Critics on ratings based on their subjectivity
It is (not) difficult to believe that rating agencies perform consulting services, and this is an obvious source of potential bias in ratings. (Remember the story of woolf-boolf!) The credit ratings game is played under the condition that their principal source of revenue comes from the firms whose products they are rating.133 CRAs have been accused of biased evaluation and violating principles of objectivity. Generally, CRAs have denied the existence of any conflict of interest. They have stated that rating decisions are not made by individuals, but by committees, and the analysts have not received any compensation based on their ratings. Rating agencies now us mathematical models, the details of which are not fully disclosed. We already know that models are based on human assumptions. Furthermore, the results of any model can be overridden by humans (they might be called a “rating committee,” whose activity are kept secret). To make the rating procedure more transparent, the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) required CRAs to disclose their methodologies. (Well, it would be nice if they did so.) So we have the question: who should have the last word: the computer or the human?
Objective algorithms versus subjective conflict of interests
What would be the difference between a subjective credit rating and an objective credit rating? We have again the dilemma: what would be the difference between a subjective and an objective credit rating? A subjective credit rating would be one individual’s, or CRA’s, point of view. It would reflect the expertise of a particular analyst and their agency’s proprietary algorithms. An objective credit rating, on the other hand, would be something based on open databases and open source algorithms. If CRAs were really objective, then there wouldn’t be any need for more than one agency, and we wouldn’t have different rating results. CRAs would not make big revenues; anybody could simply use the only ratings agency’s publicly-available, consistent criteria to generate the (objectively existing) ratings.
Unhappy Reactions:From China to Europe
Several years ago, S&P downgraded China’s credit rating, and the finance ministry of the huge country vehemently criticized the validity of both S&P’s procedure and its result. Other developing countries, most importantly India, continuously rebel against the CRAs. India has a battle with Fitch, which has refused to upgrade India’s credit ratings each year since 2006. Since India has recently tried to attract more foreign investment, it is very painful to get a mediocre grade for creditworthiness. Europeans generally feel the Big Three CRAs show bias towards the United States. The US has managed to maintain its AAA rating despite a growing deficit and high levels of public debt. But in August of 2011, S&P downgraded the US’s credit rating to AA+ for the first time ever in history. The other two agencies still assign top credit scores to the U.S., but S&P affirmed the US’s AA+ credit score this year, reflecting the balance between positive and negative factors expected over the next two years.
Should we or should not we?
As debates over the merit of credit ratings abound,they remain a crucial facet of the international financial system. The spirit of this book is in accordance with the evaluation of Sebastian Mallaby from the Council on Foreign Relations:134 The best way to counter the monopolistic power of the Big Three, he argued, is for investors to stop giving their ratings so much weight.
“The reason why the subprime bubble could happen, or the reason why the European sovereign debt crisis can happen is, largely, that very blind investors bought bonds relying on ratings, and [didn’t do] their own homework about what the real credit risk was in the bonds.”