X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Are Rating Agencies too Powerful? - Outside View by Asad Dossani
 
 
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!

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

Equitymaster requests your view! Post a comment on "Are Rating Agencies too Powerful?". Click here!

1 Responses to "Are Rating Agencies too Powerful?"

SUNIL AGARWAL

May 9, 2011

Rating agencies are powerful only in the sense that most of the GLOBAL AND LOCAL INVESTMENTS are based on their reports as executives of no institution can risk the investment of public money ignoring these ratings. But these rating agancies have never been able to predict global financial trends accurately

Like 
  
Equitymaster requests your view! Post a comment on "Are Rating Agencies too Powerful?". Click here!
 

More Views on News

Sorry! There are no related views on news for this company/sector.

Most Popular

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

The Most Profitable Investment in the History of the World(Vivek Kaul's Diary)

Aug 8, 2017

'Yes, it looks like a bubble. And, yes, it's like buying a lottery ticket. But there's something happening that has never happened before. It's an evolutionary leap in money itself.'

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

Bitcoin Continues Stellar Rise(Chart Of The Day)

Aug 10, 2017

Bitcoin hits an all-time high, is there more upside left?

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS