Tuesday, January 17, 2012

Why Debt Downgrade Matters Even Though It Shouldn't

Given the fact that bond yields of most of the euro area countries that were downgraded by Standard & Poors actually fell (contrary to what one might expect), similar by the way to how U.S. treasury yields dropped after they got downgraded by S&P, one can ask if S&P and other credit rating agencies have become irrelevant.

The short answer is: no thay haven't, though they should.

First of all we must realize that the move was expected and therefore already more or less priced in before the formal announcement after Friday's closing, so big changes wasn't to be expected. And other factors, for example ECB bond buying was active in pushing down yields.

And secondly, we have a really good reason to expect ratings to matter: namely that regulation requires many fund managers to only hold bonds that have sufficiently high ratings. It was because of this that Portuguese bond yields (already the second highest after Greece's) soared, as the downgrade forced many bond holders to sell.

But this is clearly something that should be changed. The credit ratings of credit rating agencies shouldn't in any way be encouraged or be made a mandatory standard by governments. They shouldn't play any role in legal accounting rules, nor in rules of which securities funds should invest in. This is both because it is principally wrong for governments to give private institutes such priviligies and because of their awful track record (to the extent they've been "right" it has almost always been because of the self-fulfilling prophecy mechanism).

So unfortunately, the incompetent redit rating agencies matter. But they shouldn't.


Blogger doug said...

They shouldn't matter at all. Seems to me that at some point, rules will be changed to allow bondholders to hold bonds of lower rated countries to ratchet down investment standards in lockstep with a declining credit environment. I find despicable the loophole around Greece's 50% haircut triggering the CDS explosion. Why invest if rules will simply be changed to screw you anyhow?

8:47 PM  

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