A Ratings Agency Can Also Be Downgraded

Will the new financial regulation reform bill point to leaner times for the rating agencies? The soon-to-be-adopted bill allows investors to bring these ratings agencies to court for misguided advice, whether the bad advice was deliberate or due to negligence.

Is this a warning shot for the institutions that have been in the spotlight since the financial crisis? Of course. This bill and its implications have not passed unnoticed. According to Standard & Poor’s (S&P), the new legislation could impact the credit ratings of its rival and colleague, Moody’s. As of June 29, Moody’s short-term credit rating of A-1, which is the second-highest rating for S&P, was placed on CreditWatch with negative implications. In other words, Moody’s rating has a more than 50 percent chance of being downgraded in the coming weeks.

According to S&P, this new law will allow ratings agencies to be prosecuted and possibly fined for fraudulent ratings and thus be at risk for increased liability and a possible decrease in profits. Furthermore, because the reform requires regulators to eliminate certain unnecessary references to ratings in regulations, investors may begin to less frequently rely upon and employ these rating agencies. This is further bad news for Moody’s and S&P, as well as for Fitch, which holds 90 percent of the market share for rating agencies.

Nicolas Véron of Bruegel, a European economic think tank, commented, “This is all very amusing because S&P is faced with almost all of the risk factors that it mentions as reasons for [Moody’s] possible downgrade. In a sense, for that matter, one can note that S&P did not evade its responsibility as a ratings agency, even on this delicate ground.”

So does S&P hold the recipe for its own downfall? Yes and no. The American agency, which is in fact held by McGraw-Hill, can claim that it is a diversified company. In addition to its ratings work, S&P is also known for its stock research. In contrast, ratings represent 90 percent of Moody’s business.

Moody’s has found itself with its feet held to the fire these past few weeks. This has occurred even more so since the beginning of June, when former employees were interviewed by a congressional oversight committee for the financial crisis. Employees described how they worked in an atmosphere in which they were pressured to favorably rate risky financial products in order to guarantee business. This has further highlighted the conflict of interest presently found in rating agencies that are paid by the very institutions they review.

These rating agencies have faced the wrath of companies and countries who have criticized them for their role in the subprime crisis. They were incapable of forestalling the risk from these explosive mortgage-backed securities, and they accelerated the financial tornado by brutally downgrading banks. These agencies have also faced criticism for their role in the eurozone crisis. They created chaos when they downgraded Spanish, Greek and Portuguese debt.

The United States’ financial regulation reform brings the rating agencies’ golden age to an end. In order to restore their sheen, they will have to defend their most precious asset: their credibility. And what is more convincing than a ratings agency that applies the same “punishments” which it inflicts on others onto itself?