Credit rating agencies have one job – to provide investors with info about a country’s or company’s ability to pay back the debt. Unfortunately, they royally suck at it, and these ratings are often faulty. But why do we need ratings in the first place?
A company without a credit rating is like a job applicant without a degree or even a CV. You may really be good at what you do, but how can your potential employer know that without any proof? It’s the same with enterprises and even nations.
The need for objective and independent credit ratings is obvious, so why doesn’t it happen? To answer this, it’s important to know that when it comes to credit ratings, power is concentrated in the hands of 3 big international players – S&P, Fitch, and Moody’s. Each has been accused of false ratings, flawed methodologies, and political bias. Nonetheless, they continue influencing key financial market decisions.
Let’s look at those accusations. Overly positive ratings might not seem like such a bad thing, but they have contributed to several financial crashes. We’re talking about the stock market crash of the 70s, the Asian financial crisis of 1997, the Enron scandal of 2001, and, last but not least, the global financial crisis of 2008. False credit ratings hide financial shortcomings.
Which is why companies are eager to improve their scores. The root of the problem lies in the “issuer-pay” business model, which means that the people paying for the ratings are the same institutions that are being rated. Credit rating agencies don’t want to give bad ratings, because then companies will just go to their two competitors.
The flawed system is no secret. Both the United States and Europe have taken steps to regulate the sector and ensure more transparency by, for example, passing the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 and creating the European Securities and Markets Authority (ESMA) in 2011. But somehow, despite these regulations and billions paid in settlements, credit rating agencies are still afloat and unabashed.
The Big Three routinely fail to detect frequent near-defaults, as well as fail to downgrade troubled firms until just before (or even after) a declaration of bankruptcy. Just check out this statement from Gary Witt, a former employee of Moody’s – he said they didn’t have a good model on which to estimate correlations between mortgage-backed securities, so they “made them up”.
The best way to counter the often-ridiculous credit ratings of the Big Three is to stop giving their ratings so much weight. Instead of blindly following ratings, investors should do their own homework.