What is a rating agency?

A credit rating agency is a company that is paid to measure risk relating to a debt or debtor, and label it accordingly. This can apply to a company, bank, government or an investment.

For instance, a relatively strong company like Google may get an AA+ rating, meaning any money it borrows will cost less because lenders are more likely to get their money back.

These agencies are essentially ‘the big three’ – Standards & Poor’s, Moody’s and Fitch. These three companies make up about 90 percent of the total world ratings market.

The problem began in the early 1970’s. Until then, rating agencies were paid by investors to rate assets they wanted to buy into.

Then the payment system changed. The agencies started getting paid by the seller instead, on a per-rating basis. This gave them an incentive to rate more, and also more generously.

How it worked in the sub-prime mortgage crisis

Over the past decade, a lot of people in America couldn’t really afford the money they borrowed for their house. These were called sub-prime mortgages.

These sub-prime mortgage contracts were grouped together with some safer mortgage contracts and other investments and sold on as one overall asset.

These bundles of rubbish were known as Collateralised Debt Obligations (CDOs) and were sold on to the big investment banks that needed assets to balance out their liabilities.

They too, on-sold them to investors looking for a safe, steady income. Houses were seen as safe because prices, supposedly, always go up.

However, before any buyer bought these CDOs, they checked their rating to see how risky they were. Most buyers (investors) would not buy something with a CC rating for instance. In fact, many savings funds like pensions had a rule of only investing in A or above rated investments.

So to sell these CDOs to investors, the rating had to qualify. The problem was many of the CDOs didn’t deserve a high rating because they were based on people who couldn’t realistically pay back their mortgage.

Therefore, the banks needed the rating agencies to effectively lie and give them a higher rating.

The rating agencies were more than willing to do this because if they didn’t, the bank would simply go to their competitor down the road who would gladly take the business. And with average rating fees of over US$300,000 and margins of 50 percent, it was no wonder.

The agencies also became advisers rather than independent judges. They would tell the banks how to restructure the dodgy asset so that they could give it a higher rating. And these changes were mostly technicalities rather than anything of sound substance.

There was a supposed safety net in the system which meant that each investment had to be rated by two different agencies. However, this just resulted in two false ratings effectively making the safety net useless.

When investors complained that their supposedly safe investments were actually rubbish, the rating agencies pointed to a clause saying that they cannot be held liable for any incorrect ratings – basically “sorry, but sometimes we get it wrong”.

Despite clear deception from an entire industry on whose assessment the investment system depends, these agencies carry on today in much the same way.

Ironically, they are now downgrading the ratings of those who invested in their falsely rated products or those who have suffered from the resulting downturn. Yet, they stand in the public shadows while the banks take all the flack.

Yes the banks were at fault in pressuring the agencies to lie, but the agencies were clearly willing partners for their own financial gain.

By The Casual Truth

Related Links:

http://www.moneyweek.com/investments/stock-markets/the-great-credit-rati...

http://www.huffingtonpost.com/2009/10/21/bill-supposed-to-tighten-_n_328...

http://en.wikipedia.org/wiki/Credit_rating_agencies_and_the_subprime_cri...

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