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Rating the Trust

November 13, 2010

Just how trustworthy are ratings agencies? I was pondering this question after reading this blog entry here. It appears that the Better Business Bureau (BBB) provided an A- rating to a group that named its company after the Middle Eastern group Hamas.

“According to an ABC News investigation, ‘a group of Los Angeles business owners paid $425 to the Better Business Bureau and were able to obtain an A minus grade for a non-existent company called Hamas, named after the Middle Eastern terror group.'”

My issue isn’t that the group called itself Hamas, but that the group was able to secure a high rating after paying the BBB money for it. It leads to a Gresham’s where companies that have low ratings due to poor service, numerous complaints, etc. can deceive consumers into believing they are free from these faults. What may happen next is consumers will do business with these companies, find out that they are far from perfect and no longer trust the ratings with the BBB. This will also affect legitimate companies that have earned their high ratings as consumers begin to distrust all the ratings with the BBB.

The issue of ratings agencies and their trusthworthiness has been covered by William K. Black here regarding mortgage lenders and the companies that rate mortgage loan files.

“The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The ‘AAA’ rating is supposed to indicate that there is virtually no credit risk — the risk is equivalent to U.S. government bonds, which finance refers to as ‘risk-free.’ We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.”

As we can see, ratings agencies have a lot to gain by providing a good rating to something that is really “toxic” or doesn’t dserve that great rating. They definitely take advtange of the information asymmetry to profit at the consumer’s expense.

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