Despite their self-proclaimed independent status, ratings agencies are more likely to influence than merely act as observers. This has been only too evident in the role the agencies played in the global economic downturn. So why is it we put so much faith in rating agencies when they get it wrong so often?

Rating Agencies

Rating Agencies: Triple A junk

After all, wasn’t it agencies such as Moody and S&P that applied an AAA stamp to subprime mortgage backed CDOs, defending their actions even while downgrading the very same institutions? When investors sued, the agencies declared that their AAA accreditation wasn’t a rating; it was an opinion!

By that rationale, it was an ‘opinion’ that destroyed Lehman Brothers. Since then, the rating agencies have gone on record to say that you can’t rely on their ‘opinions’. That’s certainly true. Very often, these opinions are flawed at best.

The big three rating agencies, Standard & Poor’s, Moody’s and Fitch were all making record profits

At the height of the subprime bubble, the big three agencies, Standard & Poor’s, Moody’s Corporation (NYSE:MCO) and Fitch, were all making record profits. It was the job of these agencies to make independent assessments of financial firms that were putting together securities packages, many of which contained toxic investments based on subprime mortgages.

Of course, these very same firms paid the agencies well. Between 2004 and 2007, for example, S&P’s profit grew 73%, and Moody’s jumped 68%. Just before the collapse, Moody’s Corporation (NYSE:MCO) was making almost half its profit from rating structured financial products – the same ones that would cause the collapse.

After the collapse, the excuses were insubstantial. Moody’s Corporation (NYSE:MCO) blamed their own ratings on a computer glitch. The US Financial Inquiry Crisis Commission wasn’t so lenient labelling the agencies ‘key enablers of the financial meltdown’.

Rating agencies: Big mistakes, little accountability

Let’s also not omit to mention S&P’s $2 trillion accounting mistake when the agency took the bold precedent of downgrading the US when Obama signed Dodd-Frank into law. Even when the mistake was pointed out, S&P still proceeded with the downgrade!

Yet, at the same time, in Ireland, where there was good reason for downgrades, the rating agencies were slow to act. Shane Ross is an independent member of the Irish parliament:

‘They were behind the curve by a long way. Quite often you see situations were markets are well ahead of the ratings agencies. And that was certainly the case with the Irish banks. The markets were selling a lot of the bank shares before the agencies downgraded them.’

Rating Agencies: Downgrading Europe

When the big three did begin attacking the economies of Europe through downgrades in the summer of 2011, there were catastrophic repercussions for global markets. The downgrades made it much harder for governments to borrow. Spending was cut, especially on social services. The most disadvantaged in society suffered.

It all begs the question: why do these ‘key enablers of the financial meltdown’ still have so much clout in the markets? When an agency downgrades, the markets take notice. Yet most of the time, the reasons for the downgrades are already in the public domain.

It’s all in our heads

Jeffrey Stibel of Dun & Bradstreet Credibility Corp believes the influence of the agencies is largely psychological:

‘There is way too much information out there, which causes a lot of people to shut down, so what governments, markets and investors need is someone to distil that information into a single conclusion. For better, or for worse, the information overload requires someone to make sense of it all and that’s what these agencies do. If it wasn’t S&P, Moody’s Corporation (NYSE:MCO) or Fitch doing the job, then another company would be.’

So at the end of the day, we aren’t really listening to the agencies; we’re more interested in how we think our peers will react to statements by the rating agencies.

And as Stibel says, the scariest thing about this questionable industry is:

‘It’s likely that they’ll make another big mistake again.’

In the meantime, perhaps it’s time we downgraded the agencies.