U.S. Rating Agencies Part III

By | October 18, 2021

Still, there is no doubt that rating agencies are as powerful as many critics want them to be. During the euro crisis, it has so far appeared that the rating agencies have constantly been in “arrears”. They downgrade countries only after investors have already “priced in” the new risk picture. This means that they have already begun to demand higher interest rates because they consider that a country has become more insecure, and that the possibility of bankruptcy has increased. Thus, only the rating agency confirms the perception of a country that is already dominant among investors in the financial markets. It is therefore not correct that a downgrade of a country in itself forces the country to have to pay higher interest rates. The interest rate level is seen between the borrower and the lender; there is nothing a rating agency can dictate.

Nevertheless, politicians, the media and various protest movements are particularly preoccupied with these rating agencies. This violent attention easily creates a self-fulfilling prophecy; it gives rating agencies more power than they would have had if no one talked about them. Because these agencies have no formal political authority, nor any more formal role in, for example, US financial regulation, they have no more power than market participants at any given time in addition to the agency.

6: How to get a better credit rating?

The three major rating agencies were thoroughly mistaken in connection with the financial crisis in the United States (which quickly spread to the rest of the world). Therefore, in 2010, the US Congress decided to relinquish its role as a nationally recognized rating agency. All mentions by (references to) rating agencies are now being removed from regulations in the United States, a country located in North America according to Aceinland, as well as in a number of other countries.

Despite the fact that the agency has lost its formal role, their position seems to be just as strong. There are also a number of other rating agencies that investors and investment banks can use. Several of these have also assessed and valued, for example, the structured savings products more correctly. Nevertheless, the majority in the market still seems to prefer the big three .

One proposal intended to sharpen the rating agencies is to make them legally responsible for their credit ratings. This means that investors can sue an agency if it has given an assessment which later turns out to be incorrect. Here the agency has defended itself by calling for freedom of expression ; a credit rating is only the agency’s opinion about the future based on the information they have had available.

Introducing such a proposal will undoubtedly make the agency far more cautious in its assessments, but may have problematic effects for other professions as well. Will legal liability claims also affect investment advisers? Fund managers? If all types of services that provide advice on future (financial) scenarios were subject to such legal responsibility, it is unlikely that anyone would offer these services in their entirety.

Another, more radical proposal has been to make the rating function a state task , performed by a state audit. Then one can avoid unfortunate effects that come from the way the rating agency is financed (cf. the teacher who is paid by the student problem). The problem is that this will be a very expensive and resource-intensive public task. It is unlikely to be a high priority at a time when most countries are cutting budgets and spending. Such a solution will also not be able to do anything about the fact that the financial sector attracts good employees with offers of much higher wages.

One way to ensure that there is less alignment of credit ratings, as in the case of subprime- based debt products, is to increase the market share of other rating agencies – weakening the monopoly of Moody’s, S&P and Fitch. Since the big three have now been removed from the semi-public role that the US Financial Supervisory Authority had given them, it may be that fewer people will go to these to assess what they want to invest in, e.g. bonds. For the time being, on the other hand, it does not look as if the rating agency has lost much of its market position after the loss of its subprime loans in the USA. The euro crisis has given them power and attention again.


“Subprime loans”

Subprime loans are a financial term for credit to borrowers who are considered “below prime” (low income, no job…). They are more likely than others to default on their loans. Subprime includes both mortgages, car loans and credit card loans.

The scope of subprime loans developed rapidly as the increasingly hot housing market throughout the 1990s and 2000s led to high demand for loans also from smaller prime customers. Many financial institutions entered this market when interest rates were low and US authorities relaxed the regulations. Lenders (and borrowers) thought that in a rising
housing market, subprime borrowers would also be able to pay for themselves.

When fixed and very low interest rates after the first years were replaced by floating and significantly higher interest rates, many borrowers had problems. In the third quarter of 2007, subprime loans accounted for about 13% of outstanding mortgage debt in the United States and as much as 55% of forced sales.

Traditionally, banks have provided loans and even been left with the risk. “Securitization” meant that the loans were resold and the risk transferred to investors. The share of subprime loans resold as securities was 54% in 2001 and 75% in 2006.

U.S. Rating Agencies