Why there can be a conflict of interest for credit-rating agencies?

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Credit rating agencies are generally considered to have conflicts of interest because they are paid to rate securities by the firms who issue them. Poor ratings can drive away business and revenue for the agencies. Credit rating agencies especially exposed themselves to this criticism in the mid-2000s by assigning their top AAA ratings to collateralized debt obligations, which were mainly composed of risky mortgages. Mortgage issuers had been granting mortgages to borrowers without any significant requirements in the way of income or adequate credit ratings, namely because these mortgages could be easily sold to the firms who were packaging them in CDO's. The CDO's, in turn, were easily marketable because of the high credit ratings the three agencies assigned them.

Banks and other institutions participated in this immensely risky trade to the very end because all their competitors were involved; not engaging in that kind of trading would have made them much less profitable. Charles Prince, chairman and chief executive of Citigroup, one of the largest lenders in America, became infamous for his comment that "As long as the music is playing, you have to get up and dance." When mortgage holders began to default in large numbers in the late 2000s, markets crashed around the world and large financial institutions required massive bailouts from governments to avert a global depression. All this only happened because of the inflated ratings given to highly risky securities. William Harrington, a top executive at Moody's, admitted that management put pressure on analysts to inflate credit ratings at the agency.

Efforts at ending this conflict of interest after the crash did not work. The agencies were allowed to continue being paid for their ratings by the institutions who issue the securities they rate. One initiative, which came to nothing, was designed to encourage the credit rating agencies to rate securities and institutions for free. To date, the agencies have not produced any such ratings.

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