Conflict of Interest With Credit Rating Agencies

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Credit rating agencies rate the creditworthiness of businesses and other organizations that issue debt obligations, such as bonds. These credit reporting agencies play a critical role in the economy by indicating to investors the likelihood that a company will pay back money loaned to it. The rating that a company receives from an agency will often directly affect how much interest it pays on its bonds. However, agencies can face conflicts of interest.

Credit Rating

When a company issues bonds, it must first receive a rating from a respected credit rating agency. The agency will generally rate both the bond issuer and the issue of bonds itself, rating their respective creditworthiness with a letter grade -- the higher the grade, the more creditworthy the agency deems the entity. The agency will be paid for this service, and investors will use these grades to make decisions about whether to purchase the bonds and at what price.

Conflicts

Bond issuers are often allowed to pick which company they want to rate their bonds. When selecting from credit rating agencies, these issuers will have a natural inclination to choose the firm that is most likely to offer it a high rating. For this reason, rating agencies may have a conflict of interest in that they are both attempting to solicit the business of bond issuers while trying to make impartial assessments of their creditworthiness.

Effects

According to "The Washington Post," this conflict of interest may push credit rating agencies to offer ratings of creditworthiness that are too high so as to encourage more companies to take their business to them. This can lead investors to have more faith than is warranted in the creditworthiness of a particular issuer. If the issuer defaults, the investor may lose a significant amount of money.

Legislation

In order to encourage more competition in the credit rating industry, the Securities and Exchange Commission has begun to recognize more credit rating agencies as legally allowed to rate U.S. companies for regulatory purposes. In addition, according to "The New York Times," there have been calls by investors for more regulation of credit rating agencies. However, as of February 2011, no significant regulatory legislation has been passed.

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