Credit ratings are far from perfect
Rating agencies were one of the contributing factors during the Global Financial Crisis of 2008. There are two problems with the way the industry works which caused this.
Firstly, SPVs (special purpose vehicles) containing lots of different investments can be given a single credit rating by these agencies. This is highly subjective and can result in an SPV containing junk bonds being AAA-rated if it also contains AAA-rated bonds.
Secondly, the companies that create and sell SPVs pay the agencies to rate them. This creates competition and the agency most likely to give an SPV the highest rating is likely to be hired.
The result was a bubble in SPVs that should have been rated as junk but were instead rated AAA. Investors were happy to pour billions of dollars into products backed by low-quality, subprime mortgages because they were AAA-rated. When these mortgages began to default, the entire industry collapsed, along with several large institutions.
The moral of the story is that investors should always do their homework and never rely entirely on the opinion of someone else. It is, however, worth knowing how a downgrade to junk status can affect investments, companies, and economies.
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