The Great Financial Crisis and its aftermath slayed industry titans like Lehman Brothers and Bear Stearns – and would have done the same to AIG and America’s automotive industry were it not for massive government bailouts. But one industry managed to escape relatively unscathed: the giant rating agencies.
That is not because they were blameless. In fact, the agencies’ conflicts of interest and exaggerated assessments of risky mortgage-backed securities helped cause the crisis in the first place, with the Financial Crisis Inquiry Commission finding in 2011 that they “were key enablers of the financial meltdown.”
This sordid history, though, has not diminished their standing in the international investment community – and it wasn’t even enough to deter future bad behavior. This begs the question: why do investors continue to rely on these agencies, and does their input matter as much as we think?
Indeed, a cursory review of their actions suggests it may be time to take their ratings with a massive grain of salt. Consider the largest and oldest of the big three credit rating services, S&P Global Ratings. There is a clear history in recent years of the agency carrying out anti-competitive practices, engaging in pay-for-play rating schemes and flawed credit ratings, and ethically and legally questionable conduct resulting in billions of dollars in fines and legal settlements.
In 2015, for example, the Department of Justice filed a lawsuit against S&P for allegedly defrauding investors in structured financial products known as Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) – causing them to lose billions of dollars during the GFC. The agency was accused of falsely representing that its ratings were objective, independent, and uninfluenced by S&P’s relationships with investment banks.
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After a lengthy back-and-forth between S&P and the government, the agency agreed to pay $1.5 billion to settle lawsuits and publicly admitted that it uncovered no evidence that the DOJ had retaliated against it for downgrading the U.S. credit rating. S&P escaped without having to admit it violated U.S. laws but did sign a statement of facts acknowledging that its executives delayed implementing new models in 2005 that produced more negative ratings on the investments.
More recently, Texas joined a multi-state investigation into S&P into the agency’s publishing of Environmental, Social, and Governance (ESG) ratings and possible violations of consumer protection laws – leading the agency to drop its usage. In 2022, S&P removed a part of its proposed model for determining the creditworthiness of insurers after numerous complaints and a pointed letter from the DOJ that it might violate U.S. anti-trust laws.
These are just two examples in a long history, but they illustrate the problem with the big three credit rating agencies: they are too influential and can manipulate their ratings with little to no recourse. S&P and Moody’s alone dominate 80 percent of the international market, while Fitch controls another 15 percent. If this were any other industry in the world, the Big Three’s Herfindahl-Hirschman Index would have demanded government intervention decades ago.
This market dominance may be inoculating the agencies from private sector criticism, even in cases where companies are subjected to faulty, questionable, or qualitative ratings. It is simply too costly for companies to spar with the agencies publicly, as their influence over the market can have bottom-line impacts and drive investment to competitors.
That is likely well-understood in corporate boardrooms around the world. Consider Royal Park Investments, which sued S&P for $5.14 billion just months ago following losses allegedly caused by the credit rating agency’s “flawed” ratings of eight CDOs.
But litigation like this takes years, costs significant resources, and puts the burden of proof on the aggrieved party. There is little recourse in real-time. What the agencies say about a company goes – and has massive implications for corporate finance, the investment climate, and overall reputations.
Compared to the damage caused in part by well-documented systemic missteps in recent decades, the way the S&P and other agencies rate and set the terms of the debate around individual companies may seem like small potatoes – and, in some ways, it is.
But placed in the broader pattern of its behavior, market analysts should think long and hard about rating agencies, their trustworthiness and credibility, and the broader market implications if we continue to trust in them blindly.
Jared Whitley is a longtime DC politico, having worked in the US Senate and White House. He has an MBA from Hult business school in Dubai.
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