Credit ratings agencies played a pretty significant role in the recent financial crisis; yet even after some of their ratings were proven dead wrong, their power appears little diminished.
Ratings agencies were assigned their special role in markets by the government in the seventies—and they've had a special aura ever since.
But credit ratings are little different than other kinds of financial analysis—stock analysts offer buy, sell, hold recommendations on a regular basis.
Maybe it's time we severed the regulatory tie and relegate them to their rightful place beside all other analysts.
By now we've all heard of Moody's, Standard & Poor's, and Fitch—they're credit ratings agencies. They played a pretty significant role in the recent financial crisis; yet even after some of their ratings were proven dead wrong, their power appears little diminished. For example, it's been big news every time the credit rating agencies have downgraded Greek sovereign debt. Or there's been rampant speculation whether the US and UK can maintain AAA status—as if a downgrade seals our doom.
Just why do we care so much?
Capital markets—dominated by bonds we might add—grew up and thrived for hundreds of years without credit rating agencies. Modern analysts (for stocks and bonds) didn't really get started until after World War II. Even then it was understood they were providing a service to investors. "Hey there, look what interesting tidbit we noticed this week—in our opinion, this might affect your investments."
But in the seventies, stock analysis and bond analysis went their separate ways.
Seeking to define just what kind of capital counted for federal regulatory limits—the government awarded status of Nationally Recognized Statistical Rating Organization (NRSRO) to the likes of Fitch, S&P, and Moody's. Then they endorsed NRSRO ratings as the determinants of what kinds of assets financial companies could hold to meet capital adequacy ratios. That's a pretty big deal. And, of course, materially affected the industry. An aura sprang up around credit ratings—if the government endorses them, they must be extra-special bulletproof, right?
Well, it's hard to see that in practice. These agencies were pretty wrong about structured credit products a few years ago. And we shouldn't be surprised. As S&P explains on its website, "based on analysis performed by experienced professionals who evaluate and interpret information from a multitude of sources, credit ratings provide a detailed opinion about a corporation's risk." Key words here: professionals, interpret, and opinion. At the heart of it, these are people, just like you and me, thinking and speculating—they are as apt to be wrong as anyone else.
Now all this isn't to say the big credit rating firms don't know what they're talking about. They're staffed with smart, capable, and informed individuals. But stock market analysts are pretty smart too. And stock analysts issue ratings of their own—buy, sell, hold, etc. Not so different from AA or BB+. We've never known a stock rating to make headlines each and every time it changed. That's partly because stock ratings are rightfully viewed as tools, helpful markers—not infallible standards handed down from on high—and partly because they aren't so entwined with regulatory authorities.
Amid all the financial regulation talk, a discussion of credit rating agencies' role in markets is justified. Maybe it's time we severed the regulatory tie and relegate them to their rightful place beside all other analysts. The ultimate arbiter of risk should first be the individual, and then individuals en masse—the market.