The Dual Role of Rating Agencies

Pfäffikon SZ, Switzerland – The original idea of a rating agency is a noble one. When investors are in need of a value assessment they can consult an independent rating agency. With a range of somewhat simple fonts the valuation of financial products, businesses or bonds is continuously marked. AAA is the most well known. Standard & Poor’s is the oldest rating agency in the world. In 1860 Henry Poor started mapping out the history of financing of – among other ventures – the American railways, as a guide for investors.

The big three
In 1906 the Standard Statistics Bureau was founded, which was active mainly outside the railway industry. In 1940 both forces were combined and Standard & Poor’s became a reality. Moody’s was founded in 1909 by John Moody. Moody published analyses of the highly unpredictable railway industry, by applying valuations to stocks and bonds. John Fitch founded Fitch in 1913 which is a modest version of the two other agencies. To this day these three agencies reign over a gigantic array of valuations worldwide.

Controversial
Over the course of time the rating agency business model changed gradually making today’s revenue model controversial. Businesses, governments and financial institutions go shopping at the various agencies in order to achieve the highest possible rating, for which they readily pay. Conversely, if investors want more insight into the substantiation of a given rating, they too must pay. The benefits, then, for the rating agencies are twofold. The rating agencies are more than content with this dual role. Moreover, one must consider that the big three cover over 95 percent of the market, which is reminiscent of a monopoly.

In the run-up to the 2008 crisis various agencies gave out their highest valuations (AAA) which less than a year later turned out to be worthless. Many investors and governments follow the ratings blindly, which resulted in a painful lesson in 2008. The Dutch state, with ING in its wake, is all too familiar with this phenomenon.

Rabo abuses rating
The sales trick of the greasy salesman, who oafishly wave about their AAA ratings, became slightly overused in those days. But banks also used their high ratings in a boastful manner. The best example of this behavior in the Netherlands is the Rabobank. The Rabobank was a shrewd player of the game. By boasting with its AAA status in the run-up to the crisis the bank tried to rake in a lot of savings. This was also very necessary because the Rabobank had – long in advance – spotted trouble ahead. I wish to remind the reader that the Rabobank attracted expensive money to strengthen its core capital. One doesn’t do that if all is well. It is a typical example of abusing the AAA status in the run-up to tougher times. The Rabobank, in the mean time, has lost its AAA status.

Power
The three agencies wield great power due to their high concentration as many institutional investors work with the valuations of these agencies. For this reason it isn’t that strange that Europe in particular would like to start working with its own agencies. But that’s easier said than done. The reality of the matter is that the big three still dominate the industry and there is no sign of competition in sight. The lesson here is that investors can no longer blindly follow the valuations of a rating agency. Oddly enough, an investment in a rating agency could be the perfect investment, how controversial the revenue model may be.

It remains for me to wish you a good weekend.


Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the above shares and has no intention of doing so in the next 72 hours.