Theories, Rating Failure and the Subprime Mortgage Crisis

Abstract

Investors, before making a decision on whether to invest in a debt security from a company (or foreign country), must determine whether the issuing entity will be able to meet its obligations. Credit rating agencies (CRAs) help in this process by providing an independent objective assessment of the creditworthiness of companies (and countries) and help investors decide on how risky it is to invest money in a security. CRAs “perform an important intermediary function in the global financial markets. They rate debt obligations based on the ability of issuers to make timely payments”. Borrowers, investors, pension funds, banks and governments from around the world use ratings in order to make informed investment and financing decisions. Money market funds are restricted to investing only in triple-A assets; pension funds and municipalities are restricted to investing in investment grade assets and base their investment decision on the rating attributed by the rating agencies. “Critics have argued that CRAs failed to perform their function as institutional ‘gatekeepers’ during the recent crisis by giving favourable ratings on the creditworthiness of historically unproven and structurally unstable financial instruments”.