Market responds to a large number of signals emanating from an equally large number of sources and the soundness of the market depends a lot on the reliability of these signals themselves. One of the important signals that market participants rely heavily on while choosing their investment avenues is the rating of financial institutions and their debt instruments by the Credit Rating Agencies (CRAs). CRAs do a great service by going through all the complex financial details of a company and other affecting variables and making available the credit worthiness of the corporations and governments in the form of simple letter grades, e.g., AAA, AA, A, BBB, BB, B, etc. Based on their financial knowledge and market research, these rating agencies upgrade, downgrade or keep the status unchanged of various instruments and institutions periodically.

However, the recent financial meltdown suggests that these CRAs have failed to do their jobs satisfactorily. An unwarranted higher rating of the mortgage backed securities by these agencies was one of the prime reasons that fuelled the sub-prime boom and sustained it for a long time, before it inevitably burst last year sending out shock waves whose tremors are felt even today. The poor quality of the ratings assigned to these mortgage backed securities became apparent once the mortgage holders began to default on their loans.  It has been a long and arduous journey back to normalcy; however the recent global events do not inspire much confidence.

Events in the past week suggest that Dubai has managed to escape the fall from the edge of financial disaster cliff, at least for now. However, the Dubai World might not be out of woods yet. This episode is only a stark reminder that the global financial meltdown is not over yet. The Dubai debacle became public only when the Dubai World informed that they would not be able to repay a part of their $59 billion debt by its December deadline. Both Moody’s and Standard and Poor’s have responded by heavily downgrading the debt of various Dubai government related entities. Why is it that the downgrading of the financial institutions and instruments are carried out only when the institutions themselves declare bankruptcy? These events only suggest that either the CRAs have failed to assess the credit worthiness of their clients or are hands-in-gloves with the very institutions they are supposed to keep a close watch on.

The operations of these CRAs also give the impression that their credit ratings themselves are based on the speculative euphoria of the market, providing high ratings when the market is doing well and downgrading the very same instruments and institutions when the meltdown starts.

Do these events signify that the markets have failed in one of the most important tasks of maintaining a close watch on the credit worthiness of the borrowers?

Prof Lawrence J. White of the New York University’s Stern School of Business, thinks otherwise. Through his study of the CRAs historical development Prof White demonstrates that, regulatory decisions over several decades facilitated the development of a non-competitive credit rating industry by assigning monopoly privileges to a few major agencies.

He explains in his work that how the credit industry began with the business model of “investor pays” wherein the bond investors used to buy the bond ratings contained in thick rating manuals and by early 1970s this model was abandoned by the rating agencies for the “issuers pay” model. This change of business model gave rise to conflict of interests. Now the customer of these agencies changed from the investors to the borrowers and in their quest to satisfy their new consumers, the rating agencies have the obvious incentive to upgrade the ratings to keep their customers from taking their business to their competitor. Prof White also demonstrates how the actions of the regulating agencies gave rise to the ratings market dominated by the big three (Moody’s, S&P and Fitch) and made the entry of new entrepreneurs difficult, thereby killing all the possible innovation and competition in the ratings industry.

Therefore, we observe that one of the most important signals was distorted and the information it carried was motivated or at best unreasonable. The most important task for the policy makers in this field is the creation of an environment where the rating agencies can do their job competitively, innovatively and without any conflict of interest. And this task can only be carried out by the “invisible hand” of the market, when it is left alone to operate spontaneously.