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Conclusions concerning the theory

The theory devises many ways to overcome these problems but these are specialist and beyond the scope of this book. Agency Theory has been developed from the Organisational Failure Framework of Williamson. It seems to offer some pointers as to how firms can be managed better but has problems as far as practical application is concerned. It is based upon one key assumption - that every party to a transaction acts in a rational manner in order to maximise his / her utility. This assumes of course that the evaluation of utility undertaken by every individual can be precisely calculated and thus that the same decision would always be made by the same individual in exactly the same set of circumstances. Nevertheless it helps us to understand corporate behaviour.

Rating Agencies

A rating agency is a company that devises credit rating - assessments of the risk involved - for various financial instruments and their issuers. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of such securities are companies, state and local governments, not-for-profit organisations and NGOs or national governments issuing debt-like securities (eg bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back the loan), and affects the rate of interest applied to the particular security being issued. In theory the role of the rating agency is to provide an impartial assessment - based upon their expertise and research - to potential lenders in order to compensate for the inevitable information asymmetry between borrower and lender.

The recent failures of such agencies has been well documented. Too often they gave high ratings to bonds that subsequently defaulted. Their investment grade ratings of many sub-prime mortgage-backed securities were a primary cause of the recent crisis. Such faulty assessments have allowed companies to raise capital that they later wasted while denying more deserving companies capital they could have used to create jobs. The losses borne by bond investors have been huge and the government has absorbed many of these losses to prevent the total collapse of the financial system. More recently they have been overcompensating for their rash assessments by downgrading - to an extreme extent - their assessed creditworthiness of governments and causing yet more financial chaos.

A credit rating is a statement about the future. An investment grade rating should indicate that a bond is unlikely to default. Since the future is unpredictable, some investment grade bonds will default. However, defaults should be uncommon. Rating agencies have been criticized for having too close a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled. Also information about ratings changes from the larger agencies spreads quickly so they charge debt issuers, rather than investors, for their ratings. This has led to accusations that these agencies are plagued by conflicts of interest that might inhibit them from providing accurate and honest ratings.

At the same time, the largest agencies (Moody's and Standard & Poor's) are often seen as agents of market forces, that drive companies to consider how a proposed activity might affect their credit rating, possibly at the expense of employees, the environment, or long-term research and development. The lowering of a credit score by an agency can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. This happens to countries also which is another cause of economic crisis, or prevention of economic recovery. Sadly these agencies have a track record of not just over rating securities and their lenders in the first instance but overcompensating in downgrading as a reaction. So their actual role in compensating for information asymmetry has been shown to be somewhat questionable.

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