The function of a Rating Agency:
Rating agencies act as auditors of the creditworthiness of the borrowers, which in most cases are governments that wish to raise money on the international capital markets for infrastructure projects by issuing interest-bearing securities, also known as government bonds or treasury bonds. Credit rating agencies were created during the railroad boom in America in the 19th century. Because the projects were huge, huge amounts of monies or investments were needed to fund them, but the problem was that the investors had no way of knowing if the railroad company was able to repay their loans with interest. Thus, rating agencies were created to assess the creditworthiness of companies to provide eager investors with some assurances that their “debt covenants” will be met on time. The results of the rating agencies investigations were sold to investors in the form of “credit ratings.”
The ratings are an arbitrary probability whether the company will be able to meet its debts, AAA is the highest rating and D is, of course, the lowest. Now, this doesn’t mean that if you are rated a B or C that no money will be borrowed to you, it only means that the investor will demand substantially higher interest returns from you also known as “mezzanine funding,” basically, the capital debt plus a thumb suck interest rate.
Originally the investors paid for the services of the rating agencies, but then because of our neo-capitalism economic model, soon enough the borrower started paying the agencies to score them in a more favourable light. Here’s where a “conflict of interest” – forgive the pun- started happening, because both the borrower and the lender started paying the agencies. To complicate things even more, the largest financial houses in the world, like banks and investment firms started buying stakes in the rating agencies, effectively owning them. So, of course, the question immediately arises how the agency in question can hope to remain neutral when it is also owned by its client? What complicates the situation even further is that complex financial instruments are packaged together for sale on the open market by both the client and the rating agency, and then it is expected of the same agency to provide an objective assessment of the same package it helped construct and will earn a commission from. In other words, the rating agencies are evaluating their own products.
This casts a serious light on the agency’s ability to remain neutral and offer its potential outside client’s fair value on a good deal? What compounds the situation even further is that the borrower will approach multiple agencies to solicit a better deal from them; this then forces each agency to lower its “objectivity threshold” to please the client? This is oftentimes cited as one of the main reasons for the 2007/2008/2009 global financial crash amongst others. Whilst there are 118 international rating agencies, the so-called big three being Standard & Poor’s (S&P), Moody’s and Fitch Group who as of 2013 have a collective global share of 95% of the market. Standard & Poor’s and Moody’s control 40% a piece with Fitch Group controlling 15%.
What muddies the proverbial waters even further in the favour of the ratings agencies is that they cannot be held legally liable for own ratings as it is considered “opinions,” yet as early as the nineteen seventies, borrowers were legally obliged to get approval from the rating agencies before they ventured into the markets, which had the effect of institutionalizing the ratings or credit rating establishments.
It must be pointed out that between the IMF, the primary lender to developing countries and the rating agencies assigned to them, that the abilities of the country to secure a loan on the capital markets is proportionate to how knowledgeable its “foreign desk” is. In other words, an agency may not have sufficient resources or knowledge about some smaller countries in respect of their culture and social mores to make an informed opinion and these impacts the agency’s assessment of that particular country…..