Credit rating agencies are always a popular topic when things are blowing up. Why didn’t they foresee this!? What are they good for?! Back in MY DAY, ‘AAA’ meant something!
In my mind, CRAs are little more than public declarations of opinion on assets. In that sense, they have a shared ancestry with sell-side analysts, more formal circulars like the Gartman letter and, yes, even run of the mill journalists.
But apes, chimps and folks like you and me all diverged and so did rating agencies. The interesting question is why and how, right?
I’ve found one good report and one bad report on their history. The key moment when the rating agencies came to be in the sense that Warren Buffett knows them (with an impenetrable competitive advantage) came in the 70s with the advent of the NRSRO.
But the real turning point came in the 30s. You see, in the 30s there was this Great Depression. And everyone figured that this should be the last such instance of massive bank failure, so the government did a whole bunch of stuff, even stuff FDR thought was stupid like, wait for it… deposit insurance:
It would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee. For a number of reasons of sound government finance, such plan would be quite dangerous.
Anyway, I say that for fun, but the backlash was coming.
The banks didn’t like the new capital rules and they eventually managed to wiggle themselves a bit of room. This came in the form of capital rules that looked more favorably on ‘safe’ assets (sound familiar?).
But who, pray tell, would deem the assets safe? Well, how about these folks that publish the public circulars rating bonds?
Bang.
Everyone liked the idea. Everyone, that is, except the (if I may take some political liberties) power-mad and incompetent SEC.
(from the Mercatus report above- that’s a right-wing organization by the way)
However, the SEC worried that references to “recognized rating manuals” were too vague and that a “bogus” rating firm might arise that would promise “AAA” ratings to those companies that would suitably reward it and “DDD” ratings to those that would not. If a broker-dealer claimed that those ratings were “recognized,” the SEC might have difficulties challenging this assertion.
To solve this problem, the SEC designated Moody’s, S&P, and Fitch as “Nationally Recognized Statistical Rating Organizations” (NRSROs). In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers’ capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.
So rating agencies are the creation of regulators and a result of the technocratic inclination to ever-finer engineering of rules and procedures and control. They are collections of 3rd quartile talent (guess who’s in the bottom quartile?) in an industry protected by the government.
Actually, most people that are in the bond business are protected by the government. Hell, anyone who depends on a massive slug of short-term financing to make money gets a free ride these days.
Rating agencies just don’t make as much hay.
Not Unreasonable 
Thank You. AB