The role of a ratings agency is to make an impartial assessment of the risk to an investor of backing a particular debt vehicle with AAA ratings indicating the safest bets; on down to junk status for riskier propositions. Investors are then able to match their risk appetite to the bonds or other assets on offer – the riskier the bond, the worse its rating and the greater the interest that the bond issuer needs to offer to get investors to take up their bonds. Ratings agencies are rewarded for this “honest broker” service by earning a fraction of the value of the bonds that they rate. Suspicious minds will immediately see a weakness in this system.
The Global Financial Crisis was triggered by a major loss of confidence in so-called “sub-prime” debt. Essentially, bond issuers argued that only a small minority of risky mortgages actually ended in default; so these mortgages were bundled together (“securitised”) in the belief that iffy loans, packaged together, represented a top-quality asset that could be offered to private and institutional investors alike – the pungent smell of rodent should already be filling your nostrils.
Ratings agencies went along with the idea that “consolidated debt obligations” could be investment grade assets. One of the major ratings agencies, Standard and Poor’s has just agreed to settle claims that it knowingly inflated the ratings of CDO by paying US regulators $1.38 billion. The move with the US Department of Justice will settle 19 outstanding suits stemming from claims pertaining to activities between 2004 and 2007.
S&P owner McGraw Hill noted that the settlement “contains no findings of violations of the law” which is interesting as less charitable observers would say that S&P appear to have been given a free pass for activities amounting to fraud.
The US Justice Department filed civil charges against S&P in 2013. S&P responded that the suit was without factual or legal merit at the time.
It would seem likely that more deals will be struck with other ratings agencies in the fullness of time. However, if ratings agencies cannot be relied upon to be scrupulously impartial when it comes to assessing the risk associated with a particular bond issue, the question must be asked as to what function they actually serve.