Not for purchasing, selling or holding securities

Credit Rating Agencies

When you invest your money, you don't want junk; you want some sort of assurance that your investment has a certain quality. That's what Credit Rating Agencies (CRAs) are for. A CRA is a firm that assigns credit ratings, giving securities a rating according to how likely they are deemed to fail. The ratings are labeled AAA or Aaa at the top over B and C-something to D at the bottom.

Blackmail to avoid scrutiny?
In 1975, the Securities and Exchange Commission (SEC) gave official recognition to Moody's, to the Fitch Group and to Standard & Poor's (S&P), the three biggest CRAs; this list was later augmented but these three are still dominating. Many investors began to demand good official ratings for their investments, substantially increasing the CRA profits. From the beginning there were critics, even among the CRAs; they thought this would unduly tempt the staff to give too high ratings, making the SEC at least an accomplice should there be abuse.
With their rating privileges, the CRAs could do pretty much as they wanted. And they did. If a state legislature tried to reduce their power or increase their liability, the CRAs threatened to stop rating the state bonds.
A bipartisan report said that CRAs were a key cause of the financial crisis. It recommended that SEC should permit investors to keep CRAs responsible when knowingly or recklessly not conducting a reasonable security investigation. Two days later, S&P changed the US's rating to negative (increased risk for downgrading). S&P's David Beers met with Congressional Republicans in a closed door meeting, and the same day the provisions that subjected CRAs to expert liability were removed.

Different rating grades for different securities
Although the market by large treated all CRA ratings as equal, they were not. An AAA rated municipal bond had a lower risk of default than an AAA rated corporate bond; this in turn had a lower risk than an AAA rated Asset Backed Security (ABS) which had a lower risk than an AAA rated Collateralized Debt Obligation (CDO).
The CRAs' fees were correlated with their willingness to look the other way when it came to credit risk; highest for CDOs, lowest for municipal bonds. So you could buy ratings; if you put some ABSs together and called it a CDO, you could get a better rating. You paid more for the rating and you got more when you sold your security.

Bad CRAs driving out good

Pressured to give good ratings
At first, the CRAs were paid by the security buyers. A buyer wants an honest rating, he wants to know what he gets; a seller does not want an honest rating, he wants a high rating. In the 1970s, when the sellers began paying the CRAs, the affiliation of the CRAs changed. Before, they were paid to satisfy the buyer. Now they are paid to satisfy the seller. I can imagine how the sales talk goes, "Here are some very nice subprime loans. You don't have to take my word, I got this nice independent CRA I pay to tell you how good they are."
Even if CRAs wanted to give fair ratings, pressure from their customers forced them to exaggerate. At first there was some hesitation among the CRAs about being so generous with top ratings. A very popular type of bundled mortgage securities was CDOs. At first Moody's kept out of it, sticking to the principle that a mortgage only security could not get a top rating. With the others making so much money, Moody's could not resist the temptation so they joined. And they made money. During the bubble, Moody's was 10 times as profitable as megabank Goldman Sachs.
The CRAs were not above deliberately manipulating the results. When Countrywide bank did not get the rating they wanted for their securities, they complained and Moody's went back to their computers; without any new information, the next day Moody's gave the securities top rating. The CRAs were fully aware of the risks. They could find a deal ridiculous and still top rate it. An internal S&P email warned and concluded "Let's hope we are all wealthy and retired by the time this house of cards falters".
With Credit Default Swap insurance, even the riskiest CDO tranches could get top ratings from the CRAs. In fact many CDOs were put together from only subprime loans; 75% of the CDOs still got AAA ratings because they were insured with major insurance companies.

Many things can go wrong
To get its ratings, a CRA feeds a lot of data into a computer, presses the Enter key, and waits while the computer makes a lot of computations, simulating a lot of possible scenarios and weighting them together to give a rating. What can go wrong?
Many things can go wrong. Besides the CRA manually overriding the result from the computer, the computer program can be manipulated. The program can have bugs. The program can use irrelevant statistics; instead of analyzing underlying mortgages, standard values are used. One former CRA official said that using old statistics to evaluate the new loans was like using data from Antarctica to predict the weather in Hawaii. The data from the clients might be wrong or misleading; either by mistake or deliberately manipulated. Even should the CRAs be totally honest, there would still be much uncertainty. Economic theory is not an exact science and advanced economic calculations can go very wrong; no matter how much financial gurus like to see themselves as harbingers of higher wisdom, they are not.

An officially recognized economic advisor
When the market crashed, nobody was responsible. Not the CRAs; they claimed they only expressed informed opinions, protected as "free speech". Moody's claimed that "The ratings ... are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities". I suppose this means that if a gemstone appraiser should make a howler, he has the same right to invoke free speech.
A CRA is an officially recognized economic advisor, telling its customers about the risk of their securities. Its business is collecting and selling special knowledge; if it did not have special knowledge, there would be no reason to pay its exorbitant fees. It is true that the CRAs do not tell you to sell or buy something; they tell you this is high or low risk and what you do is up to you. Many investors demand a CRA rating before investing; like direct recommendations, CRA ratings strongly influence investment decisions.
So according to the CRAs (at least Moody's, the others seem to follow suit), the ratings are explicitly not recommendations for purchasing, selling, or holding. So what are they for? Why would anybody pay for CRA ratings for any reason but for purchasing, selling, or holding? Can't see there is any reason at all to pay a lot of money to the CRAs if you are not going to use their opinions for purchasing, selling, or holding.

© Anders Floderus