Rating Agency Follies: Conspiracy Theory Edition

Will the US' debt-rating be downgraded from its current AAA-rating? And will it matter if it is?

In response to today's near-downgrade of the UK's debt rating by S&P, Joe Weisenthal wonders whether the US faces a similar fate:

The lesson from today's UK almost-downgrade? There are no sacred currencies in the world.

Even though the UK borrows in its own money (and could theoretically print its way out of a crunch), debt is, alas, debt. And no entity that's drowning in a mountain of debt as big as its GDP ought to be AAA.

But it may ultimately be a long while before the ratings agencies make such a potentially cataclysmic change in America, in part because the ratings agency monopoly is owed to the kindness of the US government. We're also still in an environment where the dollar is the place where panicked investors park their cash. And though this may end some day, there's no evidence of it happening anytime soon. The bottom line is that there's just no alternative. Not even close.

 Felix Salmon disagrees with the premise:

...S&P putting the UK on watch for a possible downgrade is a decision prompted by economic fundamentals. Any such move with the US, by contrast, would be entirely political, and in any event would say much more about S&P than it did about Treasuries.

The most important thing to remember here, however, is that ratings agencies don't matter any more. They lost their credibility when structured finance blew up, and the number of people buying Treasuries because S&P says that they're triple-A rated is exactly zero.

There are lots of triple-A rated securities; people buy Treasuries because they're liquid. The US triple-A may or may not disappear at some point, but if and when that happens it'll be a lagging indicator, and there will already be a select group of alternative securities which are trading at lower yields in dollars. So long as Treasuries have the lowest yields in the dollar-denominated world, they will retain their triple-A, and there are much more important things to worry about.

(And see the post linked in the above excerpt for more good points about how the favored status of Treasuries comes from their superior liquidity rather than credit quality per se.)

I wonder, though, if the rating agencies might have one last bit of systemic mischief in them.  Even if the rating agencies are irredeemably broken, too many parts of the financial system are still leveraged to their non-credible verdicts - not least due to the favored status of their ratings under various aspects of our banking and securities regulation.  Extracting the rating agencies' ratings from the regulatory system has so far gone as smoothly as a root canal sans anaesthesia - for example, the rule changes proposed by the SEC to remove rating agencies from their role in determining permitted investments for money market funds were conspicuously not adopted at the time other rule changes were made (see footnote 1), perhaps due to the firestorm of criticism prompted by the proposed amendment.  And I wish I could be as sanguine as Salmon that, in light of the US' spiraling debt, a potential downgrade of the US would be "entirely political" as opposed to the UK.  Salmon is surely right that the value of Treasuries is partly-at-best related to its rating, but I would think even the threat of a downgrade - even if only to AA - would sufficiently disturb Treasury auctions to make life very, very problematic for the Obama administration and its plans (not to mention the economy as a whole). 

So I wonder: might the Obama administration make it a high priority to finally remove rating agencies and their flawed judgments from their favored position within the regulatory system, before they can wreak any last havoc on the Obama administration's ability to fund its agenda in the short-to-medium term? Perhaps this could be the financial regulatory equivalent of sending Jon Huntsman to China. And as an added bonus, it would probably be good policy.

Unfortunately, I'm not sure exactly how to get the rating agencies out of the system.  Suggestions are welcome below.

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Dr. Manhattan

Dr. Manhattan is the pseudonym of a lawyer in New York City who represents, among others, clients in the investment management industry. He started blogging in early 2002, when the entire NYC-based blogosphere could gather in one room (which they often did). In between his frequent retirements, he blogged about politics, baseball, Israel and autism (especially vaccine-related matters) at blissfulknowledge.com. With the regulatory system up for grabs, for this project he has decided to try the novel approach of blogging about matters which bear some relationship to the topics that come up in his day job (within the strict limits of professional obligations, of course). In case anyone was wondering, none of his opinions expressed on this blog are necessarily those of his clients, employer or colleagues.

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