The ratings agencies have been the story of the day, so I thought it would be interesting to take a closer look at Standard & Poor’s (S&P) using some of the ideas from my earlier post on Perrow’s concept of the organization as tool, and on the use and misuse of organizations in wider political and economic crises.
Business model and resource dependency
Since S&P’s business is not exactly capital intensive, they are not reliant on public markets (or in the case of S&P, their corporate parent McGraw-Hill) for capital, and if anything throw off a nice revenue stream. This effectively removes owners/shareholders from any meaningful consideration of influence.
Instead, there are two resources on which the agencies depend – funds and legitimacy.
In terms of funds, S&P has several sources of revenue though my understanding is that the bulk of it comes from two business lines. The first of these is the fees they charge to corporate issuers for ratings, which raises obvious conflicts of interest (for more on this, see Mark Thoma here). The second is licensing fees from their enormously profitable indices (e.g. the S&P 500). They also have businesses in equity research and risk management. It’s a minor point, but the above means that saying “Wall Street” is their only client is not entirely true.
This revenue structure raises an interesting question– how are they compensated for sovereign ratings? I don’t know the answer, but in practice I’d have to think that the global sovereign team which David Beers runs is in a tricky spot internally. Being both high-profile and heading up what may be a cost center within a profitable firm is never an easy balance. I have no idea what it means in the current situation, but I’d love to know the internal dynamic.
S&P also derives its legitimacy from two sources. The first is the US government, which granted S&P, Moody’s and Fitch special status as ratings agencies (for more on this see here). The second source of legitimacy is the fact that their ratings are universally used in setting regulatory and investment policy guidelines for institutional portfolios. Their use is so widespread that it would be unthinkable for an institution not to use them, as the career risk imposed by diverging from this pattern would be enormous.
Power dynamics I: ratings as a point of maximum system leverage
Ratings can be attached to the issuer (e.g. the City of New York), the specific project funded by a loan (e.g. the Second Avenue subway extension) or even the bond itself (e.g. 5% of 2018, which I just made up). Sovereign ratings are – and here I’m working from memory, with the usual caveats – attached to the issuer, which means that they affect everything the issuer currently has in the market as well as any future borrowing. Since most sovereigns are generally reliant on borrowing in global capital markets for at least some level of funding, this makes the interest rate at which they can borrow a hard limit on domestic political activity. This interest rate is in turn determined by investors’ assessment of risk, which is where the ratings enter.
The question of how the agencies have so much power in setting the market’s assessment of risk is one of the most profound arguments against efficient markets in fixed income. The effectively universal use of credit ratings by regulatory bodies and in the oversight of total return portfolios means that the largest pools of assets in the world have at some level outsourced their decision-making to agencies. That all of this happens in spite of the widely known failures of these agencies (see Konczal and Krugman for only two examples, or cf the entire financial crisis) is a failure of rationality so severe that it doesn’t even qualify as “bounded.”
The agencies are thus doubly important – they control the price of access to markets for issuers (via their risk ratings) and they also direct the behavior of buyers. In terms of power interactions then, the agencies derive their power over issuers from their irrationally granted power over buyers, with the latter being a function largely of inertia and the complexity of the bond market.
Power dynamics II: absence of accountability
The dynamic around S&P would be entirely different if there were a natural counterweight to their influence, but at the moment they have none. As I noted above, the three largest agencies hold their position by virtue of a government-provided status that provides them with enormous influence. That influence is housed, however, within private organizations that claim the first amendment protection from liability when challenged for their disastrous failings, and which are somehow never sanctioned by the government. The result is a relatively unique combination of enormous market power (and thus profit potential) without any accountability.
The threat to AAA
The next question is how they are currently using this power (for some examples of other such cases, see Konczal). I read the S&P report yesterday and was struck by a number of things.
The first was their insistence on $4 trillion as the necessary amount of deficit reduction. They give no rationale for this, though they do note that this was the highest number offered. By contrast, a typical S&P report on even a small sovereign is typically dozens of pages long, with numbing detail and rationales. This blatant shift in practice takes their analysis out of the realm of the financial, and indicates that their methodology (intent aside) is itself politically based.
That is bad enough, but there are two other things which taken together point to the non-financial nature of the whole charade. The first is their description of the baseline assumptions on which their “analysis” is based (emphasis added):
Congress and the Administration are debating various fiscal consolidation proposals. At the high end, budget savings of $4 trillion phased in over 10 to 12 years proposed by the Adminstration (sic), (separately) by Congressional leaders, as well as by the Fiscal Commission in its December 2010 report, if accompanied by growth-enhancing reforms, could slow the deterioration of the U.S. net general government debt-to-GDP ratio, which is currently nearing 75%. Under our baseline macroeconomic scenario, net general government debt would reach 84% of GDP by 2013. (Our baseline scenario assumes near 3% annual real growth and a post-2012 phaseout of the December 2010 extension of the 2001 and 2003 tax cuts.) Such a percentage indicates a relatively weak government debt trajectory compared with those of the U.S.’ closest ‘AAA’ rated peers (France, Germany, the U.K., and Canada).
As I noted in a dialogue with Yves Smith in her comments section to a related post, this could be an even more powerful enforcement mechanism than the threatened ratings change. Anyone who imagines that we will grow by 3% per annum over the next two years is insane, and surely they’re aware of this. Second, it is politically inconceivable that the Bush tax cuts will be allowed to expire. And as Yves noted, the debt to GDP ratios they use are unreasonably high, and are anyway compromised by the unproven assumption that there is some threshold value of “danger” in the first place (for more detail, see her comments).
My take on this is that we are highly unlikely to achieve even the baseline, and that is without the GDP-killing impact of $4 trillion in austerity measures. Worse still, given their opaque calculations, they have every option to change their calculation metrics at will, and thus move the goalposts. This looks to be a recipe for unending credit enforcement, at the whim of an entirely unaccountable private organization, regardless of whether we deliver the demanded cuts.
Finally, there is S&P’s telescoping timeline over the past six months. The first threat of a downgrade was issued in October of last year, at which point the time horizon until the potential downgrade was five years. The second threat was this April (four days after Obama announced his budget, as Jane Hamsher notes), at which point the horizon contracted to three years. The third arrived last week, and effectively reduced the deadline to weeks at the most.
There is no objective financial logic to any of this. The condition of the US economy did not change materially over that time period, or certainly not by anything so drastic as to justify a collapse in timeframe. And anyway, if S&P were so concerned about the fiscal “trajectory” of the US, where were they when Bush II spent the surplus and created the grounds for the borrowing that so concerns them now?
Given this behavior, the dynamics are nonsensical from the outside. There is effectively no regulatory oversight, which means there is no limit or cost to their government-granted legitimacy no matter what they do (including threatening the same government). Moreover, from what I can tell there has been no change in their dominant role in terms of regulatory and investment guidelines. Taken together, there is zero threat to their legitimacy from this behavior. It would be reasonable to question why that is.
As an additional wild card, the firm’s resource bases don’t seem to gain much from this behavior. Does “Wall Street” (I put that in quotes because the category is so large as to be meaningless – investment management firms are very different from global banks, though both are part of the Street) really benefit from this structure? Only under the most nihilistic scenarios in which ongoing market volatility profits the largest players. Corporate issuers certainly don’t appear to benefit at this level, since they have everything to lose from higher borrowing costs.
Looking outside of these constituencies, the next question is whether there are any comparables. The closest I can see is by shifting the unit of analysis from the specific organization to the broader institution it belongs to, which I would argue is global debt enforcement. The comps would then be the World Bank and the IMF in their interactions with weakened borrowers. The parallels are not reassuring. The typical pattern in the third world has been rampant lending by banks and global investors in boom periods, regardless of credit quality. During a bust, the banks and (less frequently) investors are to some extent made whole, while the vulnerability of governments near default is then used as a mechanism to force “reforms” such as forced privatization of state assets, slashing of public expenditures and other austerity measures that have suspiciously little to do with the debt itself (Naomi Klein’s Shock Doctrine). The World Bank and IMF are the enforcement mechanisms for these reforms, in concert with local elites who have little connection with the masses of citizens in whose names they agree to these programs.
This tracks uncomfortably closely with what is happening in the US, the UK and Europe. In the US, the ratings agencies looked the other way while the Bush administration spent the surplus and then some on fiscally disastrous wars and tax cuts. Where we diverge from the third-world model is in our lack of reliance on the World Bank or the IMF. But we most certainly are reliant on our rating, which puts S&P in the same enforcement position. We also differ from third-world countries in crisis in that our borrowing rates have most certainly not soared through the roof – if anything, they have been anomalously low. The only way to maintain the parallel with the World Bank/IMF is to have a crisis, which both the political system and S&P appear to have manufactured around the debt ceiling (though as noted above, S&P started on this path months ago).
The final parallel with the debt crisis model is the participation of the government. And looking past the horse race aspect of to the fact that the policies (as embodied in the Reid and Boehner plans) are substantively identical, there is a direct correspondence between the actions of S&P and the convergence of the political establishment on the alleged necessity for austerity (TPM has a great summary on the latter here).
That brings us back to the same question, since the political establishment is itself heavily resource dependent. And since actual votes are increasingly meaningless for a Congress in which north of 80% of incumbents are re-elected, the only resource that reliably matters is corporate contributions. It is logical then to assume that Congress is delivering what its most important resource base wants.
Which in turn brings us back to Perrow, oddly enough. Because if we take corporations as profit-maximizing entities, then increased borrowing costs would be a stupid thing to trigger. But if we take corporations as complex organizations that are run for a variety of ends (see for example Jay Rosen’s take on Murdoch) then the interests of those controlling the corporations become supremely important. Logically, these interests determine corporate donations, which then control legislation and the behavior of Senators, etc. There are added complications at each level – surely there are Tea Party freshmen acting at least partially out of conviction, merit aside – but the extreme resource dependence at each stage of that chain points to those in control of the first-stage resources as a significant controlling interest.
And at this point, in the absence of more information I am in danger of entering X-files territory of attribution to some vague “them,” which is not so useful. The implications seem quite clear, and that is bad enough. I will have some smaller posts on other aspects of this.
With thanks to CSC for helpful comments. Sentence added to fourth paragraph 8/15.