Ratings agencies should have concern for companies they rate.

• Author: Manso, Gustavo
• Position: FROM WHERE IS IT

Credit rating agencies have faced a blaze of criticism in recent years about whether their rosy ratings helped create the global economic meltdown, by causing billions of dollars in losses to investors who counted on them to assess the risk of assets they were buying. But much of this criticism--which has led the U.S. Securities and Exchange Commission to propose tougher regulations for credit rating agencies--should be taken with reservation.

Because such ratings affect the credit quality of a company, rating agencies face the dual problem of setting a credit score that accurately reflects the credit quality of a borrower, while also taking into account the effect that score will have on the borrower's credit quality in the future.

The problem is that downgrades often become a self-fulfilling prophecy. When an agency cuts a company's credit rating, investor confidence in that company's ability to meet its debt obligations is undermined, and it becomes harder and more expensive for it to raise cash. In many cases the downgraded company defaults, which creates stress in the markets.

Rating agencies, therefore, must be careful to select a score that provides an accurate portrayal of the company's credit worthiness, but also takes into account the continued existence of the company.

These ratings--where the agencies have a small bias toward the ultimate survival of the companies they evaluate--allow the companies to borrow money at a lower interest rate and thus improve their chances of weathering financial shocks.

An alternative ratings environment--one in which agencies are not concerned with the survival of the firms they rate--involves tougher ratings, higher interest rates and consequently more distress. This is largely because this kind of environment incites a dangerous race to downgrade.

Rating agencies want to be seen as first-movers in cutting a credit score, lest they be accused of being behind or inaccurate. But the competition to be the "first-to-downgrade" only heightens the frequency of defaults, and the more bankruptcies, the greater strain on the financial system.

The other troubling element of such rating environments is the use of stress tests. Stress tests are an evaluation method that entails a rating agency assessing credit-worthiness by posing different worst-case economic scenarios to determine the vulnerability of the company.

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In the stress tests, companies need to be able to survive situations...