Credit where credit’s due: the problem with agencies

Credit rating agencies are key players in the financial market. They assess the ability of corporate and governmental borrowers to incur and service debt, and the interest rate cost that they face. These agencies have teams of analysts who grill executives about operations, finances and management plans. They then use these data to assess the company’s rating.

All the agencies use letter-based grading systems. S&P’s ratings range from AAA for the most financially stable companies to D for a company in default.

Last year Ireland was downgraded from AAA rating to Aa1. It has since been further downgraded to Aa2 after failing to convince the agencies’ analysts that it can afford to shore up its banking sector and cut the biggest budget deficit in the EU, given its weak economy and growing risks of a political crisis.

The Irish government’s borrowing costs have increased with the yield on ten-year bonds up 22 basis points to 5.478 percent. That is more than the 5 percent rate which Greece is paying in return for its European Union bail-out package. But if the yield stays at this level over a long period it will be very difficult to stabilise the fiscal debt. And it would become even more difficult to do so if Ireland’s credit rating is further downgraded – as Moody’s has warned it may be if the necessary austerity cuts are not put in place.

Originally agencies like Standard & Poor and Moody’s worked by acting as information brokers for the capital markets. Since 1975 these opinion-based agencies have become required “seals of approval” for those companies needing access to the capital markets. Moreover, access to capital markets became increasingly difficult without quality assurance from these agencies.

This caused the agencies to completely change their business model and revenue stream. They were no longer agencies selling their ratings to investors looking for information before investing. They were now getting paid to issue ratings on companies for the companies themselves. This transformed rating agencies from information brokers to “unofficial gatekeepers” to the financial markets.

This new model created inevitable conflicts of interest, mainly the challenge for rating agencies to remain neutral while evaluating companies that they relied on for revenue. Presently, the agencies are paid to assist in structuring a security that they will be paid to rate. There are strong incentives for the rating agencies to please the issuers. Moody’s in particular have been criticised for enabling subprime lending to develop into a global financial crisis.

Some critics have suggested abolishing the agencies’ special status altogether and giving the responsibility for ensuring credit-worthiness back on banks and other regulators. But such a drastic move would force the rewriting of hundred of regulations that require pension fund and others to hold securities that meet specific risk standards. Some have also said that the rating agency business might function best as a monopoly as the temptation to give companies good ratings would be diminished.

While these agencies continue to wield huge influence Ireland will have to inflict some tough blows on its taxpayers or risk not making the grade.