Who Would Lend Money To Me?
See how a doctor uses his stethoscope. Just as it is the first, perhaps, the quickest way of broadly ascertaining a person’s state of health, the credit rating grade is the capitalist world’s most widely used tool to assess a company or a country’s state of financial health.
In the vast world of lending and investment, only a handful of agencies like Fitch, Standard and Poor, and the Moody’s do this job. In just a few letters like AA, BB, BB- etc. they state whether a business house, a behemoth of the industrial world, a small country or even the richest country on earth – the United States – is good enough to lend money or to do business with. For countries like India, having not so strong economies, the rating given by these agencies matters a lot.
A weak rating given by these rating agencies robs a country of its capacity to borrow internationally. Foreign investors shy away from such countries. So, governments try to get good scorecard by keeping their economies in good shape. For a vulnerable country like India, a downgrade by the rating agencies brings huge embarrassment at home and abroad.
Towards the end of the nineteenth century and in the early years of the twentieth century, America’s rail networks were being laid at breakneck speed. Many rich individuals and companies were in the fray. The lure of high possible profits in later years had brought these investors to the field. Together with their own capital, they need the humungous amount of money to execute the large railroad laying contracts. They all needed to borrow.
But, who would lend money to an unknown borrower? There were investors aplenty, but they could not decide which enterprise to lend their money to. They need to check on the likely borrower’s past working, its capital base, orders in hand, profitability and above all, the credibility of the individuals who had promoted the companies. It was the job of a financial sleuth and an astute analyst. The owners of capital had little expertise in the area. Clearly, there was a gap in the borrower-lender link. It was that of a third agency which could give a clean, unbiased and well-researched certificate of the credibility of the borrower. The certificate was not to be in the form of voluminous reports and data, but in quickly interpretable format. Like this, the AA, BB rating system came into existence.
John Moody was the pioneer in this field. In 1909, he became the first financial analyst to assign letter grades to railroad bonds, giving investors an easier way to evaluate the rail companies’ debt. He, thus, started a trend that remains the most-used yardstick used today in the capitalist world.
Today a tiny club of bond-rating agencies do this job for the whole world. They are led by Moody’s, Standard & Poor’s and Fitch. They wield enormous influence. A small downgrade in the credit rating sends investors scrambling to withdraw their capital from the company or the country in distress. Such flight of capital further aggravates the plight of the borrower. So, the companies and countries are so sensitive to their rating. No one likes to be downgraded.
These credit rating companies have an army of data collectors and data processors. They collect voluminous statistics about the target enterprises history, working, future projections, profitability and capital base. The experts process the voluminous data using many different types of tools and try to arrive at a decision about the economic health of the target enterprise. Then, they allot a grade through a few letters to express their view.
Can they go wrong ? Yes. They have gone wrong so many times in the past. The global economic crisis of 2007 - 2008 that decimated countless banks and devastated many rich countries was not predicted by any of the globe-scanning financial companies.
In the past, the Justice Department of the American government filed a joint federal and state lawsuit against the ratings agency Standard & Poor’s for defrauding investors in the run up to the financial crisis with its overly optimistic ratings of mortgage-related investments.
In August 2011, Standard and Poor’s (S&P) had downgraded America’s sovereign debt outlook by stripping it of the AAA ‘gold-plated’ rating. This happened in the aftermath of the highly visible Congressional wrangling between the Republicans and the Democrats over raising the national borrowing limit. After the Congress averted a disaster at the last moment, S&P’s analysts concluded that Washington’s political climate was too factious to adequately address the country’s fiscal needs. They decided to downgrade America – the richest nation on earth. Such an audacious action infuriated the U.S. government. Some in the treasury department questioned the competence of the rating agency.
Like this, the history of the rating agencies has been riddled with controversies, poor judgments etc. One can also see that the rating given by the different agencies at any given time varies, some being more positive than the others.
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