Riled over ratings

The US justice department's lawsuit may be the best chance to ensure that the credit rating agencies are held accountable

We rate every deal. It could be structured by cows and we would rate it." This was an instant message sent by a Standard and Poor's analyst on April 5, 2007. Nearly every account of the financial crisis, from the report of the US Financial Crisis Inquiry Commission to Michael Lewis's bestseller, The Big Short, puts the major US credit rating agencies at its centre. The rating agencies firms like Standard & Poor's, whose business it is to assess the likelihood that debt obligations will be paid as agreed gave their stamp of approval to innovative financial products that were in fact incomprehensible and/or based on the premise of an unending real-estate boom. Panic set in when everyone realised that the ratings were wrong or unsupported. The major rating agencies conceded years ago that there their ratings on novel financial products didn't do as well as they could have.

What are the problems with the rating agency market, and how has the market changed since the pre-crisis years?

First, the firms that sold the financial products usually are the ones who pay for the ratings. Despite the agencies' protestations, "issuer pays" poses a serious conflict of interest, as rating agencies naturally want to please their customers, who are the people selling the products, not those buying them. In debating the Dodd-Frank act, the US Congress considered attacking this problem by randomly assigning the agency or agencies that would rate certain securities, but adopted an ambiguous provision whose only clear mandate was that the Securities and Exchange Commission study the issue. In the meantime, even smaller competitors that sought to market themselves as alternatives to the issuer-pays model have found themselves paid more and more by issuers rather than subscribers.

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