Credit rating agencies have one primary task: to examine and grade financial products and companies. Their findings can shape how a stock performs or at what rates a government can borrow. However in the wake of the 2008 U.S. financial crisis, some analysts - such as Michael Robinson of Levick Strategic Communications - say those rating agencies assigned their highest grade to the very securities that nearly brought down the U.S. financial system.
"Once we peered behind the curtain and saw that they had given their stamp of approval, a Triple A rating, an 'A-plus' rating, to securities that did not ultimately deserve that, their credibility has been spent," he says.
Among of the securities that were given the highest quality grades were complicated, high-risk instruments - such as collateralized-debt obligations backed by subprime mortgages, known frequently known as "toxic assets."
"With a mortgage-backed security where there may be 2,000 mortgages behind the bond," says the University of Maryland's Peter Morici, "all they really have to go on are the mortgage applications, and generally they don't even have that. So they tended to rate these bonds on the basis of general statements about the quality of the mortgages, which turned out to be false, and the likelihood that housing prices would fall. Models of that sort, econometric models, are notoriously unreliable. As a consequence, they essentially were selling fraudulent ratings."
The primary credit rating agencies are Moody's Investors Service, Standard and Poor's, and Fitch Ratings. They rate the financial strength and credit worthiness of investments, examining a company or government's ability to make payments on bonds and other debts. The rating is similar to the credit score for someone who might apply for a loan to buy a house.
Michael Robinson summarizes it this way: "As an investment bank, you want high rated products. Because the higher the rating the product, two things. One, you can charge more for it, and two, more people can buy it."
These rating agencies have been around for over a hundred years. They began by publishing information about stocks, bonds and other investments and selling their findings independently. Over time, the findings became so valued and influential that municipalities and financial institutions could not sell their bonds or securities if they did not have the highest ratings.
"These ratings are required often by law for mutual funds or pension funds to purchase these bonds," says Morici. "As a consequence, they really are essential."
But these agencies, which make hundreds of millions of dollars a year, have been getting paid by the very institutions they rate. And the University of Maryland's Peter Morici says therein lies the problem.
"For example, the Ohio water authority issues bonds. And Moody's comes along and says, 'We'd like to rate it. And if you don't pay us to rate it, we'll rate it on our own.' Would you rather have a rating agency that you commission, or one that goes into business for itself?"
Investors trusted the credit rating agencies before the 2008 U.S. financial crisis. Today, the reputation of those agencies is damaged, and the way they do business has come under scrutiny.
"They had always in their defense, and they did screw up, they always had held themselves up as providers of opinion, and said these are opinions, not certainty," says John Berlau of the Competative Enterprise Institute. "The law gave them this official status wrongly and that exacerbated the problem of over reliance on them, rather than investors doing their own due diligence."
Pending U.S. legislation removes a conflict of interest between the rating agencies and those that they rate, by creating a Credit Rating Agency Bureau within the Securities and Exchange Commission to assign ratings contracts. Financial institutions would no longer be able to choose which agency rates their products.
You can watch this, and all Philip's "Money in Motion" reports by clicking here.