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Lawrence J. White
Deputy Chair of Economics Department at Stern School of Business, New York University, US; Former consultant to U.S. Farm Credit Administration, U.N. Economic Commission for Europe and U.S. Federal Housing Finance Board
Dukascopy is persisting to find out more about the rating agencies that are often blamed for the failure to predict the financial crisis of 2008. As they are said to play a significant role in the ongoing European debt crisis, we have asked an expert in Economics, Professor of New York University, author and editor of a number of books on economics; Lawrence White, to give his evaluation of the matter.
1) What is your assessment of the rating agencies' current activity?
I think rating agencies are trying to make their best judgement about the creditworthiness prospects for the various European countries and banks. This is what they do for a living, although they are, in my mind, a bit late. That is a usual thing with the rating agencies; they usually leg behind the markets in their assessments. Of course, they are being criticized by European leaders who argue that the downgrades are not justified and are making things worse. But before, as you know, in the subprime mortgage securities debacle, they were criticized correctly for being too optimistic in their initial ratings of the securities. Nowadays they are being criticized for being too harsh; the European politicians are pleading agencies to be more lenient.
If we take this year's US rating's downgrade, for instance, there is a difference between what the S&P and what the market believe in. I see the S&P downgrade this year for US from AAA to AA+ as being still pretty good. If I had to give a rough words equivalent, I would say that AAA, extremely unlikely default and a double A+ is highly unlikely, but not extremely unlikely.
But still, the US Treasury debt is widely held, the markets still believe that it is not clear at this point whether there was a major market adjustment that happened as a consequence of S&P downgrade. My perception is that markets still use the US Treasuries as a benchmark. Nevertheless, I think that at some point the financial markets will get worried about the ability of the US to honour its obligations, particularly, if US political system does not come to an agreement on how to deal with the long-run deficit problems.
2) Do you support the more and more pronounced suggestions to regulate rating agencies?
I think it is a dreadful idea because these are basically information providers. From my position, people want to see more information providers in the market place. My fears are that the regulation will raise the barriers to entry: it will be more difficult or more costly to become a rating agency and this will ironically discourage entry; it will make the major rating agencies even more significant. This kind of regulation is not needed because the bond market is primarily institutional market; it is financial institutions that are investors here.
The only modest exception is that around a third of the US municipal bonds are held by households, and even there two thirds are held by financial institutions. It means that the investor is a professional bond manager for a bank, or insurance company, hedge fund, or mutual fund; and these are professional managers taught to be able to figure out what is a reliable source of information about the creditworthiness of bonds that the bond managers want to buy or sell. Maybe the investor can do his/her own research, but maybe he/she needs to rely on the third party information provider with a professional bond manager. They ought to have the expertise to make these kinds of judgments about who to rely on.
We still need to have prudential regulation of banks, insurance companies, pension funds, money market mutual funds, so as to assure their creditors that the bonds in the portfolios of those institutions are safe and appropriate. This, nevertheless, does not mean that we need to rely blindly on the rating agencies as it has been through the last 35 years and it does not mean to regulate them. The market for information should be able to discipline the bad providers of information and encourage the good ones.
Not only we do not know how to regulate the rating agencies, but we also should not. It would discourage the ideas, new methodologies, technologies, possibly even new business models. That would come with entry, but regulation would discourage it.