Where Did S&P Get Its Power? The Federal Government (Of Course)

When Standard & Poor's downgraded the credit rating of the U.S. government on August 5, and the global economy trembled, a natural question is: "Who gave them all this power, anyway?" The same question arises when Fitch announced earlier this week that it would not issue a similar downgrade. The answer to who made the credit rating agencies so powerful is: The federal government. Lawrence White encapsulates the history in the Spring 2010 issue of my own Journal of Economic Perspectives, in an article on "The Credit Rating Agencies." Larry writes: 

"However, a major change in the relationship between the credit rating agencies and the U.S. bond markets occurred in the 1930s. Bank regulators were eager to encourage banks to invest only in safe bonds. They issued a set of regulations that culminated in a 1936 decree that prohibited banks from investing in “speculative investment securities” as determined by “recognized rating manuals.” “Speculative” securities (which nowadays would be called “ junk bonds”) were below “investment grade.” Thus, banks were restricted to holding only bonds that were “investment grade”—in modern ratings, this would be equivalent to bonds that were rated BBB– or better on the Standard & Poor’s scale. With these regulations in place, banks were no longer free to act on information about bonds from any source that they deemed reliable (albeit within oversight by bank regulators). They were instead forced to use the judgments of the publishers of the “recognized rating manuals”—which were only Moody’s, Poor’s, Standard, and Fitch. Essentially, the creditworthiness judgments of these third-party raters had attained the force of law."

"In the following decades, the insurance regulators of the 48 (and eventually 50) states followed a similar path. State insurance regulators established minimum capital requirements that were geared to the ratings on the bonds in which the insurance companies invested—the ratings, of course, coming from the same small group of rating agencies. Once again, an important set of regulators had delegated their safety decisions to the credit rating agencies. In the 1970s, federal pension regulators pursued a similar strategy."

"The Securities and Exchange Commission crystallized the centrality of the three rating agencies in 1975, when it decided to modify its minimum capital requirements for broker-dealers, who include major investment banks and securities firms. Following the pattern of the other financial regulators, the SEC wanted those capital requirements to be sensitive to the riskiness of the broker-dealers’ asset portfolios and hence wanted to use bond ratings as the indicators of risk. But it worried that references to “recognized rating manuals” were too vague and that a bogus rating fifi rm might arise that would promise AAA ratings to those companies that would suitably reward it and “DDD” ratings to those that would not."

"To deal with this potential problem, the Securities and Exchange Commission created a new category—“nationally recognized statistical rating organization” (NRSRO)—and immediately grandfathered Moody’s, Standard & Poor’s, and Fitch into the category. The SEC declared that only the ratings of NRSROs were
valid for the determination of the broker-dealers’ capital requirements. Other financial regulators soon adopted the NRSRO category and the rating agencies within it. In the early 1990s, the SEC again made use of the NRSROs’ ratings when it established safety requirements for the commercial paper (short-term debt) held by money market mutual funds."

"Taken together, these regulatory rules meant that the judgments of credit rating agencies became of central importance in bond markets. Banks and many other financial institutions could satisfy the safety requirements of their regulators by just heeding the ratings, rather than their own evaluations of the risks of the bonds."

White goes on to discuss how the NRSRO category has evolved over time, and how Congress more-or-less bludgeoned the Securities and Exchange Commission into allowing some additional NRSROs in the last decade. His article, written in 2010, also points out that one reason why the housing bubble spread through mortgage-backed securities and into the banking system was that the NRSRO's like Standard & Poor's gave some of that debt a tremendously misguided AAA rating. Far too many banks and bank regulators just accepted that rating, although S&P and the other credit rating agencies had no particular history or expertise in evaluating these somewhat complex financial instruments based on subprime mortgage debts. White and others have long argued that while it's perfectly fine to have firms which sell their expertise and opinions about the riskiness of bonds, there's no reason to anoint some of them in such a way that banks and bank regulators legally outsource judgment and prudence to them.

Maybe S&P is wrong to downgrade the U.S. credit rating. But after it whiffed so spectacularly and totally missed the riskiness of the subprime-related mortgage backed securities, it's seems a bit unsporting to turn around and criticize them for being too vigilant now. And if the U.S. government doesn't like the power wielded by S&P--well, it has only itself to blame for bestowing so much of that power in the first place.