Are Rating Agencies too Powerful?
Rating agencies, such as Standard & Poor and Moody's provide a valuable service. They analyze the credit worthiness of companies, countries, and various financial instruments, and then place a rating on it. The primary basis for the rating is the probability of default - higher rating means less chance of default. Rating agencies are independent entities - free from political interference that may distort reality.
In theory, rating agencies are all good, but in reality, things are different. Consider the financial crisis in 2007-08 caused in large part by subprime mortgages that went bad. Subprime mortgages were bundled along with other mortgages into securities known as collateralized mortgage obligations (CMOs). Many holders of these CMOs lost heavily in the financial crisis when mortgages started to default.
The reason they lost money was because they overpaid heavily for these securities. Why did they overpay? When the CMOs were created, they received high ratings from the rating agencies. The ratings indicated that the probability of default was extremely low, and so the securities had a high price. Obviously these high ratings were complete rubbish. Had the securities been priced according to their true default risk, we would not have seen the large losses and write-downs.
Of course we can't say for sure why the rating agencies got it wrong. If they didn't properly understand the securities, they should not have rated them in the first place. If they colluded to artificially keep ratings high, then that is even worse. Either way, they did not do their jobs properly, and taxpayers ended up paying the price for this.
What is quite fascinating is the impact rating agencies had on the financial markets and the economy as a whole. Even now, rating agencies continue to have a strong impact. Consider the sovereign debt crisis in Europe. Countries such as Greece, Ireland, and Portugal all had to take bailouts due to their debt troubles. Their bond yields soared to unsustainable levels due in large part to credit rating downgrades.
In fact, whenever a country experiences a credit rating downgrade, it is a significant event - markets may fall, the currency falls, the bond yields rise, etc. I am not claiming here that these countries aren't deserving of poor credit ratings or that the ratings are incorrect - this example is merely to showcase the incredible impact rating agencies have.
Given the large impact that rating agencies have, it is important that these institutions are better regulated. We need rating agencies because they are an important source of information for potential investors. But we also need to make sure that there is accountability in the ratings they provide. Otherwise, it will only be a matter of time before the same mistakes are repeated.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!
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