In February 2013, the United States Justice Department filed a law suit against the credit rating agency Standard & Poor’s. The Justice Department alleges that S&P contributed to the financial crisis of 2008 by knowingly and deliberately inflating the ratings of mortgage investments in order to make them appear safer than they really were.
The Critical Assessment of Research (pp. 24-28) discusses the role of Arthur Andersen, the highly-regarded accounting firm, in the fall of Enron in late 2001. Enron had employed Andersen as its auditor, but the company overlooked—and deliberately spun—Enron’s forged documents and illegal financial transactions. The book noted the inherent conflict of interest between Andersen’s responsibility to oversee the financial integrity of Enron and its other clients and its business interests: Enron was Andersen’s client. An accurate reporting of Enron’s financial transactions would have created a conflict with Andersen’s financial self-interest.
This conflict of interest is at the heart of the law suit against S&P. Just as publicly traded companies are permitted to hire and fire their own auditors (The Critical Assessment of Research, p. 25), the agencies that rate the products issued by financial institutions are paid by the issuing institution. As noted in a February 7, 2013 editorial in USA Today, the “issuer pays” business model means that the “rating agencies get paid directly by the institutions selling the securities being rated, which puts pressure on the agencies to give high ratings or risk losing business to competitors” (http://www.usatoday.com/story/opinion/2013/02/06/credit-rating-agencies-sp/1897449/).
What is the significance of the conflict of interest whereby rating agencies are paid by the very companies whose products they rate? Investors large and small depend on the rating agencies to provide accurate information about the financial products sold by financial institutions. Indeed, as we saw in the 2008 financial crisis, the health of our financial system depends on investors’ being able to rely on accurate information about these products. The inherent conflict of interest between the responsibility of the ratings agencies to the public and the financial self-interest of the agencies means that “if someone wants a complex issue researched, he or she has to pay for the research to get it done, or risks getting a biased product.” But how many everyday investors can afford to do that?
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