Explain it to me: Credit Rating Agencies and their role after the Crisis

On Monday, an Australian court held Standard & Poor’s liable for losses that one investor suffered because it rated toxic bonds as investment grade.

Credit rating agencies like Standard and Poor’s are increasingly facing wrath from regulators, financial institutions and investors. The blame game started since 2008, when investors witnessed the worst in financial markets.

But what exactly is the role of credit ratings agencies on Wall Street. A credit rating agency is a body, which gives credibility to an organization, instrument or a sovereign. In simple words, it tells if they are worthy enough to lend your money to. And Wall Street is all about lending money and making more money out of it.

Marketplace editor Paddy Hirsch explains in very easy terms, the concept of credit rating agencies in this video. Credit ratings are simply grades assigned to corporations or sovereigns depending on their financial health.

So, if you are a company and want to raise money, you would approach a bank for a loan. The bank will ask you for a credit rating. You would then have to go to any of the credit rating agencies like S&P, Moody’s, Fitch and avail their services. They would charge you a fee and conduct a financial analysis of your company to decide how safe you are for lending money.

The highest form of credit ratings is AAA, for most of the agencies, which means the corporation or sovereign has the ability and willingness to pay back its debt. The worst credit rating anyone could get is a D, which stands for default.

How important are these credit agencies, after all the notorious publicity? Jacob Goldstein of NPR’s Planet Money says they certainly got a black eye in the financial crisis. But despite whatever their performance may have been, the big ratings agencies, they’re still written into the laws and the regulations that govern our financial system during NPR’s morning edition in April 2011, when S&P first warned about downgrading the U.S.

When Goldstein refers to the black eye, he means the flak the agencies received during the crisis. They were accused of rating dangerous bonds with higher ratings, thus guiding investors to invest in them.

Deven Sharma, the ex-President of Standard & Poor’s told Alex Blumberg of This American Life, that they might have messed during the ratings process, in this podcast which tells what went wrong with the ratings of subprime bonds.

“They missed the severity of it,” Sharma says, referring to rating analysts.

The main accusation was that the agencies used mathematical models for arriving at ratings, formulated years ago and did not take into consideration other nuances of the economy.

However, in spite of these allegations, rating agencies still remain an important wheel in the financial cycle. People still want to know how safe it is to lend money and how risky the other party is. And credit rating agencies are the only solution to it.

Whether the ratings are still perceived to be the last word by many is a question of debate.

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