by Garrett Baldwin
, Investment U
"We have really lost faith in S&P's judgment," said Los Angeles Treasurer Steve Ongele this month.
Well, who hasn't?
S&P specializes in flawed credit ratings that help sink global markets. The Department of Justice is conducting a sweeping investigation of the firm's role in the crisis, conveniently just weeks after the agency downgraded U.S. debt.
And now, the CEO is stepping down and being replaced by the COO of Citibank. This bank's parent, Citigroup, lost big in the housing market and required several hundred billion in taxpayer bailouts…
So now, it's Los Angeles' turn to chant, "Down with the S&P."
Los Angeles officials are upset because they pay S&P to rate the soundness of their investment portfolios, but they didn't like the rating they recently received.
Read that again.
The city pays someone else to give them a gold or silver star on their debt security.
But this month, the agency downgraded the city's $7-billion investment portfolio. L.A. responded by canceling its $16,000-a-year contract with the ratings giant. The city's trying to argue the portfolio is secure. Doesn't this sounds very familiar…
Forget about the actual rating for a moment. Ask another question: Why is a city paying an agency to rate the soundness of its own investment portfolio? The reason why is a problem that regulators, brokers and everyday investors have ignored for more than 30 years… and now it's biting everyone involved.
The three largest agencies – Standard & Poor's, Moody's and Fitch – dominate the ratings game. Own a company or run a nation and want to issue bonds in order to borrow money? You'll need a rating from one of these big three. If they disapprove or drop their confidence in your ability to pay it back, you're going to have a hard time finding credit anywhere.
But here's the catch. You have to pay them to rate your investment products. So, naturally, there is a perverse incentive for the agency to provide good news and keep the borrower happy. Keep that rating up, and they'll be coming back with more investment products, more reasons to borrow, and S&P would gladly provide that rubber stamp.
And now, it looks like S&P and other agencies are trying to save face after the financial crisis. Those customers who thought they deserved vaunted AAA status aren't happy.
Origin of a Crisis
Unintended consequences of government policy led to an ugly romance between credit agencies and financial institutions. In their early days, credit agencies aimed to provide investors with an unbiased assessment of competing investments. The investors paid them for access to the ratings.
But in the early 1970s, the agencies began charging the issuers of new investments fees to provide investors with those product ratings. U.S. legislators immediately feared there would be a boom in new agencies, all seeking to profit in this new ratings market. In 1975, the SEC curbed its concerns by designating Standard & Poor's, Moody's and Fitch as the only ratings firms that banks and brokers could use to score their product's credit worthiness.
And then a funny thing happened… nobody seemed to pay any attention to the quality of the ratings until after the recent crisis.