Why do markets pay attention to rating agencies?

April 28, 2010

Why do markets still pay attention to what rating agencies have to say? Following their appalling record predicting the subprime mortgage crisis, it is astonishing and sad that investors still seem to quake when Standard & Poor’s junks Greece and downgrades Spain.

An arriving Martian would find it hard to understand why anybody gives any credence at all to S&P and its rivals Moody’s or Fitch. It’s not just that they were pumping up the U.S. subprime market — for example giving a triple-A rating to Abacus, Goldman Sachs’ now-notorious synthetic collateralised debt obligation — after smart investors saw trouble in the market.

They were late in spotting the wave of corporate debt defaults, including Enron’s, in the early part of the century. And they have been dilatory in calling attention to the current euro zone sovereign debt crisis. Even after S&P’s downgrade of Spain, Moody’s and Fitch, the other big agency, are still rating the country’s debt at triple-A. Ratings agencies are consistently behind the curve.

So why do they still wield influence? There are at least two reasons. One is because they are embedded in the way markets operate. Some investors, for example, are only allowed to buy investment-grade securities. That means they have to sell securities when they are junked. Similarly, ratings are used in determining the riskiness of a bank’s balance sheet and how much capital it needs to set aside.

Ratings are also common in deciding how big a haircut is required when banks and investors pledge collateral. One saving grace in the euro zone crisis is that the European Central Bank has stopped saying that only the highest rated sovereign debt can be pledged as collateral. But ratings are still far too entrenched.

The other reason why markets pay attention when the agencies bark is what could be called the “megaphone” effect. S&P and Moody’s may not be the smartest observers in the market; but they do make a big noise. It’s a bit like shouting fire in a crowded cinema. The agencies aren’t the first to spot the problem; but they sure help create a panic.

It is high time regulators and investors dethroned them from their privileged status.


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Curiously enbouygh the removal of ratings from prudential regulatory measures has been welcomed by rating agencies, which have opposed the “hardwiring” of ratings in regulation for more than a decade.
In the case the use of ratings in rules was not to be reduced, rating agencies demanded that also other measures and benchmarks should be used to complement ratings.
That all said, institutional investors and pension funds have argued that removing ratings from securities regulation would also remove important investor protections.
Vanguard Group, one of the main US mutual funds, has commented thus: “Ratings – even if occasionally imperfect – protect investors by establish-ing a uniform, minumum credit quality for all money market funds. Removing that investor protection is akin to outlawing seat belts with the hope that drivers will be less likely to be injured if a defecting belt fails in a crash”.
Also, the Securities Industry and Financial Markets Association has acknowledged that while the use of credit ratings in regulation may foster excessive reliance on ratings, it also provides “an appropriate minimum” and “an important data point that should be part of a larger analysis”.

Posted by Pantagruel | Report as abusive

Fair enough Pantagruel, except removing is not the same as outlawing, that’s what airbags are there for. Ratings are more like contraceptives, which are used after expiry, too late or not used at all when people are drunk, like drunk with greed. Removing it could just make people think more clearly, as to outlawing it, now you are talking.

As for complementing it, I think it is already too complicated, and seeing that everybody avoids the ownership and antitrust issue, we might as well all have a haircut.

Posted by Ghandiolfini | Report as abusive

The ratings agencies have always erred in the direction of making things seem better than there actually were. This is understandable, as they were paid to do so. Now that they are lowering ratings, this is more believable, especially when many financial analysts and economists have also stated that the problems are much bigger than anyone is willing to admit. Given the many reasons for many players (including governments) to represent things as better than they are, a lowered rating is more believable than the nonsense in the past.

Posted by m11213 | Report as abusive

I hope we all understand what Abacus really was ? As far as I remember from the infographic, ‘it’ had a BBB rating, does it matter or is it relevant ?

Posted by Ghandiolfini | Report as abusive

It is hard to believe the financial reform being debated in the house and the senate left out these rating agencies, shouldn’t they be subject of any wrong doing investigation just like Goldman? It is time for the foreign countries to review if these rating agencies shall be allowed to conduct their activities worldwide spreading the virus!

Posted by alchan | Report as abusive

I agree that rating agencies could not give right prediction of the incidents. But i also believe that still they are important. A rating instrument could easily be marketed in London and well as India. So these rating make instruments global. Beside it they also provide a standard for investment purpose. So I think that we should not eliminate rating agency.

Posted by Kusaan | Report as abusive