The recent failures of credit rating agencies are now well known. They too often gave high ratings to bonds that subsequently defaulted. Their investment grade ratings of many subprime mortgage-backed securities were a primary cause of the current financial crisis.
Such failures 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 our financial system. Notwithstanding Warren Buffett's qualified defence of the industry this week.
What is causing this problem and how do we solve it? To understand these questions, we must consider how credit rating agencies produce and sell their ratings. 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. Regrettably, they have been too common.