Financial Ratings Agencies – is there a new scam in the making???

In the last few years (since the 2008 recession), we regularly see headlines such as these:

U.S. Loses AAA Credit Rating as S&P Slams Debt Levels, Political Process

India’s Investment Grade Rating at Risk as S&P Cuts Outlook

Spain’s Ratings cut to “Junk” by Ratings Agency

Who are these “Ratings” agencies who grade large countries and companies like they are school children and give them quarterly grades like A, A-, B+, C, D and “Junk”? The big ratings agencies in the world are:

Standard & Poors (S&P) with revenues of $2.9 Billion and owned by McGraw Hill companies with revenues of $6.2 Billion

Fitch Ratings owned by Hearst Corporation and Fimalac worth multi-Billion dollars

Moodys Corporation worth over $2.3 Billion

Together they influence a large amount of investments and finance in the world. As “Ratings” agencies, their primary purpose seems to be like a mirror to countries and companies pointing out serious issues so that they may rectify them. But in reality, these ratings can cause serious problems to countries/companies:

– Spanish economy in “huge crisis” after credit downgrade

– How S&P revision has hit the RBI’s rupee battle

Going back to our school analogy, bad grades are not only a reflection of a student’s performance but also negatively impact students’ future potential.

One could say, that is unavoidable part of identifying serious problems early. But what if the “rating agency” actually profited from the ratings declines? What if the school teacher got a pay hike for failing students?

Can that happen?

I’m not an economist. I’m not sure. Even learned Economists are wrong about economics when it gets complex. And the world of finance, investment and macro-economics is very complicated.

But let us analyze this from the simple perspective of “motives”, “stakeholders”, etc.

These Ratings agencies are all profit-driven large public (stock market) or private companies. They are not non-profit or governmental or UN agencies. Their primary motive is of course to maximize profits. But they have to do it legally – under laws that govern ratings agencies.

So, who are the “customers” of these ratings agencies? Investment firms, large banks, hedge funds – basically anyone with a large amount of money looking for good investments with good returns and low risks. Ratings agencies are not around to help the poor and downtrodden. If the ratings agencies help their “customers” maximize profits, then they would be willing to pay these ratings agencies handsomely.

Let us take a hypothetical scenario:

Step 1: Company A pays the Ratings Agencies to rate their new Bonds issued to Banks, Investment Banks and private investors

Step 2: Ratings agencies give them high ratings

Step 3: Company A pays Ratings agencies more money by paying for more research reports, etc.

Step 4: Company A eventually goes into bankruptcy

The above scenario seems to have happened in the case of Enron, Sub-prime mortgages and mortgage-backed securities which caused the Great Recession of 2008.

To prevent such issues, US and European governments seem to have enacted new laws to control these Ratings Agencies from carelessly giving high ratings.

Dodd-Frank Financial Reform Act, 2010

EU Ratings Regulations 2010

But here is a very different scenario:

Step 1: Ratings agencies reduce rating of a country/company

Step 2: The country/company with lower rating has to pay higher interest on loans in the market – from banks, investment funds, etc.

Step 3: Banks, investment funds gain more profit because of higher interest rates.

Step 4: Banks, investment funds pay more money for research reports, etc from Ratings Agencies.

In the above, very reasonable and realistic scenario, Ratings Agencies have a clear and strong incentive to reduce the ratings of countries/companies to be lower than they really should be. But in the above case, the Ratings Agencies or the large investment funds dont directly do anything wrong.

Could the above scam also be happening? I’m not sure. As I said, I’m not an economist.

But according to the facts, the Ratings Agencies and Investment Funds are making historic profits. Is there a a correlation?

Update: As an interesting note, the downgrade in ratings are also affecting large banks like Morgan Stanley and they estimate their cost due to these downgrades might be as high as $ 7.2 Billion! Ouch!

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About navanee
Citizen of the Universe. Visiting Earth on a valid world-visa, presently parked in Bangalore India. Detailed Bio here: http://www.linkedin.com/in/navanee Previously, lived 17 years in Coimbatore, 4 years in Chennai, 2 years in Provo, Utah and 11 years in San Jose, California.

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