Did Credit Rating Agencies Cause the European Sovereign Debt Crisis?

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Rosa Abrantes-Metz, Jan 28, 2014

It must not be easy being a rating agency. Where corporate debt is concerned, the major credit rating agencies are said to be too slow and lagging the market. When the topic is structured finance, the agencies are said to inflate ratings to attract business. And when the subject is European sovereign debt, those same agencies are said to be suddenly too conservative, issuing aggressive downgrades that destabilize the market and precipitate a crisis which otherwise would not have happened. (If only those CRAs remained slow laggards issuing inflated sovereign ratings, all would be well.)

But, in the sovereign debt case at least, is it instead that CRAs are simply the messenger, telling us what we should have known-that certain sovereign debt service may become unsustainable. Are the CRAs the villains in this story, or are they more like the little boy who announces, “the emperor has no clothes?”

The accusation that CRAs essentially caused the European sovereign debt crisis goes something like this: downgrading a sovereign causes an increase in its cost of funding, which will put further pressure on its balance sheet, which will cause further downgrades, and which, in turn, will increase its funding costs even more, until default becomes inevitable.

Such self-fulfilling arguments are neither novel nor unreasonable. The classic example is a bank run: if people think the bank is unsound, it may well consequently become unsound. Some variant of that argument may apply quite generally: if people think that XYZ Enterprises is insolvent, they will withhold financing so that it may well become insolvent. We can presumably substitute “Greece” for “XYZ Enterprises” and leave the central argument almost unchanged. But what really is different when the focus is sovereigns?