The Power of Rating Agencies

Businessmen by Allen Sima
Businessmen by Allen Sima

The US may lose its AAA rating! This warning has brought a new sense of panic into the financial market. Why is the decision of one firm, a rating agency, so important? Do we need such agencies? And how do they determine their ratings?

BB-, A+, AA…

Rating agencies assess the financial strength of companies and governments. Their ratings are like school report card grades, showing how the rated object is able to meet all its obligations. The rating for a given debt issue reflects the agency’s degree of confidence that the borrower will be able to meet the promised payments of interest and principal in time.

Investors‘ confidence highly depends on the agencies’ analyses. A change of rating means a change of the sum a borrower must pay its debt-holders. When the rating of an economy decreases, it will make it more expensive to borrow since investors want a higher return for taking on more risky debts.

Standard & Poor’s, Moody’s Investor Service and Fitch Ratings

Standard & Poor’s is the biggest and the most influential rating agency in terms of the magnitude of its impact and even the range of its coverage of securities issuers. Its work includes Credit Ratings, Market Indices, Investment Research, Risk Evaluation, and Financial Data and Information. Currently, it rates more than US$32 trillion in outstanding debt. Standard & Poor’s is also known for maintaining one of the most important indices of American stocks: the S&P 500.

The name David Beers isn’t well-known across the world, but you can be sure that every finance minister in the world knows it very well. David Beers is the global head of sovereign credit ratings for Standard & Poor’s, and he’s the man who has decided the US rating.

However, it’s not the only agency warning that can make the US lose its current credit. Moody’s Investor Service and its somewhat smaller rival, Fitch Ratings, are also considered to be influential big rating agencies. Moody’s hasn’t changed its rating and Fitch will decide later in august.

Critical Words

Rating agencies have received merciless criticism for the quality of their work. Their critics claim that they’re poor forecasters, unable to spot negative trends to revise their ratings. "The ratings agencies failed the world economy in spades in the past,” said Lord Peter Levene, chairman of the Lloyd’s of London insurance market and former senior adviser to the British finance ministry. “Their track record has not exactly been stellar.”

Many specialists lost confidence in the agencies, recalling their fundamental mistakes. "This is the agency [S&P] that within recent memory assured investors that not only were Bear Stearns and Lehman Brothers blue chip investments but that the various collateral-derivative-swap-trade-debt-obligations were as safe as houses. And let’s not talk about the dotcom boom era of the late 1990s,“ wrote Richard Adams in his commentary for the Guardian. Another concern is the differences among ratings given to the same country. "The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment — or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue,” explains Standard & Poor’s.

However, rating agencies still have a significant impact on investors‘ decisions, and investments drive the market. Whoever questions their reliability, they still have great power over the lives of millions of people.

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