I take this phrase to emphasize its importance in the world of finance and economics by explaining the role played by Credit Rating Agencies in various financial crises including the crisis of 2008. Rating agencies gave high ratings to those firms that had accumulated loans worth 3 trillion dollars. These loans were given to sub-prime borrowers i.e. risky borrowers like home buyers. These borrowers could not be trusted fully with many having unstable incomes through 2007. By 2010 most of these triple ‘A’ rated organizations were given junk status. The losses incurred by these came out to roughly half a trillion dollars. Due to this colossal error, various renowned banks including Lehman Brothers were shut down and the government was forced to buy debt worth $700 million.
Even when borrowers complained about incorrect ratings, agencies ignored these allegations because they were being paid by the very organizations that they had to rate. Rating agencies were afraid of loss of revenue due to the tarnished reputation of their clients. Agencies are not answerable to any superior authority and are not punished for the adverse consequences of their questionable actions.
In October 2008, a committee was setup to provide suggestions for the efficient functioning of the European financial regulation. It provided reasons behind the crisis of 2008. Some of these were-
• Conspicuous flaws in rating methodology and inadequate data. The methodology underestimated the risk of lending to sub-prime borrowers.
• Weakening of guidelines ensuring safe loans
• Rising competition between rating agencies for big clients leading to error in judgment. These agencies deliberately gave higher ratings to organizations which were facing financial troubles.
• Inadequate historic data imperative for analyzing credit history.
• Rating agencies ignored the deteriorating lending standards followed by many renowned organizations.
Effect of Poor Rating on EU Crisis
Before the crisis officially began, there were evident indicators of rising debt, deteriorating competitiveness and national deficit in countries like Greece and Portugal. However they were given risk free status. Moreover, rating agency Fitch finally downgraded Greece’s ratings only when then prime minister announced that national deficits were higher than what had been projected. Since 2004, the European Statistical Office was vocal in its denunciation of Greek figures, stating that spurious national deficits had been revealed.
Some More Examples:
In 2001, rating agencies were castigated for taking too long in downgrading the rating of Enron, an energy, commodities and services company. The Big Three had given Enron a rating of BBB without analyzing its public findings, ignoring allegations of financial fraud and being gullible enough to take the word of officials. In September 2008, Lehman Brothers filed for bankruptcy even when it had a highly stable rating of A-. AIG, an insurance company, similarly had a rating of A- while it was being bailed out.
Various analysts lowered their rating of World Com, a telecommunications company. These analysts downgraded the ratings while projecting the company to be profitable, sending a mixed signal. Alongside, the Big Three rating agencies received criticism, as without questioning the company’s profitability, they downgraded ratings to junk status.
Parmalat, a food company filed a complaint against rating agency S&P for projecting false ratings which did not reflect the financial problems being faced by it. A week before the company buckled under pressure, it was given an investment grade rating by the agency. Suddenly within the next two days, the agency slashed the rates to 12 points above default, an extremely low rating.
We see through these examples that rating agencies were competing for renowned institutions to rate. They were paid by the very institutions that they were supposed to dispassionately assess. US congress senators Carl Levin and Tom Coburn denounced these agencies by stating that CRAs weakened their rating standards by providing favorable ratings to big firms. This was done with the sole purpose of winning big clients and expanding market share. These agencies play an important role in projecting correct financial strength of firms. Their ratings aid individuals wishing to invest in certain companies. Ratings also preclude adverse situations like financial crises beforehand. Individuals, companies and governments all over the world trust ratings agencies. More over whatever rating agencies portend actually happens. Had rating agencies been ‘honest’ in assessing big companies, various crises could have been averted. Economies could have been saved from ruin.