An Interview with S&P's Global Head of Sovereign Ratings

While most of the talk among politicians and pundits has centered around whether the US will default on its debt if the debt ceiling isn't lifted, I've always believe after our 10 year spending binge that the real threat was that the US debt would be downgraded by the rating agencies. While an increase in interest rates would benefit savers, it will punish debtors like the US very heavily.

Last night, Larry Kudlow spoke with David Beers, head of S&P's sovereign debt rating committee. Beers made it very clear: the U.S. must take steps to lower its debt/GDP trend over the long run. He is looking at all the plans, and he is waiting for a final product. But right now a U.S. downgrade is 50-50. S&P's next step could come very soon.

Over the next couple of weeks, it will be interesting to see if the ratings agencies will have the nerve to make a gusty call. With the passage of the Dodd-Frank Financial Reform act they are no longer completely independent entities, but are now regulated by the very government they must pass judgement on. From the Senate documentation summarizing the bill:

CREDIT RATING AGENCIES

Establishes a new Office of Credit Rating Agencies at the Securities and Exchange Commission to strengthen regulation of credit rating agencies. New rules for internal controls, independence, transparency and penalties for poor performance will address shortcomings and restore investor confidence in these ratings.

Why Change Is Needed: Rating agencies market themselves as providers of independent research and in-depth credit analysis. But in this crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex structures.

Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities - adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.

New Requirements and Oversight of Credit Rating Agencies

• New Office, New Focus at SEC: Creates an Office of Credit Ratings at the SEC with its own compliance staff and the authority to fine agencies. The SEC is required to examine Nationally Recognized Statistical Ratings Organizations at least once a year and make key findings public.
• Disclosure: Requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.
• Independent Information: Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.
• Conflicts of Interest: Prohibits compliance officers from working on ratings, methodologies, or sales.
• Liability: Investors could bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.
• Right to Deregister: Gives the SEC the authority to deregister an agency for providing bad ratings over time.
• Education: Requires ratings analysts to pass qualifying exams and have continuing education.
• Reduce Reliance on Ratings: Requires the GAO study and requires regulators to remove unnecessary references to NRSRO ratings in regulations.