Rating agencies risk losing credibility

Although rating agencies are needed to maintain financial efficiency in the markets, there judgments are at times questionable.

Rating agencies play a huge role in the financial efficiency of American business. A credit rating agency is a company which rates certain types of debt obligations as well as the debt instruments themselves.

The credit ratings issued by the agencies are used by investors, investment banks, issuers, brokers, and governments. Rating agencies assign letter rankings to a debt obligation, which signifies how much risk is associated with this debt.

There are three major rating agencies in the United States: Standard and Poor's, Moody's Investor Services, and Fitch Ratings.

Standard and Poor's is a United States Financial Services Company that has been around since the 1860s. It is a division of the McGraw Hill Companies that publishes financial research and analysis on stocks and bonds.

Moody's Investor Services was founded in 1909 by John Moody. Moody's has a 40 percent share in the credit rating market. Moody's does financial research and analysis on stocks and bonds in both the United States and abroad.

Fitch Ratings, whose parent company is The Fitch Group, was founded in 1913 by John Knowles Fitch. "Fitch Ratings is a global rating agency committed to providing the world's credit markets with independent and prospective credit opinions, research, and data," according to FitchRatings.com.

There is a clear conflict of interest among rating agencies and the issuers who give their business to agencies. Essentially a company wants to issue debt to raise capital. The company will contact the rating agencies and the rating agencies will charge the company to rate their debt.

Professor Carew compared the conflict of interest among rating agencies and the debt they rate, to that of a company that hires a CPA firm to audit its books.

Arthur Andersen, Enron's auditors at the time, knew they were hiding huge amounts of debt from their books, but they felt they needed to so they would not lose Enron as an account.

Since it is in every company's best interest to have the highest/safest rating they may give majority of their business to a rating agency that gives them slightly higher ratings.

"Understanding rating agencies and how the rating agencies operate, you can get a flavor of populist conflict of interest here when in reality that is the practice," said Carew.

Similar to their accounting scandal, Enron was able to manipulate their rating back in the early 1990's when agencies were aware that Enron was in bad financial shape. The public was led to believe Enron's debt ratings were investment grade until a few days before the company filed for bankruptcy.

Rating agencies also have an indirect power over the financial markets. The lowering of a credit rating agency of debt obligations over multiple companies in similar industries could cause a sell off in that industry.