Markets shouldn’t be scared by the rating agencies

May 21, 2009

Ratings agencies got in trouble for being too lax on the way up. Now they are in trouble for being too strict on the way down.

News that Britain was in danger of losing its AAA rating left investors uncertain where to put their money. At least for today, Britain’s embarrassment spilled over into other markets. A decline in stocks was to be expected. The more traditional safe havens of bonds and the dollar also got hit. Places to hide seemed in short supply. Bill Gross added to the anxiety by suggesting that the US could be next on S&P’s hit list. The unrest is likely to be short-lived.

After the stellar ratings offered by Standard and Poor’s to sub-prime securities it is a wonder that they still have enough credibility to move markets. Being charitable one might argue that the agencies should be more reliable on sovereign ratings than on structured products. After all, the inbuilt conflict of interests is less acute. Nations are less able to shop around for a superior rating if let down by Standard and Poor’s in the way that CDO issuers did. In a skittish market investors may not even need to respect S&P’s analysis of Britain. They merely need to believe that others do.

Whether Britain deserves this slur on its reputation partly hangs on how much money it recoups when the government finally sells its large stakes in the banking system. Standard and Poor’s believes debt could rise to 100 percent of GDP by 2013 – up from their January forecast of 83 percent. Even so Britain is in good company. The state of public finances in most developed economies is looking increasingly unhealthy. If nations decline in tandem it should be neutral for the foreign exchange market.

Beyond what is likely to be a short term impact on the markets, S&P’s decision itself may have little long term significance. Not only did the sky not fall in when Japan lost its triple-A rating, it didn’t even have to pay more to borrow.

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