Europe downgrades the rating agencies

The Greek crisis prompts Europe to spurn the much derided credit rating agencies, but its taxpayers may soon regret the switch.

Greece's brush with disaster has prompted Europe's regulators to take a step skeptics have long called for – cutting its reliance on the credit rating agencies led by Moody's and S&P.

Unfortunately, policymakers are doing so at a point where their decision won't reduce the power of the credit watchdogs -- and may leave European taxpayers holding the bag if Greece does end up defaulting on its debts.

The European Central Bank said Tuesday it would keep giving banks cash in exchange for their Greek government bonds, without regard to their credit rating.

The central bank suspended the use of credit ratings on Greek bonds to forestall a crisis that could have developed in the event of a downgrade by Moody's, which has the highest credit ratings on Greek debt.

The ECB said it made the move in part because the European Union and the International Monetary Fund have arranged for a $146 billion bailout of Greece that they hope will see the country through its current crisis.

The bailout package and Greek government promises to slash spending "are the basis, also from a risk management perspective, for the suspension," the ECB said.

But while downgrades of Greece, Portugal and Spain have gotten the attention of investors and policymakers in recent weeks, the problem with the rating agencies is not that they're too pessimistic. It's that they have had a habit of underestimating the risks they're supposed to be alerting people to, thanks in part to conflicts of interest with their bond-issuing clients.

The problem was most pronounced in the so-called structured debt tied to the U.S. housing bubble. The SEC case against Goldman Sachs centers on a subprime-related investment that won triple-A ratings and went on to lose all its value within a year.

But a similar dynamic has played out in sovereign debt. Even after last week's S&P downgrade, Spain – with 20% unemployment and a stressed banking system – retains a triple-A sovereign rating from Moody's and Fitch.

Upbeat assessments of credit quality around Europe are looking increasingly problematic. So the European central bank's decision to throw the raters overboard, at a time when some of their judgments are starting to fall into line with the market's, is a troubling turn.

"I don't disagree with the idea of regulators having less reliance on rating agencies, but any reasonable analysis here would find that the credit risk is too high," said Matthew Richardson, a New York University finance professor, in reference to the ECB decision to accept Greek bonds no matter what their rating. "It is not really a rating agency problem."