How reliable are the credit rating companies? Who is over seeing them?
Most of the times, the lending institutes check credit rating of borrowers on continuous basis. In case of consumer, it is through three major agencies. In case of businesses agencies like D & B provides credit worthiness of business. We see/hear numerous examples of how flawed such reports could be and how difficult it may be to remove incorrect information. These agencies relay only upon posted transection but do not unearth the reason behind posting. In case of bonds and equity, we have some private firms (Moody for example) fired by issuing companies, and we know the outcome of their corrupt practices.
To small businesses which rely on such ratings both for their credit worthiness and that of clients, these ratings can be very critical.
Question: How reliable is this system? Who oversee (punish them for their mistakes - severely..)? Why they have grown so big and so powerful? Do we need overhaul of credit rating system with credit card companies? Is big brother is "sleeping" and need to be watching?
Good Answers (1)
Lynn W.
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in the congressional hearings looking at toxic CDO issuers paying the rating agencies for triple-A ratings (when both knew that they weren't worth triple-A), the word "fraud" was used several times.
Supposedly SOX (sarbanes-oxley passed in wake of enron and worldcom) required SEC to do something ... but there doesn't seem to be anything but this report:
Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets; As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002
http://www.sec.gov/news/studies/credratingreport0103.pdf
Part of the congressional hearings made a point that the switch in the early 70s from the buyers paying for the ratings ... to the sellers of the instruments ... paying for the ratings ... marked the start of the change.
Last week one of the TV business news shows had on a couple CEOs from smaller credit rating agencies that are paid by the buyers of the instruments
... and repeatedly made the point that they aren't being influenced by the instrument sellers to give the highest possible rating.
Links:
- http://www.sec.gov/news/studies/credratingreport0103.pdf
- http://www.garlic.com/~lynn/2008p.html#9
- http://www.financetech.com/news/showArticle.jhtml?articleID=212501185
Clarification added December 19, 2008:
in the case of consumer credit rating, having the "relying party" paying for the rating ... rather than the consumer, is more consistent. In the congressional hearings, there was also the point that having the issuers of the toxic CDOs paying for the (triple-A) ratings ... mis-aligned the business interests (i.e. the rating agencies were no longer performing in the interests of the parties relying on the ratings).
similar discussion from two months ago ... shortly after congressional hearings ... discussing that regulation is significantly easier when there are properly aligned business processes
http://www.garlic.com/~lynn/2008p.html#9 Do you believe a global financial is possible?
and things can really get bollixed up when business processes are mis-aligned.
An semi-related recent article (although the topic was also touched on in the rating agency hearings):
Corporate Fraud and Misconduct Risks Driven by Pressure to do 'Whatever It Takes'; Fewer episodes reported by companies with ethics and compliance programs
http://www.financetech.com/news/showArticle.jhtml?articleID=212501185
from above:
Of more than 5,000 U.S. workers polled this summer, 74 percent said they had personally observed misconduct within their organizations during the prior 12 months, unchanged from the level reported by KPMG survey respondents in 2005. Roughly half (46 percent) of respondents reported that what they observed "could cause a significant loss of public trust if discovered," a figure that rises to 60 percent among employees working in the banking and finance industry.
... snip ...
With overall industry avg. of 46% ("could cause a significant loss of public trust if discovered") and the financial industry specific avg. of 60%, which should place the non-financial industry avg. below 40%. That would make the financial industry avg. somewhere between 50% and 100% worse than other industries.
Clarification added December 20, 2008:
earlier this fall, the congressional hearings into CDOs looked at rating agencies giving toxic CDOs triple-A ratings ... even though the toxic CDO issuers and the rating agencies both knew they weren't worth triple-A rating (the word "fraud" was also periodically used in the hearings). The toxic CDO triple-A ratings significantly increased the number of institutions that would deal in these toxic CDO instruments (as well as significantly increasing the amount of money that unregulated institutions had to lend).
related side-effect of (often) unregulated institutions being able to immediately offload loans:
The Man Who Beat The Shorts
http://www.forbes.com/personalfinance/global/2008/1124/042.htm
from above:
Watsa's only sin was in being a little too early with his prediction that the era of credit expansion would end badly. This is what he said in Fairfax's 2003 annual report: "It seems to us that securitization eliminates the incentive for the originator of [a] loan to be credit sensitive. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care."
... snip ...
Last Sunday, CSPAN had panel with several people from industry. One of the comments was that the subprime was supposedly targeted at low-income, first time home owners ... but only something like 10% of subprime loans went to that market.
With huge influx of funds from securitization and no regard who got loans ... they were cycling loans through the mill as fast as possible to all comers (speculator looking at 20%/annum inflation ... a no-down, no-documentation, 1% introductory, interest-only ... flipping after a year ... represents significant ROI). CBS 60mins had segment on some of these speculators in the overheated Florida and California real-estate markets.
The CSPAN panel also seemed to be torn between the industry claiming being ignorant and totally incompetent vis-a-vis admitting they just ignored (and/or manipulated) all the indications.
On CSPAN, a couple months ago there was comment that in the congressional session that repealed Glass-Steagall, the financial industry made $250m in congressional contributions. In the recent session that approved the $700B bailout, the financial industry made $2B in congressional contributions.
The PBS programs/webpages discussing some of the wall street influence on congress, wall street fix (including repeal of Glass-Steagall)
http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet
On the institution side buying these (triple-A rated toxic CDO, packaged) mortgages .... the institutions were 1) playing long/short mismatch and 2) heavily leveraging. Playing long/short mismatch (alone) has been known to take down institutions for centuries (in this case, even if the toxic CDOs had been worth their triple-A ratings). Comments were that Bear-Stearn and Lehman had marginal chance of surviving playing long/short mismatch. This was further aggravated with heavy leverage ... in some cases leveraging capital 40-80 times in buying triple-A rated toxic CDOs.
article from year ago about playing long/short mismatch (including transactions being carried offbalance ... some possibly are still lurking more than a yr later)
http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-siv-ent-fin-cx_bh_1113hamiltonmatch.html
decade old article from SanFran FED on problems with long/short mismatch
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
More Answers (7)
Frank F.
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The corporate credit rating agencies are basically incompetent and cannot be trusted or relied upon. Relative to any corporation, you should do your own due diligence.
Their opinions are contrived by analysts who have little clue what they are doing. And they are extremely poor at assessing risk.
They also are like stock analysts who don't like to downgrade anything. Most companies today have ratings which are way too high, and should be reduced by at least one full peg across the board to be anywhere near objective, especially in today's environment.
They also are very late to update their ratings, and do not review their ratings frequently enough. As a result, they are again unreliable and of little forward-looking value. Indeed, a company could go bankrupt and still be sitting with a satisfactory rating.
As to personal credit ratings, I cannot really comment.
The above is all in my personal opinion, of course.
Jonathan H.
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"How reliable is this system?"
It's as reliable as the data put into it, and the people staffing it... the same as any other institution that deals in data (government, media, etc).
"Who oversee (punish them for their mistakes - severely..)?"
The people who pay them for their services--if one of the big rating companies is exposed as particularly unreliable, they will lose customers and either fix themselves or go out of business.
"Why they have grown so big and so powerful?"
Economies of scale--when you're bigger, you have more customers and more people providing you with information, so you can be more accurate without having to expend as many resources as 5 small companies doing the same thing.
"Do we need overhaul of credit rating system with credit card companies?"
Credit card companies are probably a seperate topic.
"Is big brother is "sleeping" and need to be watching?"
No, the government usually makes things worse instead of better (regulation of interstate trucking and airlines, SOX compliance, Fannie & Freddie, Medicare/aid driving up everyone else's medical bills by paying $0.40 on the dollar, etc).
Janet M.
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The rating system failed. How reliable can something be when the rating is paid by the issuer, not the buyer?
The reliance on financial and statistical modelling also failed.
Caveat Emptor.
Links:
Josh C.
Director of Operations at Web Industries, and Decent Little League Coach
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Hi Amit,
One huge problem with the corporate rating companies, especially with regard to privately held companies, is that the reports rely on data submitted by the company being rated.
Josh.
James C B.
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Hi Amit,
Credit rating companies provide private opinions - some are correct and some are wrong. When you purchase this research you must be aware that it is a private opinion.
Watch Congressional hearings in 2009/10 - After the Dot.com bust Congress passed Sarbanes-Oxley Act of 2002:
http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act
JC Brandon
Links:
How reliable is this system? It depends. If we're talking big publicly traded companies then I'd say they are pretty reliable. Although after Enron, I would not bet my life/career on this.
Who oversee (punish them for their mistakes - severely..)? The value of their reports depend on their accuracy. Their punishment is that they lose market share. For instance, I don't use reports for small or mid-size companies from *** because I found them to be junk. Imagine paying for a subscription only to get a report saying "not enough data to create a score" I use *** to get lien information and court filings instead.
Why they have grown so big and so powerful? Information is power. Our perception that they have this massive database on us has allowed this.
Do we need overhaul of credit rating system with credit card companies? No, the credit rating is just one of several tools used by credit card companies.
Is big brother is "sleeping" and need to be watching? If you've been watching the news lately, big brother just woke up. This does not necessarily mean things will get better.
Michael C. D.
Senior Supplier Contracts Manager at Flextronics
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I was not aware that credit rating entities were subject to governmental oversight. Hmmmm. Perhaps this is a big part of the problem resulting in costly mistakes made by individuals and organizations based on wildly inaccurate credit ratings.
