The big credit rating agencies – Fitch, Moodys, Standard & Poors – are in the news. They almost certainly find themselves on the front pages of newspapers more often than they would like. Their opinions carry heavy weight. Consider the consequences for European financial markets when Standard & Poors downgraded its rating of the bonds issued by Greece, Portugal, and Spain. Some people may find their influence puzzling. After all, the rating agencies did a spectacularly bad job judging the risks of securities backed by subprime mortgages. Why do investors still place so much weight on the grades assigned by credit rating agencies?
In the early twentieth century rating agencies gained credibility with investors by providing disinterested expertise in assessing the creditworthiness of corporate borrowers. Because they specialized in evaluating the risk of hundreds of corporate bonds, the rating agencies could bring more information to bear than most nonspecialist investors in determining the odds that a particular bond issue would default. What is more, the rating agencies expressed the likelihood of default using a consistent standard and one that was easy for investors to grasp.
This kind of expertise and product standardization has obvious value, especially to institutional investors who must provide to their own shareholders, debt holders, and regulators a straightforward explanation of the riskiness of their assets. Although the fact is nowadays often forgotten, rating agencies were once mainly funded by the investors who purchased corporate debt rather than by the companies attempting to sell debt to the public. This meant the incentives facing rating agencies were closely aligned to those of their customers. If the rating agencies awarded high grades to dodgy debt issuers, their own reputations would be damaged along with the wealth of the customers who paid for their faulty ratings. The rating agency’s future sales to investors could be hurt.
Since the 1970s the revenues of the credit rating agencies have mainly depended on the issuers of new debt rather than the buyers of debt. Companies that issue debt must now pay the rating agencies to obtain a rating for their debt. This funding arrangement is far from ideal. In order to get business from customers who issue huge amounts of debt, the rating agencies might offer lenient ratings or provide proprietary information to favored issuers so they can tailor their new debt to obtain a high rating. Of course, the lenient grades may eventually hurt the agencies’ reputations when a highly rated debt goes into default. It isn’t clear, however, whether the loss of reputation will be particularly harmful to the agencies. A credit rating agency is mainly in the business of selling its services to entities that are selling debt rather than buying or holding it.
Institutional investors still demand a standard credit rating for most of the debt they hold in their portfolios. For understandable reasons their own investors and regulators would like to see summary statistics on the creditworthiness of their holdings. This creates a steady demand for the product that rating agencies sell. Even though credit rating agencies failed stunningly in their evaluation of subprime mortgage securities and despite the fact that they sell their services to the “wrong” customers, their ratings still carry considerable weight with investors. Some investors must use a flawed and discredited product because no other alternative is readily available. Even those investors who perform their own credit analysis may still need to provide understandable summary statistics on the risks of their portfolio, something their own credit analysis may not produce. The main point, however, is that credit agencies are selling their product mainly to entities that want to sell debt rather than to the investors who want to buy it. The fact that this market is large means the agencies collect sizeable fees and can support a large and specialized staff. Their ratings may be flawed, but for a wide range of investors the agencies’ ratings are better than no ratings at all.