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Do the coveted triple AAA ratings issued by Standard & Poor’s, Fitch and Moody’s really represent the gold standard of creditworthiness? As countries struggle with massive debt, these ‘seals of approval’ are being retracted, prompting calls for reform around the globe. We explore the role credit ratings agencies play, and how their judgments affect local, national and global economy.
- Lawrence J. White Professor of Economics, The Stern School of Business at New York University
- Sebastian Mallaby Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Senior Fellow in International Economics, The Council on Foreign Relations
MR. KOJO NNAMDIHave you ever loaned money and wondered if you'd be paid back? The answer usually depends on whether your borrower is responsible enough to reimburse you. Luckily, the financial world doesn't just rely on hope to determine if borrowers can repay money. They have three credit ratings agencies, Standard and Poor's, Fitch and Moody's to determine if cities, states and even whole countries are credit worthy. But the big three have raised hackles recently for downgrading countries like France, Austria and the U.S. that once held pristine triple A credit ratings.
MR. KOJO NNAMDIGovernment leaders at home and abroad say these agencies hold too much power over financial markets. They point to the credit agencies' disastrous role in the 2008 financial crisis as proof that reform is urgently needed. But is this just a case of wanting to kill the messenger or do these all important seals of approval really carry too much weight?
MR. KOJO NNAMDIJoining us in studio to discuss this is Sebastian Mallaby. He is the Director of the Maurice R. Greenberg Center for Geoeconomic Studies and a Senior Fellow in International Economics at the Council on Foreign Relations. Sebastian Mallaby, thank you for joining us.
MR. SEBASTIAN MALLABYGreat to be with you.
NNAMDIJoining us from the studios of the Argo Network in New York is Lawrence White, Professor of Economics at the Stern School of Business at New York University. Lawrence White, thank you for joining us.
MR. LAWRENCE J. WHITEThank you for inviting me.
NNAMDISebastian, before we get into the issues swirling around these credit ratings agencies, would you remind us what the primary job of the ratings agencies is and how investors use their ratings to make decisions.
MALLABYSure. Well, I mean, a ratings agencies job is to take a look at a bond which is a debt instrument and make a judgment as to the likelihood that the borrower who issued the bond will pay back the holder who bought the bond. So it's as simple as that. You know, what is the likelihood of a default?
NNAMDIA downgrade from S & P or Moody's might not tell investors anything they don't already know. So why do they tend to run financial markets so much?
MALLABYI think sometimes investors don't know more than the rating agencies. They're rather lazy. They hold a lot of bonds, but they don't have time to check them all out individually. So they subcontract that thinking, that assessment to the ratings agencies. And when the ratings agencies downgrade you, you know, investors may say, gee, that's not so good. I'll sell these bonds and then the price goes down. And also, the expectations that there may be some other investors out there who will do that could cause investors who do know more nonetheless to expect the price to go down because you expect the other investors to be selling.
NNAMDILawrence White, how did the world essentially end up relying on the judgment of only three main ratings agencies? What about other or third party alternatives?
WHITEThose are excellent questions. Partly, they develop their importance because they had a pretty good track record in providing information, opinions about the credit worthiness of the bonds issued by corporations, by municipalities and by countries. But also -- and this is a crucial part of the story -- starting in the 1930s, financial regulators, specifically bank regulators in the United States, started telling banks, you must pay attention to the ratings of basically these three guys when you make your decisions about what bonds you may want to buy and hold in your portfolios.
WHITEThe basic idea, we want banks to have safe bonds in their portfolios. Perfectly good idea. The trouble was by delegating this safety decision to basically these three guys we built up their importance to a much greater extent than otherwise would've been there just based on the reputation. And to expand on what Mr. Mallaby just said, when the big three, one or more of them, downgrade the bonds of an issuer, not only are the things that he said going on but also by downgrading this can affect whether a bank or a mutual -- or a pension fund or an insurance company or a money market mutual fund is allowed to hold that bond.
WHITEAnd so the downgrade really can affect the markets, not because they're telling the world anything about the underlying credit worthiness, but just because it's going to affect the regulatory ability of a bank or an insurance company or a pension fund to hold those bonds.
NNAMDII'd like to invite our callers to join the conversation. 800-433-8850 is the number. Are the credit ratings agencies' authority out of proportion with their findings in your view? 800-433--8850 or go to our website kojoshow.org, join the conversation there. Send us a Tweet at kojoshow or email to email@example.com. Larry White, about six years ago congress developed guidelines for fledgling credit ratings agencies to become licensed, pushing for an alternative to the big three. Are we seeing more upstarts on the horizon as a result?
WHITEWell, if you go back to the end of the year 2000 there were literally only those three, Moody's, Standard and Poor's, Fitch who had the special designation that regulators had told the banks, etcetera, you must attention -- pay attention to these guys. The Securities and Exchange Commission had become a huge barrier to entry. Since then, partly at the urging of congress and then the formal legislation in 2006, there have been more information providers that have gotten this special designation.
WHITEThere were two Japanese firms, now only one. There's a Canadian firm. There's AM Best insurance specialist and three smaller U.S.-based companies. In addition, there are smaller firms that don't have this special designation that can provide information to investors, but they don't have that official demarcation.
WHITEAnd another sort of underappreciated source of information, remember what's the information about, as Mr. Mallaby said, it's addressing the fundamental question of finance. Am I going to get paid back or what's the likelihood I'm going to get paid back? Well, at every securities firm, a Merrill Lynch or a Morgan Stanley or a Goldman Sachs or even smaller -- or a UBS or a Barclays, there are men and women who have the term fixed income analyst, that's their title.
WHITEWhat do they do? They provide information about the credit worthiness of fixed income securities. Those are bonds. They are additional sources of this kind of information. So there's lots of potential information out there. What I think we need to do for the future is try to open up the information space, reduce barriers to entry, get more firms providing information, if not letting a thousand flowers bloom, at least let a few dozen flowers bloom rather than just three.
NNAMDIMore about that later in the conversation, but allow me to remind listeners that the raters' opinions are usually characterized by a letter grade, the highest, the safest being AAA, with lower grades moving to double and then single letters and then down the alphabet from there. Sebastian Mallaby, we cannot talk about this topic without reminding our audience about the major role that credit ratings agencies played in the U.S. financial crisis before 2008. What happened?
MALLABYWhat happened was that there was a profusion of new credit instruments, these mortgage-backed securities known as CDOs, CDO squares and so forth, which turned out to be utterly toxic and were not paid back on. And that was the origin of a large part of the financial distress then spread throughout the system and led to the collapse of Bear Stearns, Lehman Brothers and so forth.
MALLABYAnd the reason that rating agencies have come in for a lot of criticism is that they rated those mortgaged-backed securities. And they often gave them a AAA rating and said, this is safe. And then, people bought them without looking carefully at what was the underlying quality of the mortgages, which turned out to be very dubious. And people got burnt. People lost all their money having put their faith in the ratings, which turned out to be the wrong place to put their faith.
NNAMDI800-433-8850. Do you think investors rely too strongly on the opinions of credit ratings agencies? 800-433-8850. Sebastian, in the midst of the housing crisis much of the criticism of these agencies centered around their business model in which the issuers of the debt paid the agencies for their ratings. But the United States and Europe have taken steps to try to mitigate these conflicts of interest. In the past few years they created new offices at the Securities and Exchange Commission and an independent authority in Europe. How effective or how influential have these offices been?
MALLABYYou know, I think they would claim, you know, they're working hard and it's too soon to pass judgment. But this debate about the conflict of interest at the heart of ratings has been around for a very long time. And essentially it's true that, you know, the issuers of the bond have an interest in a high rating. And they're the guys who are paying the ratings agencies to do the rating. And so there is a conflict of interest there.
MALLABYThe counterbalance to that is reputation. Is that if S & P were to be tempted to give a high rating just because they're being paid by the issuer of the bond and then it turned out that they were wrong, they take a reputational hit. And sooner or later, people won't pay attention to their ratings. And then, of course, there's no point being rated by them because the whole point of the rating is to make it easier to sell the bond. So this is an old conflict.
MALLABYAnd you won't escape the basic problem so long as investors find it useful to pay attention to the ratings and don't want to pay out of pocket to do their own research to judge the value of the bond. And the fact is that enormous amounts of bonds get issued and enormous amounts of institutions buy these bonds. Not all of them have the time, the energy, the resources to go and do fundamental research on the nature of the issuer of the bond. And therefore there will be these intermediaries that provide information and they're more likely to be paid by the issuer than by the buyer.
MALLABYAnd so market forces and so forth sort of prevent you from solving this conflict of interest to a large extent.
NNAMDIWhat do you think the big three agencies learned from the financial crisis?
MALLABYWell, I mean, one thing they might learn is that -- I mean, I think there's a simple lesson that they have learned and something else that they ought to learn. The simple lesson that they have learned is that you need to be tough. If something is going to get into trouble for goodness sake downgrade it ahead of time. Otherwise people will point their finger at you later. Of course they've done that with respect to European sovereign governments now. And the French government doesn't like being downgraded and so they get into trouble from the opposite direction.
MALLABYYou know, you mentioned, Kojo, in your introduction that they came -- the rating agencies were criticized both for their role in the crisis leading up to 2008 and for their role more recently in the European crisis. But of course they've done the opposite in those two cases. They were too lax on the mortgage securities and then they're arguably or they're accused of being too tough on the European sovereigns more recently.
MALLABYI think the more subtle lesson that is to be learned from the run up to 2008 is simply that any time you get a very fast expansion of a particular type of financial market, people have to ramp up their skills in assessing that new instrument. And they tend to be bad at that because you can't have enough and train enough smart people fast enough to keep up with the share of volume in new issues.
MALLABYAnd so that's what happens with hedge funds that I've written about that, you know, when they grow too fast they blow up. And that's also what happened with ratings agencies, that there was this profusion of mortgage-backed securities and there were simply not enough bodies to go and do the due diligence on all these different issuers of securities.
NNAMDILarry White, I'll ask you a two-part question that includes the same question I asked Sebastian. What do you think the big three agencies learned from the financial crisis. But I'll add to that an email we got from Sarah in Silver Spring that says -- or asks, "What kind of repercussions were there for the credit ratings agencies after the financial crisis? Who do they answer to when they make a multibillion dollar mistake?"
WHITEAll right. Let me take your question first and then Sarah's.
WHITEAnd I would echo what Mr. Mallaby just said. I think they have learned, you know, their reputation, which they'd been relying on, can get tarnished. They have to do a lot of repair of that reputation. They have been repairing their reputation but it's clear they still have a distance to go. And we won't know for a number of years, have they pulled their socks up enough. Have they really tightened things up?
WHITEUnfortunately as a consequence of having messed up so badly in the mortgage-backed securities area, that market has almost entirely dried up and it's going to be a while before it comes back. And so we won't -- that's where the problem was. We won't really know.
NNAMDIHow about repercussions?
WHITEAh, the repercussions. Well, they've gotten sued. And they -- I'm not a lawyer and so I would never want to practice law without a license. I don't know how those lawsuits are going to come out. Partly they've tried to defend themselves by claiming that they have First Amendment protection, that basically what they're offering is an opinion. And in that respect they are no different from the Wall Street Journal or the Washington Post or the New York Times editorial page. They're just offering an opinion.
WHITEAnd indeed there was a Law Review student, I think it was the Cornell Law Review who described a rating on a bond as the world's shortest editorial. Now in the Dodd-Frank legislation of 2010, among the other things that the legislation did was to step up the regulation of the credit rating agencies. I think that was a mistake. We can come back to that.
WHITEBut that's going to be costly for them. So they are enduring higher costs. And it lessened the protection for them and basically they can't use the First Amendment as a protection, or so the congress tried to legislate. Whether they can or cannot will ultimately be a decision of the courts because it's the courts who will decide the constitutionality of, you know, what gets protected by the First Amendment or not.
NNAMDIHere is Martha in Fredericksburg, Va. Martha, you're on the air. Go ahead, please.
MARTHAThank you. I've been -- I went through the S&L crisis in the '80s, and I've been watching this debacle play out, and having worked at a subordinate tranche holder in the CNBS world, we got a pretty good flavor of how the rating agencies looked and felt and interacted with folks. One of the questions I had was about the CDO square, the CDO cube. I mean, here these guys...
NNAMDII'm not sure our listeners understand what you mean by CDO square, CDO cube.
MARTHAThese are subordinate tranches of previously issued mortgage-backed securities...
MARTHA...that are then bundled into a collateral debt obligation.
MARTHAAnd the subordinate tranches themselves were rated below AAA, but yet, the CDO squares and CDO cubes somehow miraculously came out with AAA ratings. On its face, this makes no sense. There should be some criminality here in the way of fraud. How come nobody's going after these guys for doing something like this?
NNAMDIWell, as Larry White indicated, somebody is going after them in the case in the -- in lawsuits, but I don't think we have anyone here who can give you an expert legal opinion on how that is expected to turn out. Sebastian, you care to comment?
MALLABYI'll just make one comment which is that in fact as you perfectly well know since you've worked in this space, if you combine 25 risky things, but the risk is not correlated, so they go up and down in value and that's risky, because they're going up and down in value in different ways, in different directions, at different times, some of that volatility in instrument number one is going to cancel out and dampen the volatility in instrument number two, which also cancels out number three and so forth.
MALLABYSo it's not on its face ridiculous to say you can take 25 different risky securities, bundle them up together and create something which is AAA rated. Now, they got it wrong in this case, but it's not quite as simple as saying it's on its face ridiculous.
NNAMDIGot to take a short break. Martha, thank you very much for your call. Larry, hold that thought for a second...
NNAMDI...because we're going to come back after we take this short break. If you'd like to call us, 800-433-8850. Do you think the U.S. deserved its credit rating downgrade last summer? What about the downgrades in Europe? 800-433-8850. I'm Kojo Nnamdi.
NNAMDIWelcome back. We're discussing the controversy over the credit ratings agencies with Sebastian Mallaby. He's the director of the Maurice R. Greenberg Center for Geoeconomic Studies, and a senior fellow in international economics at the Council on Foreign Relations, and Lawrence White. He's a professor of economics at the Stern School of Business at New York University. And taking your calls at 800-433-8850.
NNAMDILarry White, you mentioned the Dodd-Frank Wall Street Reform and Consumer Protection Act which was enacted in 2010. It created an office of credit ratings at the Securities and Exchange Commission to hold rating agencies accountable and protect investors and businesses. You testified in Congress last year that the very provisions of the Wall Street Reform Act that are supposed to create competition for those agencies and spur innovation will actually discourage it. Please explain.
WHITESure. You have to understand that the Dodd-Frank Act, when it comes to the credit rating agencies, is sort of two minded. On the one hand -- and understandably reflecting the frustration -- reflecting the anger. Figuratively what the legislation does is tell the SEC grab these guys by the lapels, shake them, and shout in their faces do a better job, and so the SEC is instructed to draft regulations which it has done, to require that the credit rating agencies pay more attention to those potential conflicts of interest, and to be more transparent.
WHITEAgain, this is understandable, but the problem there is this kind of regulation raises the costs of being one of these designated credit agencies. The larger credit rating firms like Moody's, like Standard & Poor's, like Fitch, they're not gonna like the costs, but they can absorb it, they can deal with it. They have a big enough bureaucracy, they can handle it.
WHITEWhat this kind of regulation does is discourage entry. It's much harder on a small firm to try to deal with regulations. It's the same fixed cost basically is much smaller -- is much harder for a small firm to absorb, and so what I fear is that this is going to discourage competition. Ironically, it's going to make the big three even more important rather than less important. Now the other..
NNAMDIAnd go ahead. Go ahead.
WHITEAll right. The other strand, the other mind of the Dodd-Frank was to try to make the whole credit rating process less important for banks, for insurance companies, for pension funds, for money market mutual funds, and securities firms by telling the federal regulators look, figure out another way to make sure that there are safe bonds in the portfolios of your regulated institutions. Don't have this automatic reliance on just this handful, literally, handful of credit rating firms.
WHITEThe Securities and Exchange Commission to its credit has been moving ahead rapidly to tell the money market mutual funds and securities firms, look there are alternative ways to make sure that you're making safe investments. Unfortunately, then bank regulators, the controller of the currency, the Federal Reserve, the FDIC have been dragging their feet and have been much slower in revising bank regulations so as to reduce reliance and open up the possibilities of different voices, new voices, new opinions, that is all to the good.
WHITEWith new opinions, new voices, with entry, you get innovation, you know, new technologies, new methodologies, maybe even new business models. Innovation is good, and we need to see more of it. The first kind of regulation that I described is not going to encourage entry and innovation.
NNAMDISebastian Mallaby, your take?
MALLABYWell, I think Larry White advances an attractive vision of how you would get better quality ratings. More competition, more innovation, more voices in the picture, don't just reinforce the oligopoly with stifling regulation that increases barriers to entry and pushes the newcomers, prevents them from coming in. The problem is that when -- I think the original sin is the fact you've got too big to fail banks which are regulated by the government and which taxpayers are basically on the hook for to bail them out if they go wrong.
MALLABYNow, in that kind of world where banks risks are basically being safety netted, underwritten by taxpayers, the banks reasonably and rationally will take too much risk because the risks are being underwritten by the taxpayers. And so long as that's the case, they're gonna try and find clever ways of buying very risky bonds because they get paid more for them, and they will go out and try and create trouble. Now, that being the case, we need the government to prevent them from taking too much risk, so there has to be some regulation of the type of assets that they're holding, and if they have risky ones, then they're forced to hold more capital as a shock absorber if they don't get paid back on those risky bonds.
MALLABYThat's the whole apparatus of sort of bank regulation that's evolved over the last generation. Now, if you're going to do that, you have to have somebody making judgments about the quality of the bonds, and the government has a big interest in making sure that the raters are in fact overseen, shaken by the lapels as Larry White says, and told to do a better job. If you just said, you know, let's have competition, then the risk is that the banks will get themselves rated by the softer guys, or whether they will buy the bonds which have been rater by the softer guys, and, you know, the risk -- normally they wouldn't do that you might think because they're gonna risk their own money. But if, in fact, that's the taxpayers' money that are being risked, there's kind of a moral hazard there.
NNAMDIWell, here before you respond, Larry, I want to take it up a notch with Jack in Washington D.C. Jack, you're on the air. Go ahead, please.
JACKHi Kojo, thanks for taking my call. Great show. I wanted your guest to contemplate the idea of -- I hate to use this word, but I think it's appropriate, the nationalization of those big three rating agencies, combine that with less regulation of perhaps the banks or the market per se. With that thought, we do of course have SEC, FDIC and other regulatory agencies that govern, you know, the banks and so on, but why not do less of that and in essence turn these rating agencies into government operations.
JACKI think it makes a whole lot of sense, and I think also that any time our issuers are the ones paying the rating agencies, we're gonna end up in trouble. Case in point is that mortgage stuff in 2008 where basically they took BBB pieces and turned them into A bonds.
NNAMDIOkay. Allow me...
JACKThanks. I'll take my answer...
NNAMDIFirst you, Larry White.
WHITEOkay. First, let me address what Jack just talked about, and then I want to talk a little bit about what Sebastian Mallaby just...
NNAMDIWe do have some limits on time, but go ahead.
WHITESure. Okay. I'll try to be brief. Gosh. I think nationalization would be the absolutely worst possible outcome. I want more diversity of opinion and with nationalization you get a whole lot less. Further, I would worry about innovation. Also, and this links to what Mr. Mallaby just said, I'm a strong believer in effective prudential regulations of banks, insurance companies, pension funds. We want these guys to be -- these financial institutions to be making safe investments.
WHITEWe don't want them shooting them moon. We don't want them going out and doing wild and crazy things, and that's what we need prudential regulation to do. Capital requirements are a big part of that, making sure they have enough net worth to absorb potential losses, and he's right, that if you allowed a bank to get its information about making investments from anywhere, they would have an incentive to favor the information provider that would tell them go ahead, make this risky investment.
WHITEWe'll call it safe, and you can tell your regulator its safe, but you and I will know it's really risky, and that way they can take on more risk. What that means is the prudential regulator, the FDIC or the controller of the currency, or the Federal Reserve, have to look over the banks' shoulder, and have to not only ask them about the investments they're making, but ask them where you're getting your information. Are you doing your own research? Show us your research.
WHITEAre you relying on the XYZ credit worthiness advisory service? Tell us why you think XYZ is a reliable source of information. There's just no avoiding this kind of looking over their shoulder, but that would allow a greater opening of this information space.
NNAMDIWhat do you say Sebastian Mallaby?
MALLABYI think this does get to the nub of the question. I mean, there's not a lot of distance between Larry White and me I think on this, but what I'd say is that, you know, if you imagine the bank surveillance team, they arrive in the bank and they're trying to look and see whether there's too much risk being taken. We both agree that there's an incentive for the bank to take too much because of the too big to fail taxpayer safety net.
MALLABYAnd so the surveillance team shows up and it says, okay, how are you figuring out whether these bonds you're holding are really safe or not, and basically it seems to me that conversation ends up with oh, so you're getting your information about whether this bond is safe from some guys we've never heard of? Sorry, that doesn't work for us. You need a real rating on this thing from a reliable reputable company, otherwise we don't trust you, and then you're basically back to saying it's got to be Moody's, Fitch, S&P. So I think that tension is hard to escape.
NNAMDIWe're running out of time, but I do have to raise the politics issue. Last August, just after legislatures had reached an agreement that prevented the U.S. from defaulting on its debt, Standard & Poor's downgraded the AAA rating the U.S. has held for 70 years. Afterward there was a lot of complaining that this downgrade was largely influenced by political stagnation in Congress. Should agencies take politics into account when they make their decisions?
MALLABYObviously. I mean, the whole essence of deciding whether a given government is going to pay you back is to see, look, is the Parliament, is the Congress in this country actually going to vote the kind of tax policy and spending policy that makes it possible for these guys to pay us back, and so the whole nature of rating the credit quality of a government depends on looking at the people in that government including very much the people who make the laws about the budgets. So I find it a nonsensical complaint.
WHITEI agree. I, you know, you've -- the rating has to be a combination, the basic economics, the basic finance, but also the politics. I mean, if you think about last August, the United States came awfully close to not reaching an agreement, and possibly defaulting, and -- or at least for a few days not being able to satisfy its obligations. Now, remember, what did that downgrade mean? We went from extremely unlikely to default to a AA+, which is highly unlikely, but not extremely unlikely.
NNAMDII'm afraid we're...
WHITEWell, how can you disagree with that?
NNAMDII'm afraid we're just about out of time. Lawrence White is a professor of economics at the Stern School of Business at New York University. Larry White, thank you for joining us.
WHITEThank you for inviting me.
NNAMDISebastian Mallaby is the director of the Maurice R. Greenberg Center for Geoeconomic Studies, and a senior fellow in international economics at the Council on Foreign Relations. Sebastian Mallaby, thank you for joining us.
MALLABYGreat to be with you, Kojo.
NNAMDI"The Kojo Nnamdi Show" is produced by Brendan Sweeney, Michael Martinez, Ingalisa Schrobsdorff, and Tayla Burney, with assistance from Kathy Goldgeier, Elizabeth Weinstein and Paolo Esparone (sp?) . The managing producer is Diane Vogel. Our engineer, Andrew Chadwick. A.C. Valdez is on the phones. Podcasts of all shows, audio archives, CDs and free transcripts are available at our website, kojoshow.org. We encourage you to share questions or comments with us by emailing us at firstname.lastname@example.org, by joining us on Facebook, or by tweeting @kojoshow. Thank you all for listening. I'm Kojo Nnamdi.
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