Sam Brotman, JD, LLM, MBA January 15, 2014 4 min read

Issues Affecting Credit Rating Agencies

Competency, Trustworthiness of Ratings, and Conflicts of Interest

Credit rating agencies have not been held accountable for their ratings. Meaning, an inaccurate rating brings no repercussion to these agencies. If one is not held accountable for their actions, logically there is less incentive to perform well or even at a high standard.

These agencies knew their services were needed under government recommendation yet they were not held to a standard which required the utmost diligence and scrutiny to measure the accuracy of their ratings (15 Chap. L. Rev. 138). This type of attitude towards the agencies allowed the agencies to become comfortable with their existing practices and did not encourage any improvements in the methods these agencies used to rate the instruments. Although no rational investor would choose an instrument based solely on the credit rating, the ratings were generally accepted by the public as an accurate estimation or calculation of the instrument’s creditworthiness. Therefore the general public, after decades of accepting these ratings as common practice, assumed these ratings were legitimate because they were backed by expert analysis and economic insight.

It is fair to say that the average and even above average investor relied on these ratings as trustworthy information provided from an agency which is strongly encouraged by the government. Further, these agencies often acted on information provided by the companies they were rating and not confirming the information with third-party resources (15 Chap. L. Rev. 137-39). Thus not ensuring the accuracy and integrity of the information they were using while calculating ratings.Conflicts of interests only made things worse by compounding the problems of the competency of these ratings and their trustworthiness.

The entire business model which the big agencies operated presented immediate conflicts of interest. The rating agencies would be paid by companies who wanted their instruments rated (15 Chap. L. Rev. 136-37). Because there is more than one agency to rate financial instruments, the companies could now shop for a better rating amongst the competing agencies. In turn, these agencies were competing for the largest market share in the ratings industry. Therefore, to gain more share, the agencies were often providing favorable ratings to these companies and their instruments to gain their business and add to the agency’s market share.

Providing these favorable ratings often required the agencies to jeopardize the integrity of these ratings by altering the methodology in which they are calculated. This provided the agencies with higher profits yet the public still trusted these ratings as a recommended factor of investing.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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