You Get What You Pay For
By Simon Johnson
Standard & Poor’s downgrade of United States government debt last month has been much debated, but not enough attention has been devoted to the fact, reported last week by Bloomberg News, that it continues to rate securities based on subprime mortgages as AAA.
In short, S.&P. is suggesting that these mortgages are more creditworthy than the United States government – a striking proposition. Leave aside for a moment that S.&P. made a big mistake in its analysis of the federal budget (as explained by James Kwak recently in this blog). Just focus on all the things that can go wrong with subprime mortgages – housing prices can fall, people can lose jobs, the economy may fall into recession and so on.
Now weigh those risks against the possibility that the United States government will default. As we learned this summer, that is not a zero-probability event – but it would take either an act of Congress, in the sense of passing legislation, or a determination by members of Congress that they could not act. S.&P. finds this more likely to happen than some subprime mortgages going bad.
Now S.&P. might be right, of course. Or its assessment might be influenced by the fact that it is paid by the issuer of those mortgage-backed securities – which presumably wants a higher rating. The rating agency’s employees may want to do an accurate assessment; management can reasonably expect to make higher profits if its ratings please the paying customers.
Perhaps we should just disregard what S.&P. and its competitors say. But this is not so easy, because many investors are guided by rules – either self-imposed or created by regulators – that tie investment decisions, and thus these investors’ holdings, to ratings. Ratings changes undeniably can move markets.
How can we take seriously a rating agency that is compensated by the issuers of securities? This system has long outlived its usefulness and should be discontinued.
In a similar vein, let me ask why we should take seriously economic analysis offered up by a financial-sector lobbying group on behalf of its members — if, for example, it says that regulation of its members will slow economic growth? Surely, we should check the numbers in the analysis carefully and be skeptical of the policy recommendations.
A timely example comes from the Institute of International Finance, which calls itself “the Global Association of Financial Institutions” and whose board members are all from big banks. (Indeed, the institute is more than a mere lobbying group; in the recent Greek debt negotiations, it was in charge of coordinating the terms proposed by private-sector banks for their involvement in the debt restructuring.)
So what do we make of its policy recommendations? In a report released this week, “The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework,” for example, the institute asserts that additional capital requirements for its members could result in “3.2 percent lower output by 2015 in these economies than would otherwise be the case” (see paragraph 5 of its news release).
In recent conversations with policy makers from the Group of Seven nations, I was told that the institute’s previous, interim report on this same topic was largely without value (some said completely without value).
I hope the official policy community reacts the same way in this instance, because the institute refuses to acknowledge the vast cost imposed on society by the combination of big banks, high leverage and low capital that it endorsed through 2008 and that it defends, without only minor modifications, today. (James Kwak and I wrote directly about these issues in 13 Bankers – and we’re now hard at work on the sequel.)
The institute’s report is nothing more than lobbying masquerading as economic analysis. And just as S.&P. is paid for its ratings by the issuers, the institute is paid to represent the views of big banks. We would be wise to suspect that in both cases, the paying customer would prefer a particular outcome – irrespective of what the evidence says.
An edited version of this post appeared this morning on the NYT.com’s Economix blog. It is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.