Europe's War on Downgrades

By Lawrence White, Robert Kavesh Professorship in Economics & Deputy Chair of Economics

Europeans have decided to continue their reliance on ratings for financial regulation – but apparently not when those ratings are unfavorable.

Restricting ratings on European governments’ bonds? This is a terrible idea. To understand why, let’s review what the three large credit rating agencies -- Moody’s, Standard & Poor’s and Fitch -- actually do, and why they are so important in financial markets.

Rating agencies offer judgments, in the form of ratings, about the creditworthiness of bonds -- issued by corporations, municipalities, national governments and mortgage securitizers. The agencies help lenders address the question: “Will I get paid back?” (And remember, bonds are loans, so bond investors are lenders.)

Some lenders do their own research. Others need help and turn to providers of information on creditworthiness, of which the rating agencies are a major category -- but not the only category. Some smaller information providers may not call themselves “rating agencies,” but they offer similar information. And every large securities firm has “fixed income analysts” who do the same thing for their firms’ clients.

Read full article as published in The New York Times.