The Shame of the Ratings Agencies: How Moody’s Blows It Again

FROM TIME | JUNE 3, 2011

If the economic news wasn’t bad enough after the release of yet another anemic jobs report, the highly influential global ratings agency Moody’s just announced that it was contemplating a downgrade of the U.S.’s credit rating.

The proximate cause is the continued impasse in Washington over raising the debt ceiling, which if unresolved by early August will technically leave the federal government insolvent and unable to meet its daily expenses (little things like paying the army, sending out Social Security checks, turning on the lights at VA hospitals). Said Moody’s in its statement: “Although we fully expected political wrangling prior to an increase in the statutory debt limit, the degree of entrenchment into conflicting positions has exceeded expectations. … The heightened polarization over the debt limit has increased the odds of a short-lived default. If this situation remains unchanged … Moody’s will place the rating under review.”

This announcement follows a similar but less strongly worded warning by S&P several weeks ago, and these were seized upon by Republicans as proof that spending in the United States must be drastically cut. “This report makes clear that if we let this opportunity pass without real deficit reduction, America’s financial standing will be at risk,” thundered House Speaker John Boehner. “A credible agreement means the spending cuts must exceed the debt limit increase. The White House needs to get serious right now about dealing with our deficit and debt.”

The commentary surrounding the Moody’s announcement was predictably partisan, but lost in that fray is this: the most disturbing aspect of this episode isn’t America’s fiscal position, which we already knew about; it’s the power of a few private ratings agencies to create turmoil.

Moody’s, Standard & Poor’s, and Fitch are three of the most powerful actors in the global financial system. Their inability to discern the flimsiness of those “investment grade” mortgage-backed securities between 2006 and 2008 was one reason for the implosion of that system in 2008 when it became apparent that those trillions of dollars of securities and their derivatives were worth a lot less than it seemed. Yet for all the reforms since then, the ratings agencies remain largely untouched.

That’s because those ratings underpin almost every major investment decision by every major institution in the world. Often, those institutions – from pension plans to sovereign wealth funds to companies themselves – cannot invest in bonds that are less than investment grade as determined by those agencies. It is a perfect “pass the buck” system and allows institutional investors to evade some responsibility if their decisions prove wrong. “Hey, it wasn’t out fault. Moody’s said they were credit-worthy.”

Add to this yet another issue: the United States debt market of Treasury bonds and bills is one of the anchors of the global economy. The dollar remains the preferred – though not much loved – currency of international commerce. The purchase and sale of U.S. Treasuries is not something the world can halt if Moody’s or S&P or Fitch decide one day that there are credit questions. Until the Chinese yuan or the Brazilian real or the euro or some new synthetic currency replaces the dollar, and until there is a market liquid enough to absorb the trillions now invested in U.S. Treasuries, countries and institutions can’t just shift gears and divest of their U.S. holdings simply because one day ratings agencies decide that they should.

So it is patently ridiculous that these agencies are even in a position to hold court on U.S. creditworthiness. It’s not that their analysis of the challenges and pitfalls is useless: far from it. But it is the degree to which that analysis is supposed to be connected to action, and there is a world of difference between saying that company X is no longer investment grade and saying the same of the United States. At best, such a decision will roil markets and sow confusion; at worst, they will trigger a wave of selling and a race to the bottom that could make the mistakes of the ratings agencies during the financial crisis look small in comparison.