Time to Downgrade the Rating Agencies

Last Updated Aug 6, 2009 6:41 AM EDT

In today's financial markets, it is credit rating agencies that have the privilege of power without responsibility. Their assignment of letters, numbers and plus or minus signs can make or break a bond issue or raise a company's borrowing costs.

Such is the power the agencies command that two UK companies, Rexam and Reed Elsevier, have recently issued almost £1.2bn of new equity rather than face the prospect of a ratings downgrade.

Companies are used to having their accounts picked over by equity analysts whose 'buy' or 'sell' recommendations can cause shares to soar or plunge. But the credit-rating agencies differ in one key respect: they are not employed by banks or brokers on behalf of investors but act for the companies whose borrowings they assess.

Corporations whose debt is downgraded have to pay to be insulted and then pay again when the cost of the credit increases. And while bonds were occasionally issued without ratings before the credit crunch, an unrated issue is now unfeasible.

A dozen or more equity analysts may pronounce on a company's shares, but there are only three credit-rating agencies â€" two and a tiddler in reality â€"- to comment on debt (Standard & Poor's, Moody's and Fitch & Co). And as the unpaid agencies proffer no view, investors cannot see a range of credit ratings before deciding whether to buy or sell.

These are the people who failed to warn of Enron's collapse seven years ago and failed to see the coming credit crunch five years later. Now, to compensate for their optimism in the bull market, the agencies are slashing ratings for troubled or leveraged companies rather than get caught out again on the downturn.

If only because they have such a monopoly, credit-rating agencies are more powerful than any individual investor or investment bank, yet unlike others in the financial sector they remain unregulated.

Belatedly, administrations from the European Union to the United States are calling for rating agencies to be registered and to provide transparency on their methodology and track records. Making them responsible as well as powerful is a good start, but it would be better still if investors relied less on their trio of agencies.

In the new order being established after the credit crunch, we should treat their ratings with a pinch of salt rather than assume they are set in stone.

(Pic: 'Playingwithbrushes' cc2.0)