In a field that includes Bernie Madoff, AIG, Lehman Brothers, and Bear Stearns, it’s pretty tough to take home the prize for most publicly hated financial institution, but credit-rating agencies are now putting up a strong fight. Few institutions have drawn as much political heat in recent weeks as the three main agencies: Standard & Poor’s, Moody’s, and Fitch.

Much of the criticism is well-deserved. The ratings agencies failed to sound the alarm in time on the risks carried by U.S. subprime mortgages and the securitized and derivatives products based on them. The rating agencies were, according to the U.S. Financial Crisis Inquiry Commission 2011 report, “key enablers of the financial meltdown” and of the economic aftershocks that followed the 2008 financial crisis. The raters only downgraded problematic assets in 2007, despite the fact that they were aware for at least a year of the magnitude of the subprime real estate bubble. An earlier downgrade would have likely gone a long way toward at least mitigating or diffusing the magnitude of the crisis.

Given the rating agencies’ mandate is to inform investors of credit risks, it’s hard to imagine a more colossal failure. These institutions plainly need serious reform. But the biggest risk facing markets, investors, and governments at the moment is not that ratings agencies are incompetent but that government efforts to “fix” them will be motivated largely by the need to assure near-term economic stability, fatally undermining their independence and integrity. Efficient markets and fair competition depend on access to reliable data and information. Politicizing the ratings game would only make matters worse — for tomorrow and for the more distant future.

During the financial crisis, raters were too close to the financial institutions whose debt they were supposed to assess. In some cases, they have been accused of advising banks on how to create new financial products to earn better ratings. There is also an unsolved and inherent conflict of interest, as the issuers of debt (governments and corporations) directly pay the agencies who rate them. Ratings agencies also form a powerful oligopoly, one whose ability to move markets is problematic, given the opacity with which they make calls.

Both the United States and the European Union have passed reforms over the past year that go some way toward better regulating the credit raters, for instance by putting in place rules requiring more transparency in the assignment of credit ratings. In the United States, legal requirements for certain corporations to use rating agencies (an important driver of the raters’ business) have been removed. This should create more competition and, over time, the development of alternative rating methods and organizations. The EU is pushing to break the credit ratings’ oligopoly by creating a more competitive space to allow new private ratings agencies to arise and/or by creating an EU-run “independent” ratings institute. The last option is a particularly bad idea, given the obvious conflicts of interests involved, but fostering more ratings competition is a welcome goal.

That said, it’s worth considering that not all current government actions are meant to create accurate ratings. There’s an increasing, and more troubling, risk that governments, especially in Europe, will politicize this reform process to pressure the credit raters, as well as other independent assessment providers, to suppress negative analysis. Governments, when faced with the prospects of another crisis, would rather prefer favorable than accurate and fair ratings. 

Consider an alternative scenario. What would have happened to the rating agencies if they had properly done their jobs? What if, say in 2005 or 2006, the three raters had downgraded the credit of all the U.S. mortgage products and institutions and burst the U.S. real estate bubble? Alternative history often raises more questions than it answers, but some logical assumptions can be made. Had raters fulfilled their responsibilities before the financial crisis made landfall, markets would have still registered serious losses. Banks and other financial institutions with significant exposure to real estate would have lost shareholder value. The U.S. economy might well have slowed dramatically. It could even have fallen into recession, though the dip might not have been nearly as deep and wide as the curve we’re riding now.

Foreign Policy

Gilbert Houngbo Giorgio Napolitano Giovanni Lajolo Girma Wolde Giorgis Gjorge Ivanov