
Dr. Justin Robinson, Head of Department & Lecturer in Management Studies,UWI,Cave Hill
On Friday August 5 2011, while most of Barbados was partying with Rihanna, there was a loud bang, and the financial world was shaken to the core with the news that major Credit Rating Agency, Standard & Poors (S&P) had downgraded the long term credit rating of the United States of America from AAA to AA+, and with a negative outlook. This momentous decision to downgrade the USA, justified or not, may well in my opinion, hasten a dramatic reduction in the role and influence of the CRAs in global financial markets, and the financial world will be much better for it.
CRAs are private profit oriented entities that issue an opinion on the likelihood a borrower will default on its debt. The opinion is issued in the form of a letter grade, with AAA being the highest rating. The industry is dominated by Moodys Investors Services and Standard & Poors, with Fitch running a distant third. Financial economists have long questioned the value added by the CRAs. To put it simply, many argue that in good times, rating agencies upgrade borrowers, and in bad times they downgrade them. Do you really need them to state the obvious? The CRAs were much maligned for assigning AAA ratings to now worthless subprime mortgage loans, and infamously rating Enron as “Investment Grade” in the same week the company filed for bankruptcy.
Much of the power of the CRAs seems to come from the fact that the credit opinions (ratings) they issue have been written into the law and contracts in many countries. For example, by law or contractual agreement many institutions are only allowed to invest in financial instruments carrying a certain credit rating by one of the major agencies. Also, in many instances, contracts require that financial instruments posted as collateral have a AAA rating. Financial Economists refer to this as the regulatory license granted to the CRAs. In essence to be a player in many financial markets you need the blessing of the CRAs. Due to this fact, attaining or losing a certain credit rating by one of the major agencies is a major issue for many investors and financial institutions. If these laws and contracts are enforced, then come Monday, a number of contracts would have been violated and investors may be forced to sell assets, find new collateral and so on. My guess is rather than face this massive inconvenience, or rather chaos, a number of clauses will either not be enforced or simply changed to allow institutions to continue to hold US government securities and use them as collateral for all kinds of financial contracts despite the downgrade. If this happens, the regulatory license, which has the source of the power of the CRAs would have been undermined and with it some of their influence.
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