Why Exactly Were Credit Agency Ratings So Wrong?

Following the subprime credit crisis and the financial crisis of 2008, many people are wondering why credit agency ratings for so many companies were so far off target. In fact, many people blame the large credit ratings agencies for helping to lull investors into a false sense of confidence in many types of mutual funds and other securities that were based largely on subprime mortgage home loans. Furthermore, many people blame the way that credit agencies actually arrive at ratings for companies and financial products for making many companies and funds appear stronger than they actually were.

Flaws in the Credit Agency Ratings System

The major credit rating agencies: Moody, Standard & Poor's and Fitch Ratings, Inc. have all been accused of poor credit ratings methods and practices. In fact, it is often said that the credit ratings agencies very nearly allow a company or to purchase a good credit rating. While this accusation is somewhat far-fetched, there are definitely conflicts of interest in the way that the credit agencies do conduct their business and issue credit ratings.

For example, the credit ratings agencies are normally paid by the companies that they rate; in fact, the major corporate credit rating agencies earn a large portion of their revenue by helping companies and funds attained a certain credit rating. Therefore, in some ways, the credit ratings agencies may actually become part time investment bankers. Many times they work side-by-side with major banks and dealers to determine how a particular financial product should be structured; therefore, they are often accused of rating their own products.

Obviously, this is a clear conflict of interest.

Other Corporate Credit Ratings Agency Problems

Besides the conflicts of interests associated with many credit ratings, there has been large speculation that the credit ratings agency simply did not pay attention to the signs that something could go wrong. For example, many analysts and experts state that the credit ratings agencies didn't take into account that future losses would not be equivalent to historic losses -- and indeed could be many times worse than anything that has ever occurred before. Many analysts also accused the agencies of doing a lot of fancy modeling that was based on what happened in the past without taking into account the way the global economy and the world was changing.

Because many governments and pension funds are required to buy only securities that carry a top rating from the majors ratings agency, poor judgment or biased decisions made by a credit ratings agency can prove to be devastating for millions of small investors and retirees. When credit ratings agencies make mere assumptions about the future performance or profitability of a particular company or securities fund, they are putting the investments and savings of millions of people at risk.

Therefore, analysts, experts and lawmakers are demanding changes in the way credit ratings agencies conduct their business and make credit ratings available to the general public. Perhaps, this will be the only way to make credit ratings agencies accountable to the public and the taxpayers that bailout companies once in favor with the ratings agencies.

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