In yesterday’s blog entry I began the process of investigating the credit ratings agencies (CRAs) in light of Standard and Poor’s alteration of its advice on US government debt from ‘positive’ to ‘negative’. I said that this would be the start of a series of entries on the CRAs. Today, here’s more on the sector, including Standard & Poor’s (S&P).

The big players in the CRA business are S&P, Moody’s Investor Service and Fitch Ratings. These are just three of the ten Nationally Recognised Statistical Ratings Organisations determined as officially fit for use by financial firms by the US Securities and Exchange Commission (SEC). This favouring of a handful of CRAs has come in for some criticism by those who feel this is against the normal rules of competition.

Big CRAs run on a business model where the ‘issuer pays’. This means that the organisation that is offering bonds for sale pays the CRA to provide an assessment of the organisation’s credit rating. This leads to inevitable criticism that it is in the issuer’s interests to seek a rating from the CRA most likely to give its approval. It is understandable that this model leads some observers to cry ‘foul’, as the system appears open to corruption. Some smaller CRAs use a ‘subscription-based’ model which makes them less reliant on the bond issuers they rate.

Since the onset of the financial crisis in 2007, the negative aura surrounding CRAs has grown stronger. The CRAs have become intimately linked to the subprime credit bubble. They made vast profits from rating so-called ‘structured financial products’ such as Collateralised Debt Obligations (CDOs) and Residential Mortgage Backed Securities (RMBSs). Since almost all (well, 93% is pretty close) of these AAA-rated subprime RMBSs are now ‘valued’ as junk, you can see why CRAs have left people feeling increasingly bitter about the sector.

But another area of great and growing controversy has emerged in recent years: the CRAs rating of sovereign debt. This is not the ‘commercial paper’ issued by private organisations such as companies, but the bonds, gilts and bills sold by governments across the world. Some observers have asked why CRAs are involved in this field. Their downgrades of Greek government debt attracted some intense reaction from that country. The EU has also noted the adverse effects of CRA involvement in rating Eurozone member states’ debts.

The response of the financial markets, analysts and economists to S&P’s US debt default warning, though, has been interesting. Are there really default threats in a country whose debt is denominated in its own currency? Growing numbers of commentators appear to doubt it.