A couple years ago, I was talking to a group of high school students about the economic crisis.  One of them asked me a pretty simple question: If I had to blame any one person or group for the crisis, who would it be?  Back then I had said the major rating agencies (Moody’s, S&P and Fitch) were probably most to blame, succumbing to massive conflicts of interest and generally doing a poor job.  I thought it was a combination of greed and laziness.  But now I’m beginning to see that there’s no way those two forces alone could be steering these organizations.  Since S&P downgraded the credit rating of the United States of America (for the first time in history), I’ve come to the conclusion that they’re also stupid.  And maybe a little bit evil.  In fact, if I were to adopt the debating tactics of some Fox News pundits, I might go so far as to say:

Standard and Poor’s (S&P) hates America.  S&P also hates freedom.  (Search engines, eat your heart out.)

First some basics: the rating agencies have the job of determining how creditworthy a particular investment is.  They give ratings to everything from mortgage-backed securities to bonds issued by the US Treasury department.  In some cases, we refer to the rating of an entity (for example, the State of Delaware is rated AAA by all 3 major rating agencies).  This just means that when that entity issues bonds, they get whatever rating we’re saying is held by the entity itself.  The ratings places like S&P assign are supposed to reflect how likely it is that an investor will be paid the money he or she has been promised.

Why should we care?  Credit ratings matter.  References to credit quality as defined by these ratings are everywhere, even formally written into some laws and regulations governing how public money can be spent.  Lots of investors rely on them, and portfolio managers often are constrained by them as well.  Almost everyone in the economy is directly affected by credit ratings in at least some small way, and everyone in the world is indirectly affected.  Credit ratings can have an impact on investment availability, investment performance, how easy it is to get a small business loan, how governments manage and raises taxes, rates on mortgages and student loans and car loans…basically everything financial.

How does a place like S&P determine what the ratings should be?  Well, presumably they do a lot of really sophisticated analysis, involving interviews, reading, investigation, and lots of rigorous economic modeling.  In reality, it’s more like reading the newspaper and throwing darts.  Here are some highlights from the past few years.

Real Estate Prices
Rating agencies are often tasked with assigning credit ratings to investments that are tied to real estate markets (for example, mortgage-backed securities).  Before the bubble burst, some of the economic models used to determine these ratings didn’t allow for the possibility of negative price growth.  That is: sometimes it was assumed that real estate prices could stay the same, go up a little, or go up a lot.  But a fundamental assumption built into the very beginning of some of the analysis was: real estate prices don’t go down. Of course those bonds are going to come out with perfect AAA ratings!  They’re tied to investments that can never lose money!

Conflicts of Interest
Pretend you’re a rating agency.  An investment banker comes up to you with a new kind of bond you’ve never seen before.  The way they work is buried in 400 pages of legalese, but they’ll give you a slick PowerPoint presentation that shows how financial wizardry, brilliance and magic turns risk into gold.  You really have no idea how it actually works.  But here’s what you DO know: if you give it a perfect AAA rating, people will buy the investment, and the banker will make more of those bonds.  Every time he sells a batch of bonds, he needs you to put the “AAA” stamp on them, and each time you use that stamp, you get paid $50,000.  If you give his new idea a lower rating, you only get one payment and he never comes back to you.  Don’t you think those bonds are looking like a pretty safe investment?  This is more or less exactly what enabled the subprime markets to get out of control.

If you ask me, stamping AAA on everything that came across their desk was probably the #1 contributing factor to taking down the global economy back in 2008 and 2009.  If the rating agencies has said “No way, these are super risky” things wouldn’t have been nearly so bad.  A move like that would also have been known as “doing their job.”

Slow Reactions
Rating agencies are supposed to be out in front of news.  Ratings are supposed to predict what’s going to happen, how likely an entity is to default.  But in fact, rating agencies are often very reactionary; their ratings reflect the past, not the future.  They downgraded the United States government AFTER the biggest danger had passed.  Before there was a debt ceiling deal, yes, maybe there was a high probability of default.  But S&P basically decided to point out a problem after the worst of it had been taken care of.

Even internally, rating agencies are slow to react to problems.  Remember those massive conflicts of interest we were just talking about?  It wasn’t until after the meltdown that Fitch decided “Maybe we shouldn’t have the guys who give the ratings be the same guys who quote the prices and try to drum up new business.”  I found out this fact from a Fitch employee who was actually BRAGGING about how proactive they were being and how well they were learning their lessons.

General Incompetence
When S&P downgraded the United States of America, they gave the government a preliminary copy of their report.  The government almost immediately found a two trillion dollar error.  That’s “trillion” with a T.  Now, I’d like to think that a group of people making an announcement that will affect the health and actions of the entire global economy would be a little more careful than that.  But if an error was pointed out to them, don’t you think they’d at least have the common sense–or even the basic human decency–to go back and double check things again?  If a two trillion dollar error immediately jumps out of a report (a report which doesn’t even contain all the details and proprietary models), what other mistakes might they have made?  So guess how S&P responded:

They deleted the part of the report with the error and downgraded the United States anyway, according to their original schedule.  And I suppose it bears pointing out that they’re hurting the United States today for reasons that were largely the fault of the rating agencies themselves.  Which prompts me to ask…why does S&P hate America so much?

I can’t tell what the exact mix is between greed, stupidity and evil, but I do have a proposal:

Let’s all band together as a global community and just stop listening to these people.

Or at the very least, I’m going to start my own rating agency which rates the credibility of other rating agencies.  Right now, I’d say Moody’s is in the lead with an F, while S&P and Fitch are neck-and-neck with solid F-minuses.  I’ll give my own rating agency a BB (that is, way ahead of the other agencies, but honestly, it’s all speculative.  I’m just a guy with a blog–but at least I’m an HONEST guy with a blog).