Warren Buffett on the Financial & Housing Crisis and Credit Rating Agencies (2010)

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A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. The value of such security ratings has been widely questioned after the 2007--09 financial crisis. In 2003, the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest. More recently, ratings downgrades during the European sovereign debt crisis of 2010--11 have drawn criticism from the EU and individual countries. A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK). Credit rating agencies have been subject to the following criticisms: Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months. Or, for example, Moody's gave Freddie Mac's preferred stock the top rating until Warren Buffett talked about Freddie on CNBC and on the next day Moody's downgraded Freddie to one tick above junk bonds. Some empirical studies have documented that yield spreads of corporate bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings. This has led to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads when calculating the risk in their portfolio. Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. These agencies meet frequently in person with the management of many companies, and advise on actions the company should take to maintain a certain rating. Furthermore, because information about ratings changes from the larger CRAs can spread so quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers, rather than investors, for their ratings. This has led to accusations that these CRAs are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings. At the same time, more generally, the largest agencies (Moody's and Standard & Poor's) are often seen as promoting a narrow-minded focus on credit ratings, possibly at the expense of employees, the environment, or long-term research and development. These accusations are not entirely consistent: on one hand, the larger CRAs are accused of being too cozy with the companies they rate, and on the other hand they are accused of being too focused on a company's "bottom line" and unwilling to listen to a company's explanations for its actions. While often accused of being too close to company management of their existing clients, CRAs have also been accused of engaging in heavy-handed "blackmail" tactics in order to solicit business from new clients, and lowering ratings for those firms . For instance, Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the insurance firm indicating that "it looked forward to the day Hannover would be willing to pay". When Hannover management refused, Moody's continued to give Hannover Re ratings, which were downgraded over successive years, all while making payment requests that the insurer rebuffed. In 2004, Moody's cut Hannover's debt to junk status, and even though the insurer's other rating agencies gave it strong marks, shareholders were shocked by the downgrade and Hannover lost $175 million USD in market capitalization. http://en.wikipedia.org/wiki/Credit_rating_agency