Good morning, Your Honor. May I approach the bench, to do a sort of defense of Standard and Poor’s, pro bono?

There are many reports which indicate that the US department of justice is expected to file a civil lawsuit against Standard & Poor’s for the issuing of overly rosy credit ratings with respect of some collateralized debt obligations. 

If I was allowed to defend S&P, pro bono, without of course implying that any outright illegalities committed by it should not be punished, I would state the following: 

Your honor: Credit rating agencies have been around for a long time issuance opinions which are certainly quite often very wrong, by being very rosy or by painting a too dark picture. Doing the first investors and lenders might lose out in favor of borrowers, doing the latter borrowers might lose out in favor of investors or lenders. C’est la vie. 

But one thing I am absolutely sure of is that, had the bank regulators not assigned so much importance and so much credibility to some human fallible rating agencies, like by allowing banks to hold AAA to AA rated securities against only 1.6 percent in capital, and which translates into a mindboggling approved leverage of bank capital of 62.5 to 1 times, we would not be standing here. 

There would have not been the kind of pressures exerted on credit rating agencies to produce these AAA to AA ratings, and if produced there would not have been the same outrageous demand for these securities, and the consequences would not have been something to write home about. 

And so, if you ask me, the credit rating agencies broke the window, but the bank regulators, placed the stone in their hands. 

Your honor, in evidence of what I am saying I introduce here a letter I wrote in January 2003, and which was published by the Financial Times. It states: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds” 

Also, in April 2003, in a formal written statement delivered as an Executive Director of the World Bank I held: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on a limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.” 

And in May 2003 in an Op-Ed I also wrote “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators we find it so strange that the Basel Committee delegate, without any protest, so much responsibility in the hand of so very few and so very fallible credit rating agencies” 

Your honor, unfortunately the bank regulators did not want to listen, just as they still do not want to do. If you find Standard and Poor’s guilty of misdoings, something which you might do, I beg of you not to ignore those who unwittingly, but with extreme arrogance, set us up to all this disaster.

A wicked question to credit rating agencies, about risks and sovereign ratings

I suppose you are all professional with solid academic degrees and a lot of knowledge and experience rating the creditworthiness of borrowers. If not, excuse me and ignore the following question. 

You must be aware of course that bank regulators allow the banks to hold much less capital when investing in an asset that has been deemed to you as belonging to the privileged group of “The Infallible” than when holding an exposure to something less well rated or unrated. 

And you must be aware of course that this allows banks to expect to earn much higher much higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

And of course you must understand that this means than banks will invest more and more in assets considered to be part of “The Infallible” and less and less to assets considered “The Risky”, like small businesses and entrepreneurs. 

And so here is my question to you: With banks that are given special regulatory subsidies to invest, almost exclusively, in “The Infallible” and abandon, almost totally, the lending to “The Risky”, in a competitive world, can any country keep a healthy economy that allows it to service its long term debt at current levels of public debt? Is not a very important degree of risk-taking by banks a must to keep economies rolling? 

Would you, as risk analysts and practitioners, in normal circumstances, ever think of giving your personal investment managers similar risk-adverse orders? 

I know what the extreme importance given by the regulators to your credit ratings has done to your business… but, come on, frankly, is that just not something too risky for the world you want to hand over to your children and grandchildren? 

Sincerely, 

Per 

A friend, not out to shoot the messengers