The origin of credit ratings agencies can be traced back to 1840 when agencies started rating merchant’s ability to repay their financial obligations. It was the gift of 1837 financial crisis which saw increased credit defaults and it led to the birth of credit rating agencies which can predict the interest and debt repaying abilities of the lenders. The functioning of these credit ratings have remained questionable ever since and this topic revisits itself after every financial crisis, sub-prime crisis is no exception.
The whole purpose of structural finance and financial engineering for sub prime loans was to improve the credit ratings of various financial instruments by credit enhancement and converting them into marketable securities. The underlying risk of the financial innovation and the difference between Prime AAA+ securities and sub-prime AAA+ was never contested before the whole system failed.
The biggest issue with these agencies is their financial model where they actually get there revenues from the company they rate and not from the users of credit ratings, it causes two problems,
1. The credit rating company cannot be conservative in its approach as there is high competition in the ratings business and the company may lose out on lucrative deals if it starts giving conservative ratings.
2. Most of the companies which undergoes rating process wants better credit ratings to reduce the cost of financing and no company wants to increase their cost of capital even after paying rating agencies.
If we actually compare the number of above investment grade to below investment grade ratings issued by different agencies, we will find that most of the ratings given are above investment grade. There is a need to change this financial model to make the whole structure more fundamentally strong.
The second crucial issue with rating agencies is their operating model, which relies totally on the auditor and the companies for all financial and non financial statements. It increases the risk of distorted ratings in case the auditor and the company are running a joint partnership firm which happened in case of Enron.
I feel that the world has seen enough recessions and depressions, there is an urgent need of a single world regulator who can improve the functioning of various financial markets and limit the grey areas of finance.