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In 1996 Thomas Friedman said: “There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.”

We may have an answer soon. Dave Dayen is watching the ratings agencies, particularly S&P, say that a clean debt ceiling increase won’t cut it, and that there needs to be a $4 trillion dollar deal in order to keep the United States’ credit rating secure:

This concern about the markets has happened very suddenly. All of a sudden there’s a belief that a clean increase or a small debt deal with a minor amount of spending cuts would not be enough to avoid a downgrade. Standard and Poor’s basically forced this by saying that they would downgrade if there wasn’t a $4 trillion deficit deal in the next 90 days. The claim is that this has been caused by political leaders attaching the debt limit to a deal on reducing the deficit, and the inability to reach an agreement, the political stalemate, has led the markets to lose confidence.

Two quick sources that you might find helpful. There’s a long running argument that the ratings agencies work as a mini-IMF, forcing austerity measures favorable to bond-holders everywhere from developing nations to municipalities and states here in the USA.

But their travels in the political sphere go beyond that. It’s tough to rank the awful financial-sector policy decisions that were made in the past decade, but two of the worst ones were very much influenced by rating agency political pressures. When Congress tried to put some resolution powers in place to deal with the possibility of the GSEs collapsing, the ratings agencies put pressure there. When states were trying to put in sensible state-level regulations to deal with predatory subprime lending, the ratings agencies put pressure on federal regulators to overrule (“pre-empt”) them, leaving state housing regulatory powers at the mercy of the pro-bank OCC.

Check out Josh Rosner and Joseph Mason’s "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," for specifics:

F. Rating Agencies Are Activist in Ways They Have Never Been

…What is clear is that NRSRO powers have extended to areas of public policy in ways we have not witnessed before….In early 2004, after accounting problems were discovered at Freddie Mac but before those of Fannie Mae were fully uncovered, Congress again embarked on a legislative process to create a new regulator with enhanced powers. One of the key provisions legislators considered was one that would better define the receivership authority of the GSE’s regulator in case they became seriously undercapitalized. In early April S&P “hinted about a possible downgrade of GSE debt if a new regulator had receivership powers”. This announcement supported the GSE’s goals of trying to prevent receivership authority from being included in legislation…

On October 1, 2002, the Georgia Legislature passed sweeping new anti-predatory lending legislation. The Georgia Fair Lending Act contained a provision that assigned unlimited liability exposures to lenders who made “high cost loans” (and noteholders). In January of 2003 the three major credit-rating agencies announced that they would no longer be willing to rate RMBS originated in Georgia. As a result, the Georgia legislature moved quickly to make amendments to their legislation to stop lenders from leaving the State. As other States began to move to pass similar legislation they were reminded of the effect that the Georgia law had and also limited their liability provisions.

(We discussed Comptroller of the OCC, John D. Hawke Jr., and his speech he gave to the Federalist Society on July 24th, 2003, where they announced they were going after Georgia law, here. It’s an important speech for the what a neoliberal financial-sector policy looks like in practice.)

There are a few ways to think about how the ratings agencies could add value to the financial marketplace. Information tends to be a public good, so there’s a free rider problem toward any individual investor paying to rate a bond. This is one reason why issuers tend to pay for the rating. There are also instruments so complex, or with so little historical and comparative information, or so illiquid, that the ratings agencies can bring their so-called expertise to give information.

But the United States bond market is one of the largest, most-liquid, most-studied, most transparent markets in the world. There’s nothing the ratings agencies have that anybody else doesn’t have.

And what’s more important, the ratings agencies own internal analysis shows that they are terrible at rating government debt. Their ratings are all off, as governments, especially those with a printing press for their own currency, simply don’t behave like the corporate world they were designed to analyze. And rather than just being wrong, they are wrong in that they are always overestimating the liklihood that governments will default.

Sorry for the long block-quote, but it is important to give you a sense at how awful their ratings are with public-sector debt, and the serious consequences that has for access to capital. From a fact sheet with links to complaints against specific agencies (my bold):

In June of 2001, S&P published a study commissioned by its Analytics Policy Board that reviewed public bond defaults rates from 1986-2000. The June 2001 report concluded that “the number of defaults and cumulative default rates are extremely low for public finance obligations rated by Standar & Poor’s” and that “no defaults of ‘AAA’ or ‘AA’ rated debt occurred in the 1986-2000 period.” S&P attributed this stability to the fundamental nature of governments in that “governments have ‘perpetual’ existence” and that bankruptcy typically is not an option for governments….

In July of 2001, S&P published a public bond default study which found that public bonds default at much lower rates than corporate bonds of similar or higher credit ratings. S&P published at least six subsequent default studies on public bonds from April 2004 through May of 2008. Each of these S&P studies reached the same conclusion as S&P’s July 2001 study. Moody’s was aware of all of the S&P studies….

In June of 2002, Moody’s published the “highlight” results from its own default study that Moody’s began in 2000. Moody’s found that for “the period covering 1970-2000, the one year, issuer-weighted average default rate for all Moody’s rated municipal issuers – regardless of their rating level – is just .01% versus 1.30% for all corporate issuers. In other words, for the study period, Moody’s found that public bonds were on average 130 times less likely to default than corporate bonds during the first year after issuance…

In November of 2002, Moody’s published the final version of its public bond default study. The Moody’s study concluded that “the 1, 5 and 10-year cumulative default rates for all Moody’s rated municipal bond issuers have been .0043%, .0233%, and .0420%, respectively compared to .0000%, .1237%, and .6750% for Aaa-rated corporate bonds during the same time period.” In other words, Moody’s concluded that public bonds as a group, even when including public bonds with low credit ratings, have lower default rates on average than the highest, “Aaa” rated corporate bonds….

In October of 2005, an internal report prepared for S&P’s Analytics Policy Board unequivocally confirmed that “U.S. public sector entities have historically exhibited substantially lower default rates than corporates, for a given rating.” Despite this conclusion, S&P still did not consider rating public bonds according to their true credit risk and continued to represent that its ratings were comparable across asset classes….

In March of 2007, Moody’s published a report purporting to outline how much public bonds had been underrated by Moody’s as compared to corporate bonds. The Moody’s report provided a “map” detailing the gaping differences between public and corporate bond credit ratings. The Moody’s map showed that in many cases the default rates of public bonds were equal to or less than corproate bonds rated as many as seven notches higher by Moody’s….

As one Moody’s exectuive conceded in an August 31, 2006 email: “I think there is clearly a mismatch between the default data and people’s perception of the risk associated with municipal credits.”

The ratings agencies are so in the plumbing of the financial system that even with these qualifiers they can wreck havoc on US financing. There is one policy point Moody’s has brought up that I’d like to see happen: eliminate the debt ceiling already.

Source: The Activist Ratings Agencies and Their Poor Public Sector Predictions