Incredible rating agencies

Rating agencies: Why do markets still pay attention to what rating agencies have to say? Following their appalling record predicting the subprime mortgage crisis, it is astonishing and sad that investors still seem to quake when Standard & Poor’s junks Greece and downgrades Spain. An arriving Martian would find it hard to understand why anybody gives any credence at all to S&P and its rivals Moody’s or Fitch. It’s not just that they were pumping up the US subprime market — for example giving a triple-A rating to Abacus, Goldman Sachs’ now-notorious synthetic collateralised debt obligation - after smart investors saw trouble in the market.

They were late in spotting the wave of corporate debt defaults, including Enron’s, in the early part of the century. And they have been dilatory in calling attention to the current euro zone sovereign debt crisis. Even after S&P’s downgrade of Spain, Moody’s and Fitch, the other big agency, are still rating the country's debt at triple-A. Ratings agencies are consistently behind the curve.

So why do they still wield influence? There are at least two reasons. One is because they are embedded in the way markets operate. Some investors, for example, are only allowed to buy investment-grade securities. That means they have to sell securities when they are junked. Similarly, ratings are used in determining the riskiness of a bank’s balance sheet and how much capital it needs to set aside.

Ratings are also common in deciding how big a haircut is required when banks and investors pledge collateral. One saving grace in the euro zone crisis is that the European Central Bank has stopped saying that only the highest rated sovereign debt can be pledged as collateral. But ratings are still far too entrenched.

The other reason why markets pay attention when the agencies bark is what could be called the “megaphone” effect. S&P and Moody’s may not be the smartest observers in the market; but they do make a big noise. It’s a bit like shouting fire in a crowded cinema. The agencies aren’t the first to spot the problem; but they sure help create a panic. It is high time regulators and investors dethroned them from their privileged status.