Why does anyone take S&P seriously?

By Roger Martin
August 9, 2011

By Roger Martin
The opinions expressed are his own.

It drives me nuts that anybody treats the Standard & Poor’s downgrading of the U.S. government’s credit rating with anything but contempt.  I am, by the way, not saying that the circus in Washington didn’t deserve an immediate smack-down before the real one it will be getting in 15 months.  But it stuns me that people don’t ask themselves just what S&P is and who its credit raters are before actually paying one iota of attention to them.

So who are those S&P raters anyway – the people who actually determine whether the U.S. is AAA or AA+? The only thing that can be known about them is that if they are rating bonds at S&P, they can’t possibly be good at rating bonds.  The bond market is a multi-trillion market that is immensely lucrative.  Bond trading is a great way to make a buck because there are unlimited bucks to be made – if, and only if, you know something useful about whether the bond in question actually has a lower or higher risk inherent in it than level implied in the market’s current pricing.

So if you are any good at all at rating the riskiness of debt instruments, you will not be working for a couple hundred thousand a year at S&P, you will be working for yourself, or for the bond trading desk of an investment bank or a bond hedge fund making tens of millions of dollars per year – or a lot more if you are running the hedge fund.  Only if you are incapable of knowing something useful about the true risk profile of bonds will you take a job rating bonds at S&P. Or alternatively you actually know something useful but have no confidence whatsoever that you know do so you won’t put any personal financial risk behind your opinions.  In either case, the output is clear: because of the position you occupy, you are someone to whom no one should listen.

Some may argue that no, these people are public servants, like teachers or judges, who rate bonds business they think it is a higher calling and even though they could earn tens to thousands more trading bonds than rating them, they stick it out because of their great hearts.

That is a pretty difficult argument to make. S&P is a subsidiary of publicly-traded corporation McGraw-Hill.  S&P is driven to help McGraw-Hill march its quarterly earnings ever forward lest bad things happen to both subsidiary and parent.  This is hardly the environment in which we are likely to find a huge agglomeration of public servants.

And remember the business model of S&P: it makes its money from charging those it rates lots of money to rate them.  Prior to the crash of 2008, it was an awesome business because the use of its product was legislatively driven.  That is to say, most institutional investors have regulatory fiduciary requirements that necessitate the use of credit ratings as part of their daily business.  They may think that S&P really has no useful insights, but they still need to use its ratings.  So this business is pretty much like any business that is given a legislative right to serve – like your local electric or gas utility: it doesn’t need to worry much about being any good because the customer doesn’t have much choice.

This is all theoretical, you might argue.  OK then, let’s go empirical.  What is S&P’s recent track record on understanding and rating debt instruments in the USA?  Answer: disastrously bad.  Three years ago it could not have possibly been more wrong on its ratings of U.S. mortgage debt instruments.  Chimps throwing darts would have been infinitely better than these so-called experts were.

So the question has to be asked again:  Why on earth do we pay any attention whatsoever to S&P’s downgrade of U.S. government debt?  It has a horrible track record and in fact helped enormously to get the U.S. government into the crisis for which it now condemns the handling.  Their raters wouldn’t be rating bonds if they actually were any good at it.  It operates in a protected industry that insulates it from the usual consequences of incompetence.  And its business model is one big conflict of interest.

534 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Hey, nice website you possess in here.|

I’m curious to find out what blog system you are working with? I’m having some minor security issues with my latest website and I’d like to find something more risk-free. Do you have any suggestions?|

I am not positive where you’re getting your information, but great topic. I needs to spend a while finding out more or understanding more. Thanks for magnificent info I was in search of this information for my mission.|

It’s in reality a great and helpful piece of information. I am glad that you just shared this helpful info with us. Please keep us informed like this. Thanks for sharing.|

I’m amazed, I must say. Rarely do I encounter a blog that’s equally educative and engaging, and without a doubt, you have hit the nail on the head. The problem is something which not enough people are speaking intelligently about. I am very happy that I found this during my search for something regarding this.|

I am now not positive the place you’re getting your info, however great topic. I must spend some time finding out much more or working out more. Thank you for great information I was on the lookout for this info for my mission.|

Hi there! This blog post couldn’t be written much better! Reading through this article reminds me of my previous roommate! He always kept talking about this. I’ll forward this information to him. Fairly certain he’ll have a good read. Thank you for sharing!|

Howdy! Do you know if they make any plugins to help with SEO? I’m trying to get my blog to rank for some targeted keywords but I’m not seeing very good results. If you know of any please share. Cheers!

Greetings from Florida! I’m bored to tears at work so I decided to check out your website on my iphone during lunch break. I love the information you provide here and can’t wait to take a look when I get home. I’m surprised at how quick your blog loaded on my cell phone .. I’m not even using WIFI, just 3G .. Anyhow, wonderful blog!

Hello! I’ve been reading your blog for some time now and finally got the bravery to go ahead and give you a shout out from Austin Texas! Just wanted to mention keep up the fantastic work!

When I originally commented I clicked the “Notify me when new comments are added” checkbox and now each time a comment is added I get several e-mails with the same comment. Is there any way you can remove me from that service? Thank you!|

Excellent post. I will be going through a few of these issues as well..|

Greetings! I’ve been following your blog for a long time now and finally got the bravery to go ahead and give you a shout out from Lubbock Tx! Just wanted to say keep up the great work!

It’s really very complicated in this active life to listen news on Television, therefore I simply use world wide web for that purpose, and obtain the most up-to-date news.|