Sit down for this one. Because you’re just not going to believe it. It seems that the more credit rating agencies are paid by corporations and banks to rate their debt, the more favorable ratings they hand out! This goes against everything I know about the untainted, incorruptible hand of the free market, and comes very close to shaking my faith in the credibility of the rating agencies.
Credit-rating companies routinely award higher rankings to debt issued by banks and corporations that pay them the most, a conflict of interest that may escape Congressional efforts to change the way they do business.
Bonds from countries and cities that pay about half as much as issuers of less creditworthy debt are “rated more harshly,” according to a study by scholars at Indiana University in Bloomington, Washington, D.C.-based American University and Rice University in Houston. Sovereigns rated A had no defaults over a 30-year period, compared with 1.8 percent of corporate bonds and 27.2 percent of securities backed by debt such as mortgages and loans assigned that ranking, the study of Moody’s Investors Service data said.
The research shows that profit may influence credit rankings after a government panel described the rating companies as “key enablers of the financial meltdown” in 2008. New York- based Moody’s, Standard & Poor’s and Fitch Ratings still dominate scoring for the $43 trillion global debt market, pressing borrowers from Spain to California to address fiscal imbalances to avert downgrades that may raise taxpayers’ financing costs.
I see where the researchers at American U. and Rice will go on to an in-depth study of the effects of mud on clothing. Maybe they’ll find out if it gets the clothes dirty!
It’s beyond obvious that the issuer-pays model of credit rating agencies is broken beyond repair. You cannot expect that the rating agency will bite the hand that feeds them and deliver a bad rating to a large financial institution or corporation when so much future business is on the line. The raters make a show of using models and sophisticated analysis to judge financial deals, but when it comes to the Big Money Boyz, they might as well just use a big ol’ rubber stamp.
Al Franken has been calling for the issuer-pays model to be junked for years now. But there it is, still at work. His solution of a competitive, randomized process for assigning financial instruments to the rating agencies is under study thanks to Dodd-Frank, but we have no idea when the resolution will be given. And considering that federal regulators have missed 77% of the deadlines for rulemaking so far under Dodd-Frank, I’d say the rating agencies don’t have a lot to worry about. At least not anytime soon.