Discussion of results

It seems that one of the reasons for the reactive nature of ratings could be the through-the-cycle methodology that is used. This in and of itself is probably not negative. The section of the literature review which discussed the genesis and purpose of credit rating agencies shows that credit rating agencies were established to eliminate information asymmetry between bond issuer and bond purchaser.

Credit rating agencies were never meant to predict crises. Also credit rating agencies do not hide the fact that they use this method. According to Altman et al.

(2006:55) both Standard and Poor‟s and Moody‟s use the through-the-cycle-methodology. Both rating agencies say their clients prefer it because it provides for stability in ratings.

Some investors prefer stable ratings. Earlier in the literature review it was discussed how pension funds in certain jurisdictions are by law required to invest in securities with a certain rating. Long term investors like pension funds would likely prefer stable ratings instead of rapidly changing ones. So in that sense using the through-the-cycle-methodology is preferable. If an investor wants security information that incorporates current information at all times then the equity market is more suited to that.

It should be noted of course that this study covered Standard and Poor‟s securities that defaulted in the years 2004, 2005, 2007 and 2008, so the results are specific to this study. As mentioned earlier though, credit rating agencies do piggyback on each other, so the results could apply to the securities rated by other credit rating agencies. Caution though should be applied when doing so. This is especially true when the results obtained need to be used to discuss whether or not credit rating

64 agencies should be regulated. The next section will discuss whether the results in the sections above support more regulation for credit rating agencies.

4.5 Regulation of credit rating agencies

Credit rating agencies were never meant to predict crises, but rather to eliminate information asymmetry between bond issuer and bond purchaser, so to regulate credit rating agencies because they are unable to predict crises may be misguided.

Regulation would probably force agencies to make short-term predictions and they were never meant to do that. Of course this paper is very specific, so a blanket conclusion to the question of regulations would be incorrect. Though some agencies may have been guilty of some wrongdoing, but even if this were corrected, it would still not have improved their ability to predict – it would simply have influenced their actions in reducing information asymmetry.

Instead of regulating credit rating agencies to do something they were never meant to do, investors will be better served by looking at other sources for more timely indicators of distress affecting different securities. Credit rating agencies have been put in an unfair position by investors and regulatory bodies; Katz et al (2009:3) mention that many regulatory bodies “outsourced” their regulatory functions to credit rating agencies by requiring certain firms to only invest in securities with certain ratings. This outsourcing of responsibility is probably not fair to credit rating agencies. Earlier on in the paper Whalen (2008:55) put the blame for the sub-prime crisis on former United States Federal Reserve Bank Governor Alan Greenspan and former United States treasury secretaries Larry Summers and Robert Rubin for failing to insist on stricter regulations for financial institutions. Credit rating agencies should not be the only regulatory body responsible for shouldering the duty of insisting on stricter regulation, other regulatory bodies should also contribute to ensuring that stricter regulation is enforced. A solution could be that various regulatory bodies should come together with credit rating agencies to determine different methods of foreseeing crisis - it is not only the responsibility of credit rating agencies.

65 It should also be said that unwarranted regulation could lead to undesirable unintended consequences. A consequence could be that credit rating agencies could choose to rate fewer securities because rating more would just not be worth the trouble. With less rated securities there would once more be that gap between issuer and investor that Henry Valum Poor wanted to bridge when he created his manual on the creditworthiness of major US railway companies in 1849.

4.6 Conclusion

The calculations done in this chapter showed that credit rating agencies are unable to warn investors of imminent crisis because they are reactive and not proactive when it comes to signalling rating changes when crises occur. This is a result of the cycle methodology that credit rating agencies use. The through-the-cycle methodology in and of itself is not an incorrect method as credit rating agencies were not meant to predict crises in the first place, but rather to eliminate information asymmetry between bond issuer and bond purchaser. Investors looking to get more immediate information about the quality of a security will be better off looking at other sources such as stock prices. That said, the results though are for a very specific group of securities, those are Standard and Poor‟s securities that defaulted in 2004, 2005, 2007 and 2008.

66 Chapter 5