Markets Are Underestimating Risks: Whose Fault Is It?

Standard & Poor’s, the rating agency, has just agreed, on February 3rd, to pay a $1,375B fine to the U.S. authorities for having duped investors on the quality of subprime real estate credit at the origin of the 2008 financial crisis. This agreement was signed with the Department of Justice, to which S&P will pay $687million; the same amount will be paid to 19 American states. Also, and for the same reasons, S&P will pay $125million to Calpers, a California pension fund. These are all out-of-court settlements: S&P does not officially recognize any wrongdoing, but wishes to “avoid inconveniences tied to long and costly proceedings’’... Isn’t that touching?

This record fine puts an end to the procedures started in February 2013 by the United States government, accusing S&P of having over-evaluated the solidity of the sub-primes, at the origin of the 2008 crisis. Another investigation is ongoing with another large agency, Moody’s, but it seems a page is being turned, at last, on the notorious sub-primes crisis. S&P was blamed for knowingly under-estimating real estate loan risks and for facilitating their dissemination in the international financial system by giving those loans the best rating, AAA. The guilty party has been punished. End of story?

Are we now rid of this threat? Will this record fine transform the world’s financiers into virtuous ones? Are risks better evaluated, are investors more conscious, more aware? Far from it, to the contrary. Because, even though rating agencies are being more cautious than in the past and face the risk of being blamed for it – really! – (when S&P lowered the U.S. below AAA in the summer of 2011), evaluation of risks is still problematic. Let’s take Italy, for example: Its debt is growing and growing and has now surpassed 133% of GDP, which is way too heavy, while its growth is at a standstill and structural reforms are still awaited. A situation more than worrisome and, logically, S&P has downgraded the country to BBB-, just a notch above junk bond status. Are investors taking this into account? Not at all! The 10-year rate is only at 2%! We know the reason for this dichotomy: The ECB has a quantitative easing policy with a base rate at zero, refinancing opportunities and, since January 22, a monthly 60 Billion-euro QE.

This massive deluge of liquidity from central banks in Europe, Japan and the United States (more QE, albeit with zero interest rate) is provoking a general crash in the risk premiums, which renders the markets practically blind. Even though rating agencies are getting more severe, it doesn’t change anything! In a different way, central banks contribute in hiding the real risks and, thus, bring instability to an already fragile financial world. When the next crisis hits, they will be responsible to a large degree. Does that mean that the United States could sue the Fed? Now this would be fun but, really, totally improbable.