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Wednesday, July 17, 2013

Should we trust S&P and Moody's in the future?

Historical failures have some questioning credit rating agencies
Three ratings agencies control 95% of ratings
By Jim Friedman

Standard & Poor's (S&P) and Moody's are credit rating agencies. These companies assign credit ratings to debt instruments, after considering and taking into account factors like the debtor's ability to repay the principle as well as probability of default. 

These ratings are given to many institutions that take on large amounts of debt, including companies and governments, and their rating affects the costs that are associated with their borrowing. By assigning a lower credit rating to a company or country, the credit agency increases their cost of borrowing, since lenders will want a higher interest to compensate them for their higher risk.

S&P and Moody's in particular are often singled out as representative of credit rating agencies in general because so they possess so much of the market share for credit ratings. Moody's and S&P take up almost 80% of the market share globally, and when combined with Fitch Ratings, these three credit ratings firms form the Big Three and control about 95% of ratings.

Failure of credit agencies

The legitimacy, reputation and reliability of these credit rating agencies have been seriously negatively affected by the credit crisis of 2007. The credit rating agencies gave billions of securities the highest possible debt rating during the financial crisis without fully understanding the underlying assets and risk. These debt instruments and derivatives were subsequently downgraded from their perfect score all the way down to junk, as investors who previously thought that they were investing in a safe instrument were left with a small fraction of their original investment.

The Financial Crisis Inquiry Commission, formed by the United States government to investigate the underlying causes of the financial crisis, found that the ratings agencies were "essential cogs in the wheel of financial destruction." This is because the assumption that their ratings meant low risk of their investment were essential to the sub-prime mortgages being marketed as debt which is virtually risk-free because of their triple-A rating from the credit rating agencies.

History of failure

Critics of credit rating agencies suggest that such agencies have had a long history of failure when it comes to downgrading securities only after the crisis has developed. This includes past events such as the 1997 Asian financial crisis, 1998 Russian financial crisis, Enron and Freddie Mac, among other notable financial disasters.

Cause of inaccuracy

There are numerous underlying causes for the inability of securities issuers to accurately judge the quality of debt instruments. The first is the symbiotic relationship that has developed between financial institutions and credit rating agencies. Unlike personal credit rating agencies like Equifax or Transunion, investment credit rating agencies are primarily dependent on business from the entities which are being rated, and the security issuers were found to even openly threaten to take their businesses to other firms in the Big Three. This indicates a fundamental conflict of interest in credit rating agencies.

Credit ratings firms have also been accused of threatening to downgrade to compel businesses to pay them their fees, as well as being criticized for the power and inaccuracy of their ratings when grading sovereign debt. Their downgrade of sovereign debt can cause economic collapse in the countries and spur a vicious cycle, as seen in various European countries that underwent sovereign debt crises.

Overall, it seems that S&P and Moody's have become untrustworthy as institutions that determine the underlying risk of debt instruments. Their past history of failure, as well as their relationship with financial institutions and conflict of interest, shows an organization whose core interests have shifted towards generating internal revenue rather than providing the most accurate credit rating possible.

About the author: Visit Jim Friedman's site http://getreasonablywelloffslowly.com for more articles on personal finance and general thoughts on the economy.

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