But what if you could pay money to the companies that assess your credit score in order to have them make it more favorable? This seems like a preposterous concept, one that surely would never be legal and sounds too good to be true; and you would be right. This kind of heinous practice is of course reserved for the paragons of virtue that constitute this nation’s banking system.
For those who feel the dramatis personae of the 2008 financial crisis got off too lightly, it will come as a relief to hear that the U.S. Justice Department has announced plans to sue Standard and Poor’s, one of three credit ratings agencies implicated in the ordeal. The government has already taken a heavy hand with a number of the banks and insurance agencies involved, but the latest move addresses another critical dimension of the crisis.
The financial collapse was instigated largely by the addiction to selling sub-prime mortgages to people who couldn’t afford them, then passing these loans on to unsuspecting investors around the world. When people in their masses would eventually be forced to default on these unrealistic loans, trillions of dollars in investments would be lost and the entire global economy would come to its knees.
While it may seem puzzling that people would make such risky decisions, it should be stated that both homebuyers and investors were duped: the former by being offered complicated loans they did not understand by bankers and mortgage brokers they trusted, and the latter by being assured of the security of such investments. This is where the credit ratings agencies enter the fray.
In years past, ratings agencies would primarily serve investors, rating a particular investment in exchange for a fee. This is much like paying someone to inspect a house, seeking a professional opinion on the quality and stability of the building. However, in the 1970s, ratings agencies began instead to serve securities issuers, providing them with rating reports to present to investors. This would be the same as a home-seller paying the inspector to tell buyers that the house is in excellent condition, when in fact, it has major problems that go unseen.
Standard and Poor’s is one of three major credit ratings agencies implicated in the financial crisis; the other two being Fitch and Moody’s. In the years leading up to the crisis, the issuers of securities (complex packages consisting of large numbers of loans, also known as Collateralized Debt Obligations) sought out these agencies to give them favorable ratings. The higher the rating, the more attractive the securities would be to potential investors. As paid contractors, the agencies had an obvious incentive to overstate the viability of those securities.
Worse still, the three agencies were operating in competition with one another. Therefore, in order to gain more business the agencies would naturally seek to provide the best rating to issuers. If Standard and Poor’s could out-rate its two competitors, for example, it would guarantee the businesses of that debt issuer.
While it seems to defy all logic, this practice was allowed to continue in the years leading up to the housing crisis, and ultimately played an integral role in the economic collapse. Ratings agencies chose profits over ethical practices, a theme all-too-familiar amid the crisis.
Having taken legal action against others involved, it now appears to be the turn of the ratings agencies to face the music. Standard and Poor’s may be the target today, but Fitch and Moody’s will surely be anticipating similar action in the future. All three have seen tumbling share prices this week, with McGraw Hill (S&P’s parent company) seeing its largest drop since the 1987 stock market crash.
The move by the government is part of the broader measures contained within the 2010 Dodd-Frank Act, the result of a Senate inquiry into the $2.1 trillion losses by banks during the crisis. The act also seeks to increase monitoring of ratings agency practices.
Meanwhile, many question whether such entities should even exist or whether an alternative tool is necessary to placate increasingly cautious and sceptical investors, seeking to learn from their naiveté over the last decade.