Rating agencies are organizations that become most recognizable during the most challenging times for countries and their companies. Their names are well-known: Fitch Ratings, Standard & Poor’s, Moody’s. Especially now, in an era of economic instability, when country ratings are frequently lowered or raised.
Although the names of rating agencies are familiar, not everyone understands what they do or where they came from. Many view their work negatively because a drop in credit rating is rarely seen as anything other than negative. Some believe that the activities of these agencies have long moved beyond being purely indicative and have taken on a political tone. Is this true? Let’s explore it with examples, starting with the most well-known rating agency Standard & Poor’s.
Standard & Poor’s: The Origins of a Rating Agency
The story began in the 1860s with a simple study conducted by Henry Varnum Poor. The idea was straightforward: the U.S. domestic market was rapidly developing, but European investors had no direct access to it, which caused some dissonance. To make it easier for investors to understand the situation of investing in American infrastructure, an indicative tool was needed to bring maximum clarity to the financial situation.
Seven years later, Henry Poor and his son founded the Poor’s Railway Manual Company, which later became Poor’s Publishing Company and focused on publishing financial information about American infrastructure (railroads and canals). Thirty-nine years later, the Standard Statistics Bureau was established under Luther Blake, which also provided financial information, but not to European investors, but to American companies. It was from the activities of Blake’s company that the assignment of credit ratings to corporate organizations and sovereign debt obligations began, although this happened 10–15 years after the company started operating.
Two important dates for the future rating agency were 1941 and 1966. In 1941, the merger of Poor’s Publishing Company and Standard Statistics created the company Standard & Poor’s. In 1966, the company was acquired by McGraw-Hill, Inc.
Investments or Incentives?
Initially, the activities of Standard & Poor’s were limited to providing up-to-date financial information, but over time, the organization underwent significant changes. Although the evaluations provided by the agency claim to be objective, due to a specific formation mechanism, it is difficult to avoid a certain degree of distrust in the activities of the agencies. The reason is as follows: it is known that until the early 1970s, all agencies rated bonds, receiving payment from investors or potential investors who wanted to get objective information about the solvency of security issuers.
However, after the 1970s, the ‘Big Three’ rating agencies, including Standard & Poor’s, began receiving payment not from investors, but from bond issuers. It is quite logical that this phenomenon has led to criticism and accusations that the agency cannot remain impartial under this scheme. In fact, many investors equated this model to bribery: the more the security issuer pays, the higher the rating they may receive.
The economic impact of this phenomenon, as well as the activities of the agency, can be very significant and has serious consequences. Even if we don’t consider the fact that a downgrade of a country’s sovereign rating by Standard & Poor’s, considered to be the leading agency among the ‘Big Three’, exerts significant pressure on the national currency of the country, various state companies may also suffer, since the rating of companies and corporations cannot exceed the sovereign rating of the country.
We can also observe other consequences. If we take into account the ‘buyability’ of credit ratings for attracting investors, then Standard & Poor’s can certainly be blamed for a certain degree of involvement in the U.S. mortgage crisis of 2007, when some mortgage-backed securities (MBS) and collateralized debt obligations (CDO) were rated very highly by the agency. The high rating attracted additional funds, with both private individuals and organizations and funds acting as investors, but a series of defaults significantly devalued their investments.
Regardless, one must take into account the opinion of Standard & Poor’s, a rating agency that has existed for such a long time, which, by the way, allowed traders to obtain the S&P 500 index. Its influence is enormous, and it is unlikely that the situation will change soon. However, it should not be forgotten that no evaluation, even one that strongly claims objectivity, can be completely so, which means that ratings should, in my opinion, be used as an indicative tool, which they originally were, rather than as a dry guide for action.
FAQ
What is a credit rating?
A credit rating is an evaluation of a borrower’s ability to repay debt, typically provided by rating agencies like Standard & Poor’s.
How does Standard & Poor’s affect the economy?
Standard & Poor’s influences the economy by affecting investor confidence, which can impact a country’s currency and business environment.
Why are credit ratings controversial?
Credit ratings are controversial because they are often funded by the entities they rate, raising concerns about bias and lack of objectivity.
