US downgrade not surprising as integrity of agencies at stake

The recent downgrade of the US economy by credit rating agency Standard & Poors shouldn’t have come as a surprise. S&P indicated that even if the debt deal was approved they would still go ahead with the downgrade if there wasn’t a reputable policy of fiscal contraction to reduce debt. But agencies are all to aware of the critcism that they got over the credit crisis and will be mindful of this.

Conflict of Interest
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:

Bear Stearns
– rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

Below are the ratings that each company uses.

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