There has been much talk of the role that the credit rating agencies have played in the recent financial crisis, and regulators are now turning their mind to how to address this. In order to understand their challenge, we need first though to understand how they operate and why this has, in some people’s minds, contributed to the financial problems we have all witnessed in recent years.
Before I proceed I should state up front that my personal view is that ratings agencies – while seeking to address a real need from investors – are one of the less attractive parts of the financial system as currently constituted, with dubious morals and a conflicted business model. So what follows may not be wholly unbiased! Why do I say this?
The first problem is that they purport to be providing a public service (indeed many regulators, led by the US authorities, have at the agencies’ prompting enshrined their ratings in legislation – which in passing guarantees that the agencies (who happen mainly to be American) never run short of a demand for their services – but they are actually private sector profit-making companies. This gives them a conflict of objectives, viz making money and providing a legislated regulatory service, the importance of which has indeed just been enshrined in regulations (Basel II) – we may live to regret this! The latter means that in various markets, no-one can operate without the blessing of the ratings agencies for their products, and the agencies have an unregulated oligopolistic position which they use and in many cases abuse.
The second, and I think more serious, problem is that the people who pay for their services are not the people who use them. The main people who use the ratings are investors – after all, they are the ones who want to know the strength of the asset they are buying, and they make rules for themselves so that eg many investors will not buy an asset unless it is rated AAA, or whatever. But the ratings agencies cannot find a way to charge the investors for this rating: once an asset is rated, they cannot keep this information confidential or reserved for their clients, so everyone in the market knows its rating (ie the information is a public good) and so no-one will pay for it. Instead they charge the issuer, where they do have a lever over their client, because if the issuer declines to pay for a rating then no-one will buy the product.
This business model is horribly conflicted. The methods of the ratings agencies come perilously close to blackmail – “if you do not take (and pay for) our rating you will suffer, my friend” – and for their part, the issuer, who is paying for this rating, has no interest in it being a fair one, only in it being as high as he can get an agency to agree to – “if you don’t give me a AAA rating I’ll find an agency who will”. Indeed it got so corrupt that issuers and ratings agencies got into cahoots: it was common in the last stages of the credit dance for an issuer to ask an agency to help them design a product specifically so it would be AAA – “what do you need to grant me a AAA on this structure?” Any residual pretence that the rating agency is an unbiased external assessor of an asset structure evaporates at this point!
Coupled with all this, ratings agencies encouraged people to see their ratings as meaning more than they in reality they did. A rating is actually just an assessment of how likely the asset is to be honoured and not default, but investors started assuming it also gave guidance on other important things like how liquid the instrument would be and how well-protected the price would be in adverse markets. Rather than point out forcefully that their ratings never promised any information on these points, the ratings agencies were happy for people to assume they did because it made their product even more valuable and essential. It was a little rich, and far too late for them to rescue what remained of their good name, to bleat after the crash that they never claimed their ratings said anything about such qualities.
The true value of a rating agency is perhaps harshly but fairly summarised by my point (ii): those who use their service are happy to do so if it remains free at the point of use, but would not pay even a small amount of money for it. Which sounds like all those research analysts at the investment banks, many of whom lost their jobs when the industry started charging for their services and found that no-one valued them enough to pay for them.
And in case there is concern that the word “blackmail” in (iii) is too strong, I can think of no other way to describe the approach all ratings agencies use routinely to issuers who decline their blandishments and prefer not to seek a formal rating from them. In such cases, they often offer (threaten) to publish an “indicative” rating (ie one where they had not seen the issuer’s books) which was “bound to be more cautious as based on incomplete information”.
Think of an indicative rating as an unauthorised biography in which the writer has not had access to his subject’s papers, and you can see the value of it – ie close to nil. But the problem is that investors before the crisis trusted the agencies so it would have been quite damaging, especially as for Cautious one should read Negative. In effect their true message was “pay us $5 million or we will write that your debt is not sound and your finances are shaky”, an approach which the Mafia would certainly recognise but which was – then – less common in the world of financial markets.
20 years ago many issuers did feel strong enough to decline a rating. But by 2007 the ratings agencies were stronger and, as I have described, more plumbed in to the workings of the markets. In effect, the ratings agencies had until August 2007 a position of power without responsibility or restraint, and few in the market are entirely sorry that their reputation is one of the main casualties of the crash.
In their defence the ratings agencies often say that they are only meeting their clients’ needs. And even if one dislikes the ratings agencies and their business models, there is some truth in the view that they acquired their power mainly because investors delegated to them the duty of finding out what the true nature of the complicated assets they were buying was. Too many investors repeated the mantra to themselves “If it is AAA it must be OK”, and arguably they deserved to see such investments fail. There is much value in that old saying caveat emptor …
But for all that, if a better business model for the ratings agencies is just one of the outcomes from the current financial crisis, it will not have been all in vain.