What are Rating Agencies?

Mary McMahon
Mary McMahon

Rating agencies are organizations which establish credit ratings for issuers of securities such as bonds. These agencies play a powerful and important role in the financial landscape, as credit ratings can make or break a company. They regularly publish ratings updates for the benefit of the general public as well as investors, governments, and financial firms. While these agencies are tremendously powerful, they have also been criticized, especially in the 2008-2009 financial crisis, in which questionable credit ratings were blamed for fueling financial problems in some regions.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

Some examples of rating agencies include Standard and Poors, Moodys, Fitch Ratings, and Rating and Investment Information, Incorporated. These agencies generally issue credit ratings for issuers of securities or types of securities in a particular area, as Moodys does in the United States, and sometimes several rating agencies rate securities issuers in the same country. The ratings are arrived at by looking at company performance, the performance of securities issued by the company, and issues such as economic trends.

Ratings may be broken up in a number of ways, with many rating agencies using letter grades. The ratings allow people to distinguish between investment-grade securities, securities which may be marginal in nature, and securities which are “junk,” unsuitable for investment. Rating agencies may rate financial companies, individual companies which issue securities like stocks and bonds, and governments, which commonly use bonds and other debt obligations as a fund raising tool.

One of the biggest problems which has plagued rating agencies is that ratings can lag behind real time information. A company may continue to receive a AAA rating, for example, long after it becomes evident that the company is experiencing problems. Rating agencies have also been criticized for close relationships with company heads, and an inability to rate complex financial instruments properly. When a huge group of mortgages are pooled together, for example, the pool may be given a higher rating than it deserves because it is difficult for the rating agency to arrive at a rating.

Another issue with rating agencies is that a rating downgrade can precipitate financial problems. If a rating agency downgrades a state government, for example, due to issues with financial performance, that government will find it more difficult to obtain capital. As a result, the downgrade can put the government in an even more awkward position which will make it difficult to recover. While one could argue that ratings are a valuable service which allow for wise investment, the effects of downgrades by rating agencies can be very significant.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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