Rating the agencies

Credit ratings have gone from an obscure financial term to a report card on the behavior of governments. But what are these ratings, where do they come from and why should we care about them?

Credit ratings are an indication of the likelyhood that an financial instrument (bonds, securities etc.) will pay the promised returns. It is best understood when talking about bonds(corporate and country loans): it is the likelyhood that a company will pay the principal and interests on its loans. The ratings can range from AAA (No question, they will pay) to D(they won't pay). In the globalized world we live in ratings on credit are a necessity: how else would you as a small investor be able to know if it is save to buy bonds from a company around the world. Interestingly it is mainly large actors (pensionfunds etc. ) who actually do have the resources to investigate these questions, that mainly rely on credit ratings: they often even have the ratings enshrined in their statutes..

There are three major credit rating agencies: Moody's, S&P and Fitch and they are all from the USA. That means that ratings are likely to be biased to USA values, like a preference to a certain law-system(see this chapter on Fitch). It is hard to precisely understand where a rating actually comes from. To make a rating these agencies use all kinds of quantitative (e.g. amount of external debt), qualitative (e.g. willingness to pay on debts) and institutional parameters (e.g. enforceability of contracts). And out comes a single rating, which actually always means a gross oversimplification of the situation a country or company is in.

To make matters more complex: it is not the investors that pay the agencies but the issuer of the instrument. This means that the interests of the rating agencies are not fully aligned with the investors. It is rumored that during the boom of MBS (Mortgage Backed Securities), large investment banks made rating agencies put incredibly high ratings on their products, even though the chances of default where substantial. Some might say that this is one of the main reasons why the crisis began, but i will come back to that in another post.

The reason why we should care about these ratings is because other people do. Even though it is incredibly unlikely that France will default on its bonds, some large investors might be forced by their statutes to sell of their French bonds now that they are rated lower. Because of these kinds of reactions from large financial actors the ratings have a significant impact on the price of the thing that they are rating. In the case of a country it means that a lower rated country needs to pay more interest in its bonds than a higher rated country.

For all Dutch speakers: there is a very good documentary from VPRO Tegenlicht on rating agencies(about half of it is in English, so non-Dutch speakers can also watch it). I believe that the Inside Job also deals with them in understandable way.