do; focusing on downgrading deflects attention from where it is far more urgently needed.

Read more in this debate: Fabrizio Goria, Sarah Nadav, Alexander Görlach.

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