Dear Everyone: Stock Market Problems Are Not Directly Due To S&P Downgrade

from the how-to-read-a-market dept

This morning we posted about the total silliness of people overreacting to S&P downgrading US debt from AAA to AA+. We received a couple of "you clueless idiot" type comments, with people pointing out that this "matters" because some institutions are required by law to hold certain percentages of certain grade investments. Of course, we did mention that in the post, so I'm going to take the blame and admit that I perhaps wasn't clear enough and now will try again: my point is that it's stupid that anyone has to react because one firm (with a rather poor track record) in "rating" debt suddenly makes a slight shift in its opinion, and that such a change in opinion represents no real change in how people view the market.

My point -- which again, was perhaps not clear even though it was the final line of the post is this:

Markets are made based on the interaction of buyers and sellers. Not the (sometimes questionable) opinions of just a few firms.

Now, let's prove it. All of the press reports today are saying that the stock market collapse is due to the S&P's downgrade. And that may be true in a very indirect way (which we'll get to), but there's no way it's a "direct" response. Here's why: the S&P is saying that US debt is just ever so slightly riskier than it was before. If that's true, then the market would likely be dumping treasuries and the interest rate would be going up. Instead, the exact opposite is happening. It looks like buyers are flooding into treasuries and the interest rate is dropping. Even economists, who generally take totally opposing opinions to one another, are trying to point this out. You've got Paul Krugman (self-described liberal) complaining about people missing this point... and you've also got libertarian Arnold Kling making the same point.

Now it could be that the downgrade indirectly triggered the stock sell-off, but it's not because S&P is suddenly afraid of the US debt being less trustworthy. As Kling notes (and I suggested in my original post), the market already can determine how risky US debt is and has priced that into the market. One firm's opinion should not change that. If anything the action in the market suggests that people are rejecting the S&P's change, not freaking out because of it.

So then why is the stock market dropping? There could be a variety of indirect reasons. One might just be that some investors are generally overreacting to the news without understanding it at all, and thinking "bad news means sell." Another theory is that this move jolted some people's attention to larger problems elsewhere (mainly the fear of Italy running into trouble). But I actually tend to think that Krugman's analysis here is actually the most reasonable. He argues that the reaction in the stock market means that US policy makers are about to overreact badly, because of the S&P downgrade, and do something stupid to harm the economy even more:

And maybe, maybe there is an S&P story — but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.

But, why isn't anyone talking about a very serious problem: the fact that we allow ratings agencies to have so much power in the first place? A ratings agency is just an opinion. What's wrong with letting the market set the opinion of the likelihood of default on debt, rather than suddenly trusting firms that don't have the greatest track record?

Filed Under: debt, markets, ratings agencies
Companies: s&p

Judge Says Ratings Agencies Are Not Necessarily Protected By Free Speech

from the that-seems-bad dept

The big ratings agencies, Moody's and S&P have taken something of a beating for their role in the financial crisis -- often rating pure junk as if it were pure gold. But, of course, in the rush to find someone to blame legally, it made little sense to go after the ratings agencies. The real problem wasn't that the ratings sucked (they did), but that federal regulations gave those ratings power in the law. This made those ratings not only more important, but gave them an official "stamp of approval" such that people assumed (incorrectly, obviously) that they must be accurate. The idea that a small group of guys sitting in an office could more accurately rate the risk of debt over the actual market seems rather absurd -- and yet, we gave it the federal stamp of approval. Still, as bad as the ratings were, there shouldn't be any legal consequence for getting the ratings wrong. After all, unless there was evidence of outright fraud, the ratings are simply opinions, which are protected by the First Amendment... or so we thought.

In a ruling last week, a judge has noted that ratings agencies' ratings are not protected free speech if they're only disseminated to a small group of people, rather than the wider public. While the ruling cites a few earlier cases, I have to admit that I have trouble understanding this reasoning. I don't recall anything in the First Amendment that says the government can restrict freedom of expression if it's to a small group of people, but not if it's to a large group of people. This probably isn't a huge deal for the ratings agencies -- though, it will keep them busy with some lawsuits that may cost them some money. The bigger "problem" in the market came from relying on their public ratings -- and those should (still) be protected.

Filed Under: free speech, ratings agencies, wall street
Companies: moody's, s&p

Why Did We Put Ratings Agencies' Ratings Into The Law?

from the good-questions... dept

Problems and potential conflicts coming from the bond ratings agencies were well-known well before our financial crisis hit, but still many are pointing the blame finger at those ratings agencies. And, it's certainly tempting to do so. Just as with the famed financial analysts during the late 90s tech boom, the credit agencies appear to have rated certain debt offerings very highly, despite recognizing how intrinsically risky the investments were. Given what happened following the dot com bubble collapse, it's quite likely that the bond rating agencies Moody's and S&P will get slapped down for their "mistakes."

But that would be a mistake. Both Moody's and S&P were merely expressing an opinion on the credit-worthiness and risk of the various debt offerings. An opinion should never be considered illegal by itself. The problem was that people started relying on these opinions as if they were factual realities. And who's to blame for that?

Well, in part, it's the government -- which wrote the rating agencies' ratings into law, requiring certain regulated institutions to maintain a certain percentage of "highly rated" bonds in order to engage in certain activities. That made it so the real focus was on the opinions of Moody's and the S&P, rather than on what investors believed the actual risk was on those bonds. As the link here notes, why not let the market decide what the actual risk is on these bonds, rather than trusting the (somewhat questionable) opinions of individuals who are biased and conflicted?

Filed Under: ratings agencies, regulations
Companies: moody's, s&p