If you were deciding whether to loan someone money, it would be very useful to know the chances that the person would pay you back. (For example, the higher the chance they would default, the more you would charge them to borrow the money.) Rating agencies–two dominant agencies are Moody’s and Standard and Poor’s (or “S&P”)–are supposed to provide lenders with that information. The less the risk of default on a particular financial instrument, the higher the rating. The rating agencies predict (or model) the risk, and if the rating agencies don’t do a good job, financial instruments’ market prices don’t reflect their actual value.
As others have discussed in a much more nuanced fashion, rating agencies may be partly to blame for the recent financial crisis. The agencies appear to have been more concerned about keeping their clients (those who issued the financial instruments) happy than rating financial instruments accurately. The ratings were too high, prices were too high, lenders and other purchasers of financial instruments didn’t anticipate default…and (to oversimplify) there’s your financial crisis.
But there appears to have been another market failure associated with rating agencies–a totally unexploited chance for profit.