Summary: Stock rating agencies are amongst the most powerful of all firms operating in the market. They do not actually buy and sell assets themselves, instead, they offer independent opinions as to the value of an asset. For assets such as bonds, they provide a 'credit rating'. What all this means is explained below.
The world of Wall Street has essentially three all powerful companies which provide credit ratings. These credit ratings are used by investment banks, hedge funds, brokerages and so on to decide whether an investment should be bought or sold. Clearly, this is the simplified version, but that is the general principle.
It would be fair to say that S&P offer what is considered to be the 'gold standard'. However, it would also be fair to comment that all three companies tend to offer very similar ratings. This makes some sense since they are assessing the same thing and almost certainly using methods and calculations that are virtually identical.
Needless to say, their opinions are reported quite widely within the financial world and therefore, their thoughts matter. Should a company be upgraded or downgraded in their opinion, the stock price will move very significantly to take this new information into account.
Thus, if a company is considered to be in improving financial health, more buyers (fund managers) will become interested and demand will rise for the stock. This will push the price higher, usually substantially higher, quickly.
In contrast, should an agency downgrade a company due to deteriorating financial health, there will be a rush of sellers, demand will plummet as will the market price of the stock.
If this makes you wonder just how powerful these firms are, you would be right to question this. Clearly, being in possession of such information before it is released to the market could be very profitable.
You may also have heard of stock analysts. Every investment bank and many fund managers have an army of staff that look over annual reports and the trading updates from companies (they typically focus on one sector) and then write reports on their expectations for the sector and it's constituents. As might be imagined, if a respected analyst makes a buy or sell recommendation for a sector or company it can have a profound impact on the near-term direction of the price.
The name's bond
In the bond market, the opinions of the agencies decides what assets are applicable for funds. There are essentially just two grades of bond - Investment grade (the best) and everything else. Everything else is often referred to in less straightforward ways. For example, they may be 'higher yield' because of the higher interest payments that they must make to attract capital. Others will simply call them 'Junk'.
The agencies also assess the credit risk in investing on government bonds. This means that they are really assessing the public finances of governments! Such power!
As their ratings alter for currencies and bonds (they must assess the currency a bond is denominated in to be able to assess the risk of the actual bond), they can potentially have an impact on the financial health of entire nations. If they downgrade a bond because of currency instability, for example, many large investment institutions will soon be selling their assets to protect capital. This can potentially result in currency devaluation which has a knock-on impact to imports and exports and the way that the country trades with the rest of the world. This can be real world impact on a massive scale.
So for all their power and influence, just how they are regulated and overseen is a tricky question. Their reason for existence is to ensure that bonds are valued fairly by an independent entity. This makes decisions for investment banks and fund managers easier to take and of course, outsources difficult work to companies that are very able to deal with it.
The future is not bright
However, the aftermath of the credit crisis which began in mid 2007 will almost certainly see stock rating agencies changed forever. Many investment and pension funds around the world have purchased mortgage products which were rated as being safe investments and have been proved were quite clearly not suitable. Whether this is deemed to be a fault of description, analysis or greed - only time will tell. But AAA rated does seem to be a stretch of the imagination!
The situation was clearly very complex and your author does not pretend to understand it all, but the general issue is whether a firm that is paid to independently rate a financial instrument is really independent. If these agencies had been giving out ratings of BBB instead of AAA would they have been asked to rate as many products? There is a clear potential for a conflict of interest on their part.
At the time of writing in early 2013 there have been moves to reign in the power of the credit rating agencies by governments. The EU, for example, has riled against these firms again and again, partly because of the power they wield with their opinions on eurozone sovereign debt.
This is understandable. Having been roundly criticised for their roles in the sub-prime mortgage crisis and having not been objective enough about the role of debts on a balance sheet, they are being as objective as they can about sovereign debts. This comes at a time when politicians would like a little lee-way on the health of their national balance sheets.
For now it seems as though the EU and other governments have not figured out what to do about the situation, but it is hard to imagine that anything but firm legislation awaits this sector.
To read more pages from this section of the site which look into the workings of a stock exchange, please also visit:
What Is A Stock Exchange And What Does It Do?
What Is An Efficient Capital Market?
What Role Do Stock Exchanges Play In National Economies?
Investment Institutions And The Stock Exchange
Executing A Trade At The Stock Exchange
Why Are There So Many Stock Exchange Scandals?
Stock Exchange Regulations - The Sarbanes Oxley Act
Stock Exchange Investment
How Big Should Stock Market Bonuses Be?