Credit Rating Agencies - Part One

What is a Credit Rating Agency and What Task Does it Perform?

Since 1931, the United States government has encouraged or even required certain types of investors to use financial instruments or securities that have been rated high by rating agencies (15 Chap. L. Rev. 139). These agencies use available financial data, economic conditions, and various other factors to determine the strength of a particular firm, security, or instrument offered on the market. Logically, no rational investor would choose to use a financial instrument that possessed primarily bad qualities. The market should realize these bad qualities and the price of this instrument should decrease accordingly.

The credit rating agencies provide ratings which investors are advised or even required to rely on when investing in certain financial instruments. These ratings are intended to provide the investor with an accurate picture toward the quality of the financial instrument without having to do the tedious homework required to determine if credit rating given by an agency is in fact an accurate rating. Under this logic, in comparison to the average individual investor, shouldn’t a credit rating agency be more qualified and have more information to provide the most accurate credit ratings available?

Credit Rating Agencies Prior To 2008 Financial Crisis

Credit rating agencies are a common part of the financial infrastructure in the United States. In theory, it may be argued their existence is logical and necessary. In practice, it may be argued their existence is inefficient and unnecessary. When investors act on the information given by these rating agencies, there is an inherent trust placed (or misplaced) in these institutions to provide accurate and reliable information.

The general public viewed these ratings as a competent reflection of strength or weakness in a financial instrument and therefore made investment decisions on such information. The government recommended that certain instruments have at least one rating before an investor should act. This legislative influence towards the rating of financial instruments helped the public to overlook any mistakes or gaps in the ratings by taking the ratings given by these agencies as legitimate and accurate information. (15 Chap. L. Rev. 139-41).

During the time leading up to the financial crisis, there were three main credit rating agencies that controlled the majority of the market share. These credit rating agencies were Moody’s, Standard & Poor’s, and Fitch. Beginning in 1975 with more governmental influence and help from the SEC, these agencies became members of the Nationally Recognized Statistical Ratings Organization (NRSRO). Just as the government encouraged investors to buy highly rated instruments, the government in addition encouraged investors to purchase highly rated instruments by a NRSRO. However, the criteria to become a NRSRO were never easily accessible and the SEC was slow to answer many requests (15 Chap. L. Rev. 140, 142). Prior to the crisis, the ratings agencies were protected from legal action by the First Amendment from people who relied on these ratings to their disadvantage.

The courts viewed the ratings merely as opinions offered by these agencies based on the information available and the assumptions the agencies put in place while rating these instruments. Since these ratings were considered opinions based on complex assumptions and not facts, the rating agencies were able to escape almost all legal repercussions for an inaccurate credit rating.