The role of credit rating agencies in financial market The case of subprime crisis in the US

In the wake of the recent financial crisis, credit rating agencies (CAR) have been heavily criticized by investors, politicians, and the general public for not putting a red flag on the arising U.S. housing bubble and subsequently the subprime crisis. Yet, only limited research exists on the concrete performance of rating agencies throughout the financial crisis. In this context a rather prominent market segment is U.S. residential mortgagebacked securities (U.S. RMBS): banks mainly used securitization structures to sell off U.S. residential mortgages to worldwide investors and, as we know today, this fuelled the U.S. house price bubble. Because rating agencies acted as their agents and provided a credit rating for each of the issued RMBS, most of which were even rated by multiple agencies and still attested unabated credit quality in the beginning of 2008.

The role of credit rating agencies in financial market

The case of subprime crisis in the US

Diem Thi Thu Trang

Thesis submitted to the faculty of the University of Bordeaux

in partial fulfillment of the requirement for the degrees of

MASTER BFNI

Dr Raphael Chiappini

Hanoi, Jan 2017

Introduction 2

Section 1: Overview of financial markets and the role of credit rating agencies in reducing the information asymmetry 4

1.1 Financial market 4

1.1.1 An overview of financial markets and their functions 4

1.1.2 Financial instruments and two fundamental classes of financial instruments 6 1.1.3 The information asymmetry in the financial markets 8

1.2 Credit rating agencies 11

1.2.1 The formation of credit rating agencies and rating industry 11

1.2.2 The role of CRA in rating mortgage securities and their shortcomings 17

1.2.3 The credit rating market on the eve of the recent crises 22

1.2.4 Criticism of credit rating agencies 24

Section 2: The subprime mortgage crisis in the US 29

2.1 Overview of subprime mortgage crisis in the US 29

2.2 Analysing of the role of rating agencies in US subprime crisis 30

2.2.1 Rating the structured products and mortages 31

2.2.2 Errors of omission 31

2.2.3 Errors of commission 32

2.2.4 Impact of ratings on credit derivatives and credit default swaps 33

2.2.5 Downgrades by rating agencies 34

2.3 Lessons and experiences from The Failures of Credit Rating Agencies 34

2.3.1 Reasons for the mistakes of rating agencies during US subprime crisis 35

2.3.2 Solutions and recommendations 40

2.4 Conclusion 45

Introduction

In the wa.ke of the re.ce.nt fina.ncia.l cris.is., cre.dit ra.ting a.ge.ncie.s (CA.R) ha.ve be.e.n he.a.vilycriticize.d by inve.s.tors., politicia.ns., a.nd the ge.ne.ra.l public for not putting a re.d fla.g on the.a.ris.ing U.S hous.ing bubble a.nd s.ubs.e.que.ntly the s.ubprim.e cris.is Ye.t, only lim.ite.dre.s.e.a.rch e.xis.ts on the concre.te pe.rform.a.nce of ra.ting a.ge.ncie.s throughout the fina.ncia.lcris.is In this conte.xt a ra.the.r prom.ine.nt m.a.rke.t s.e.gm.e.nt is U.S re.s.ide.ntia.l m.ortga.ge.-ba.cke.d s.e.curitie.s (U.S RM.BS.): ba.nks m.a.inly us.e.d s.e.curitiza.tion s.tructure.s to s.e.ll offU.S re.s.ide.ntia.l m.ortga.ge.s to worldwide inve.s.tors a.nd, a.s we know toda.y, this fue.lle.d the.U.S hous.e price bubble Be.ca.us.e ra.ting a.ge.ncie.s a.cte.d a.s the.ir a.ge.nts a.nd provide.d a.cre.dit ra.ting for e.a.ch of the is.s.ue.d RM.BS., m.os.t of which we.re e.ve.n ra.te.d by m.ultiple.a.ge.ncie.s a.nd s.till a.tte.s.te.d una.ba.te.d cre.dit qua.lity in the be.ginning of 2008

Cre.dit ra.ting bus.ine.s.s firs.tly e.m.e.rge.d in the Unite.d S.ta.te.s (US.) in 1900s a.nd be.ca.m.e a.nim.porta.nt pa.rt of inte.rna.tiona.l fina.ncia.l m.a.rke.ts in pa.ra.lle.l with the globa.liza.tion offina.ncia.l m.a.rke.ts a.s of m.id-1970s Cre.dit ra.ting a.ge.ncie.s (CRA.) contribute to the.e.fficie.ntly functioning of fina.ncia.l m.a.rke.ts by re.ducing the inform.a.tion a.s.ym.m.e.trybe.twe.e.n borrowe.rs a.nd le.nde.rs (A.de.ls.on, 2012) But inve.s.tors., policy m.a.ke.rs a.ndgove.rnm.e.nts be.ga.n to inve.s.tiga.te the re.lia.bility of cre.dit ra.tings e.s.pe.cia.lly a.fte.r the.re.ce.nt cris.e.s a.nd the CRA.s a.ls.o we.re s.e.e.n a.s a pa.rt of the.s.e cris.e.s S.o the US., E.U(E.urope.a.n Union) a.nd the inte.rna.tiona.l orga.niza.tions que.s.tione.d the functioning of the.cre.dit ra.ting m.a.rke.t a.nd m.a.de s.om.e re.gula.tions on the CRA.s to e.lim.ina.te the.im.pe.rfe.ctions in the m.a.rke.t

The obje.ctive of this s.tudy is to s.tudy the role of CRA in fina.ncia.l m.a.rke.t a.nd its.contribution to fina.ncia.l cris.is with the ca.s.e of s.ubprim.e cris.is in the US by cla.rifyingtwo m.a.in re.s.e.a.rch que.s.tions a.s follows.:

1 Wha.t is the curre.nt role., le.ga.l s.ta.tus a.nd functions of Cre.ditRa.ting A.ge.ncie.s in the fina.ncia.l m.a.rke.t?

2 How doe.s Cre.dit Ra.ting A.ge.ncie.s (CRA.) im.pa.ct to the s.ubprim.e.cris.is in the US.?

This the.s.is cons.is.ts of two pa.rts a.nd is orga.nize.d a.s follows Lite.ra.ture.Re.vie.w S.e.ction pre.s.e.nts a.n ove.rvie.w on the fina.ncia.l m.a.rke.t a.nd the.proble.m of inform.a.tion a.s.ym.m.e.try be.twe.e.n borrowe.rs a.nd le.nde.rs This s.e.ction a.ls.opre.s.e.nts the his.tory of CA.R a.s we.ll a.s the.ir role in s.olving inform.a.tion a.s.ym.m.e.tryproble.m.s Ca.s.e S.tudy S.e.ction pre.s.e.nts a.nd a.na.lys.is role a.nd function of CA.R ins.ubprim.e m.ortga.ge cris.is in the US a.ris.ing from burs.ting of s.pe.cula.tive.bubble which gre.w up in the US hous.ing m.a.rke.t le.d to the globa.lfina.ncia.l cris.is in 2008

Section 1: Overview of financial markets and the role

of credit rating agencies in reducing the information

asymmetry1.1 Financial market

1.1.1 An overview of financial markets and their functions

Fina.ncia.l m.a.rke.ts pe.rform the e.s.s.e.ntia.l e.conom.ic function of cha.nne.ling funds from.hous.e.holds., firm.s., a.nd gove.rnm.e.nts tha.t ha.ve s.a.ve.d s.urplus funds by s.pe.nding le.s.s tha.nthe.ir incom.e to thos.e tha.t ha.ve a s.horta.ge of funds be.ca.us.e the.y wis.h to s.pe.nd m.ore tha.nthe.ir incom.e (M.is.hkin, 2007) This function is s.hown s.che.m.a.tica.lly in Figure 1 Thos.e.who ha.ve s.a.ve.d a.nd a.re le.nding funds., the le.nde.r-s.a.ve.rs., a.re a.t the le.ft, a.nd thos.e whom.us.t borrow funds to fina.nce the.ir s.pe.nding, the borrowe.r-s.pe.nde.rs., a.re a.t the right The.principa.l le.nde.r-s.a.ve.rs a.re hous.e.holds., but bus.ine.s.s e.nte.rpris.e.s a.nd the gove.rnm.e.nt(pa.rticula.rly s.ta.te a.nd loca.l gove.rnm.e.nt), a.s we.ll a.s fore.igne.rs a.nd the.ir gove.rnm.e.nts.,s.om.e.tim.e.s a.ls.o find the.m.s.e.lve.s with e.xce.s.s funds a.nd s.o le.nd the.m out The m.os.tim.porta.nt borrowe.r-s.pe.nde.rs a.re bus.ine.s.s.e.s a.nd the gove.rnm.e.nt (pa.rticula.rly the fe.de.ra.lgove.rnm.e.nt), but hous.e.holds a.nd fore.igne.rs a.ls.o borrow to fina.nce the.ir purcha.s.e.s ofca.rs., furniture., a.nd hous.e.s The a.rrows s.how tha.t funds flow from le.nde.r-s.a.ve.rs toborrowe.r-s.pe.nde.rs via two route.s

Figure 1: Flows of Funds Through the Fina.ncia.l S.ys.te.m.

In dire.ct fina.nce (the route a.t the bottom of Figure 1), borrowe.rs borrow funds dire.ctlyfrom le.nde.rs in fina.ncia.l m.a.rke.ts by s.e.lling the.m s.e.curitie.s (a.ls.o ca.lle.d fina.ncia.lins.trum.e.nts.), which a.re cla.im.s on the borrowe.r’s future incom.e or a.s.s.e.ts (Ba.ll, 2007) S.e.curitie.s a.re a.s.s.e.ts for the pe.rs.on who buys the.m., but the.y a.re lia.bilitie.s (IOUs or de.bts.)for the individua.l or firm tha.t s.e.lls (is.s.ue.s.) the.m For e.xa.m.ple., if Boe.ing ne.e.ds to borrowfunds to pa.y for a ne.w fa.ctory to m.a.nufa.cture pla.ne., it m.ight borrow the funds from.s.a.ve.rs by s.e.lling the.m a bond, a de.bt s.e.curity tha.t prom.is.e.s to m.a.ke pa.ym.e.nts

pe.riodica.lly for a s.pe.cifie.d pe.riod of tim.e., or a s.tock, a s.e.curity tha.t e.ntitle.s the owne.r to

a s.ha.re of the com.pa.ny’s profits a.nd a.s.s.e.ts

The e.xis.te.nce of fina.ncia.l m.a.rke.ts is be.ne.ficia.l e.ve.n if s.om.e.one borrows for a purpos.e.othe.r tha.n incre.a.s.ing production in a bus.ine.s.s (Howe.lls & Ba.in, 2008) S.a.y tha.t you a.re.re.ce.ntly m.a.rrie.d, ha.ve a good job, a.nd wa.nt to buy a hous.e You e.a.rn a good s.a.la.ry, butbe.ca.us.e you ha.ve jus.t s.ta.rte.d to work, you ha.ve not s.a.ve.d m.uch Ove.r tim.e., you wouldha.ve no proble.m s.a.ving e.nough to buy the hous.e of your dre.a.m.s., but by the.n you would

be too old to ge.t full e.njoym.e.nt from it Without fina.ncia.l m.a.rke.ts., you a.re s.tuck; youca.nnot buy the hous.e a.nd m.us.t continue to live in your tiny a.pa.rtm.e.nt

If a fina.ncia.l m.a.rke.t we.re s.e.t up s.o tha.t pe.ople who ha.d built up s.a.vings could le.nd youthe funds to buy the hous.e., you would be m.ore tha.n ha.ppy to pa.y the.m s.om.e inte.re.s.t s.otha.t you could own a hom.e while you a.re s.till young e.nough to e.njoy it The.n, ove.r tim.e.,you would pa.y ba.ck your loa.n If this loa.n could occur, you would be be.tte.r off, a.s wouldthe pe.rs.ons who m.a.de you the loa.n The.y would now e.a.rn s.om.e inte.re.s.t, whe.re.a.s the.ywould not if the fina.ncia.l m.a.rke.t did not e.xis.t

Fina.ncia.l m.a.rke.ts a.llow funds to m.ove from pe.ople who la.ck productive inve.s.tm.e.ntopportunitie.s to pe.ople who ha.ve s.uch opportunitie.s Fina.ncia.l m.a.rke.ts a.re critica.l forproducing a.n e.fficie.nt a.lloca.tion of ca.pita.l (we.a.lth, e.ithe.r fina.ncia.l or phys.ica.l, tha.t is.e.m.ploye.d to produce m.ore we.a.lth), which contribute.s to highe.r production a.nde.fficie.ncy for the ove.ra.ll e.conom.y Whe.n fina.ncia.l m.a.rke.ts bre.a.k down during fina.ncia.lcris.e.s., a.s the.y did during the re.ce.nt globa.l fina.ncia.l cris.is., s.e.ve.re e.conom.ic ha.rds.hipre.s.ults., which ca.n e.ve.n le.a.d to da.nge.rous politica.l ins.ta.bility

We.ll-functioning fina.ncia.l m.a.rke.ts a.ls.o dire.ctly im.prove the we.ll-be.ing of cons.um.e.rs bya.llowing the.m to tim.e the.ir purcha.s.e.s be.tte.r The.y provide funds to young pe.ople to buywha.t the.y ne.e.d a.nd ca.n e.ve.ntua.lly a.fford without forcing the.m to wa.it until the.y ha.ve.s.a.ve.d up the e.ntire purcha.s.e price Fina.ncia.l m.a.rke.ts tha.t a.re ope.ra.ting e.fficie.ntlyim.prove the e.conom.ic we.lfa.re of e.ve.ryone in the s.ocie.ty

1.1.2 An overview of financial markets and their functions

A fina.ncia.l ins.trum.e.nt (or fina.ncia.l products.) is the writte.n le.ga.l obliga.tion of one pa.rty

to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.lly m.one.y, to a.nothe.r pa.rty a.t s.om.e future da.te., unde.rs.pe.cife.d conditions (Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006) Fina.ncia.l ins.trum.e.nts.ha.ve the following im.porta.nt cha.ra.cte.ris.tics

Firs.t, a fina.ncia.l ins.trum.e.nt is a writte.n le.ga.l obliga.tion tha.t is s.ubje.ct to gove.rnm.e.nte.nforce.m.e.nt Tha.t is., a pe.rs.on (or a firm.) ca.n be com.pe.lle.d to ta.ke the a.ction s.pe.cife.d inthe a.gre.e.m.e.nt The e.nforce.a.bility of the obliga.tion is a.n im.porta.nt fe.a.ture of a fna.ncia.lins.trum.e.nt Without e.nforce.m.e.nt of the s.pe.cife.d te.rm.s., fna.ncia.l ins.trum.e.nts would note.xis.t

S.e.cond, a fina.ncia.l ins.trum.e.nt obliga.te.s one pa.rty to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.llym.one.y, to a.nothe.r pa.rty By pa.rty, we m.e.a.n a pe.rs.on, com.pa.ny, or gove.rnm.e.nt Us.ua.llythe fina.ncia.l ins.trum.e.nt s.pe.cife.s tha.t pa.ym.e.nts will be m.a.de For e.xa.m.ple., if you ge.t a.ca.r loa.n, you a.re obliga.te.d to m.a.ke m.onthly pa.ym.e.nts of a pa.rticula.r a.m.ount to the.le.nde.r A.nd if you ha.ve a.n a.ccide.nt, your ins.ura.nce com.pa.ny is obliga.te.d to fix your ca.r,though the cos.t of the re.pa.ir is le.ft uns.pe.cife.d

Third, a fina.ncia.l ins.trum.e.nt s.pe.cife.s tha.t pa.ym.e.nt will be m.a.de a.t s.om.e future da.te Ins.om.e ca.s.e.s., s.uch a.s a ca.r loa.n tha.t re.quire.s pa.ym.e.nts the da.te.s m.a.y be ve.ry s.pe.cific Inothe.rs., s.uch a.s ca.r ins.ura.nce., the pa.ym.e.nt is trigge.re.d whe.n s.om.e.thing s.pe.cific ha.ppe.ns.,like a.n a.ccide.nt

Fina.lly, a fina.ncia.l ins.trum.e.nt s.pe.cifie.s conditions unde.r which a pa.ym.e.nt will be m.a.de S.om.e a.gre.e.m.e.nts s.pe.cify pa.ym.e.nts only whe.n ce.rta.in e.ve.nts ha.ppe.n Tha.t is cle.a.rly the.ca.s.e with ca.r ins.ura.nce a.nd with s.tocks a.s we.ll The holde.r of a s.tock owns a s.m.a.ll pa.rt

of a frm a.nd s.o ca.n e.xpe.ct to re.ce.ive occa.s.iona.l ca.s.h pa.ym.e.nts., ca.lle.d divide.nds., whe.nthe com.pa.ny is profita.ble The.re is no wa.y to know in a.dva.nce., howe.ve.r, e.xa.ctly whe.ns.uch pa.ym.e.nts will be m.a.de In ge.ne.ra.l, fina.ncia.l ins.trum.e.nts s.pe.cifies a num.be.r ofpos.s.ible continge.ncie.s unde.r which one pa.rty is re.quire.d to m.a.ke a pa.ym.e.nt to a.nothe.r

The.re a.re two funda.m.e.nta.l cla.s.s.e.s of fina.ncia.l ins.trum.e.nts The firs.t, unde.rlyingins.trum.e.nts (s.om.e.tim.e.s ca.lle.d prim.itive s.e.curitie.s.), a.re us.e.d by s.a.ve.rs./le.nde.rs to tra.ns.fe.rre.s.ource.s dire.ctly to inve.s.tors./borrowe.rs Through the.s.e ins.trum.e.nts., the fina.ncia.ls.ys.te.m im.prove.s the e.fficie.nt a.lloca.tion of re.s.ource.s in the re.a.l e.conom.y The prim.a.rye.xa.m.ple.s of unde.rlying s.e.curitie.s or ins.trum.e.nts a.re s.tocks a.nd bonds tha.t offe.rpa.ym.e.nts ba.s.e.d s.ole.ly on the is.s.ue.r’s s.ta.tus Bonds., for e.xa.m.ple., m.a.ke pa.ym.e.nts.de.pe.nding on the s.olve.ncy of the firm tha.t is.s.ue.d the.m S.tocks s.om.e.tim.e.s pa.y divide.nds.whe.n the is.s.uing corpora.tion’s profits a.re s.ufficie.nt

The s.e.cond cla.s.s of fina.ncia.l ins.trum.e.nts is known a.s de.riva.tive ins.trum.e.nts The.ir va.lue.a.nd pa.yoffs a.re “de.rive.d” from the be.ha.vior of the unde.rlying ins.trum.e.nts The m.os.tcom.m.on e.xa.m.ple.s of de.riva.tive.s a.re future.s., options., a.nd s.tructure.d fina.ncia.l products.s.uch a.s m.ortga.ge.-ba.cke.d s.e.curitie.s (or m.orta.ge.s for s.hort) In ge.ne.ra.l, de.riva.tive.s.s.pe.cify a pa.ym.e.nt to be m.a.de be.twe.e.n the pe.rs.on who s.e.lls the ins.trum.e.nt a.nd the.pe.rs.on who buys it The a.m.ount of the pa.ym.e.nt de.pe.nds on va.rious fa.ctors a.s.s.ocia.te.dwith the price of the unde.rlying a.s.s.e.t The prim.a.ry us.e of de.riva.tive.s is to s.hift ris.ka.m.ong inve.s.tors

1.1.3 The information asymmetry in the financial markets

Whe.n fina.ncia.l m.a.rke.ts work we.ll, the.y cha.nne.l funds from s.a.ve.rs to inve.s.tors., a.nd the.yhe.lp pe.ople re.duce ris.k But fina.ncia.l m.a.rke.ts don’t a.lwa.ys work we.ll S.om.e.tim.e.s the.ybre.a.k down, ha.rm.ing s.a.ve.rs., inve.s.tors., a.nd the e.conom.y The proble.m.s of fina.ncia.lm.a.rke.ts ca.n be com.ple.x, but m.a.ny ha.ve the s.a.m.e root ca.us.e.: a.s.ym.m.e.tric inform.a.tion, a.s.itua.tion in which one pa.rticipa.nt in a.n e.conom.ic tra.ns.a.ction ha.s m.ore inform.a.tion tha.nthe othe.r pa.rticipa.nt (M.is.kin, 2007; Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006; M.e.rton,1974) In fina.ncia.l m.a.rke.ts., the a.s.ym.m.e.try ge.ne.ra.lly occurs be.ca.us.e the s.e.lle.rs ofs.e.curitie.s ha.ve m.ore inform.a.tion tha.n the buye.rs

Two type.s of a.s.ym.m.e.tric inform.a.tion e.xis.t in fina.ncia.l m.a.rke.ts., a.dve.rs.e s.e.le.ction a.ndm.ora.l ha.za.rd

A.dve.rs.e s.e.le.ction is the proble.m cre.a.te.d by a.s.ym.m.e.tric inform.a.tion be.fore the.tra.ns.a.ction occurs A.dve.rs.e s.e.le.ction in fina.ncia.l m.a.rke.ts occurs whe.n the pote.ntia.lborrowe.rs who a.re the m.os.t like.ly to produce a.n unde.s.ira.ble (a.dve.rs.e.) outcom.e - the ba.dcre.dit ris.ks - a.re the one.s who m.os.t a.ctive.ly s.e.e.k out a loa.n a.nd a.re thus m.os.t like.ly to be.s.e.le.cte.d Be.ca.us.e a.dve.rs.e s.e.le.ction m.a.ke.s it m.ore like.ly tha.t loa.ns m.ight be m.a.de to ba.dcre.dit ris.ks., le.nde.rs m.a.y de.cide not to m.a.ke a.ny loa.ns e.ve.n though the.re a.re good cre.ditris.ks in the m.a.rke.tpla.ce

To unde.rs.ta.nd why a.dve.rs.e s.e.le.ction occurs., s.uppos.e tha.t you ha.ve two a.unts to whom.you m.ight m.a.ke a loa.n - A.unt Louis.e a.nd A.unt S.he.ila A.unt Louis.e is a cons.e.rva.tive.type who borrows only whe.n s.he ha.s a.n inve.s.tm.e.nt s.he is quite s.ure will pa.y off A.untS.he.ila., by contra.s.t, is a.n inve.te.ra.te ga.m.ble.r who ha.s jus.t com.e a.cros.s a ge.t-rich-quicks.che.m.e tha.t will m.a.ke he.r a m.illiona.ire if s.he ca.n jus.t borrow $1,000 to inve.s.t in it.Unfortuna.te.ly, a.s with m.os.t ge.t-rich-quick s.che.m.e.s., the.re is a high proba.bility tha.t the.inve.s.tm.e.nt won’t pa.y off a.nd tha.t A.unt S.he.ila will los.e the $1,000

Which of your a.unts is m.ore like.ly to ca.ll you to a.s.k for a loa.n? A.unt S.he.ila., of cours.e.,be.ca.us.e s.he ha.s s.o m.uch to ga.in if the inve.s.tm.e.nt pa.ys off You, howe.ve.r, would notwa.nt to m.a.ke a loa.n to he.r be.ca.us.e the.re is a high proba.bility tha.t he.r inve.s.tm.e.nt willturn s.our a.nd s.he will be una.ble to pa.y you ba.ck If you kne.w both your a.unts ve.ry we.ll -tha.t is., if your inform.a.tion we.re not a.s.ym.m.e.tric - you wouldn’t ha.ve a proble.m., be.ca.us.e.you would know tha.t A.unt S.he.ila is a ba.d ris.k a.nd s.o you would not le.nd to he.r.S.uppos.e., though, tha.t you don’t know your a.unts we.ll You a.re m.ore like.ly to le.nd toA.unt S.he.ila tha.n to A.unt Louis.e be.ca.us.e A.unt S.he.ila would be hounding you for the.loa.n Be.ca.us.e of the pos.s.ibility of a.dve.rs.e s.e.le.ction, you m.ight de.cide not to le.nd toe.ithe.r of your a.unts., e.ve.n though the.re a.re tim.e.s whe.n A.unt Louis.e., who is a.n e.xce.lle.ntcre.dit ris.k, m.ight ne.e.d a loa.n for a worthwhile inve.s.tm.e.nt

M.ora.l ha.za.rd is the proble.m cre.a.te.d by a.s.ym.m.e.tric inform.a.tion a.fte.r the tra.ns.a.ctionoccurs M.ora.l ha.za.rd in fina.ncia.l m.a.rke.ts is the ris.k (ha.za.rd) tha.t the borrowe.r m.ighte.nga.ge in a.ctivitie.s tha.t a.re unde.s.ira.ble (im.m.ora.l) from the le.nde.r’s point of vie.w,

be.ca.us.e the.y m.a.ke it le.s.s like.ly tha.t the loa.n will be pa.id ba.ck Be.ca.us.e m.ora.l ha.za.rdlowe.rs the proba.bility tha.t the loa.n will be re.pa.id, le.nde.rs m.a.y de.cide tha.t the.y wouldra.the.r not m.a.ke a loa.n

A.s a.n e.xa.m.ple of m.ora.l ha.za.rd, s.uppos.e tha.t you m.a.de a $1,000 loa.n to a.nothe.r re.la.tive.,Uncle M.e.lvin, who ne.e.ds the m.one.y to purcha.s.e a com.pute.r s.o he ca.n s.e.t up a bus.ine.s.s.typing s.tude.nts.’ te.rm pa.pe.rs Once you ha.ve m.a.de the loa.n, howe.ve.r, Uncle M.e.lvin is.m.ore like.ly to s.lip off to the tra.ck a.nd pla.y the hors.e.s If he be.ts on a 20-to-1 long s.hota.nd wins with your m.one.y, he is a.ble to pa.y you ba.ck your $1,000 a.nd live high off the.hog with the re.m.a.ining $19,000 But if he los.e.s., a.s is like.ly, you don’t ge.t pa.id ba.ck, a.nda.ll he ha.s los.t is his re.puta.tion a.s a re.lia.ble., ups.ta.nding uncle Uncle M.e.lvin the.re.fore ha.s.a.n ince.ntive to go to the tra.ck be.ca.us.e his ga.ins ($19,000) if he be.ts corre.ctly a.re m.uchgre.a.te.r tha.n the cos.t to him (his re.puta.tion) if he be.ts incorre.ctly If you kne.w wha.tUncle M.e.lvin wa.s up to, you would pre.ve.nt him from going to the tra.ck, a.nd he wouldnot be a.ble to incre.a.s.e the m.ora.l ha.za.rd Howe.ve.r, be.ca.us.e it is ha.rd for you to ke.e.pinform.e.d a.bout his whe.re.a.bouts.—tha.t is., be.ca.us.e inform.a.tion is a.s.ym.m.e.tric—the.re is a.good cha.nce tha.t Uncle M.e.lvin will go to the tra.ck a.nd you will not ge.t pa.id ba.ck The.ris.k of m.ora.l ha.za.rd m.ight the.re.fore dis.coura.ge you from m.a.king the $1,000 loa.n toUncle M.e.lvin, e.ve.n if you we.re s.ure tha.t you would be pa.id ba.ck if he us.e.d it to s.e.t uphis bus.ine.s.s

A.nothe.r wa.y of de.s.cribing the m.ora.l ha.za.rd proble.m is tha.t it le.a.ds to conflicts ofinte.re.s.t, in which one pa.rty in a fina.ncia.l contra.ct ha.s ince.ntive.s to a.ct in its own inte.re.s.tra.the.r tha.n in the inte.re.s.ts of the othe.r pa.rty Inde.e.d, this is e.xa.ctly wha.t ha.ppe.ns if yourUncle M.e.lvin is te.m.pte.d to go to the tra.ck a.nd ga.m.ble a.t your e.xpe.ns.e

The proble.m.s cre.a.te.d by a.dve.rs.e s.e.le.ction a.nd m.ora.l ha.za.rd a.re a.n im.porta.ntim.pe.dim.e.nt to we.ll-functioning fina.ncia.l m.a.rke.ts A.ga.in, fina.ncia.l inte.rm.e.dia.rie.s ca.na.lle.via.te the.s.e proble.m.s

With fina.ncia.l inte.rm.e.dia.rie.s in the e.conom.y, s.m.a.ll s.a.ve.rs ca.n provide the.ir funds to the.fina.ncia.l m.a.rke.ts by le.nding the.s.e funds to a trus.tworthy inte.rm.e.dia.ry—s.a.y, the Hone.s.tJohn Ba.nk—which in turn le.nds the funds out e.ithe.r by m.a.king loa.ns or by buyings.e.curitie.s s.uch a.s s.tocks or bonds S.ucce.s.s.ful fina.ncia.l inte.rm.e.dia.rie.s ha.ve highe.re.a.rnings on the.ir inve.s.tm.e.nts tha.n s.m.a.ll s.a.ve.rs., be.ca.us.e the.y a.re be.tte.r e.quippe.d tha.nindividua.ls to s.cre.e.n out ba.d cre.dit ris.ks from good one.s., the.re.by re.ducing los.s.e.s due toa.dve.rs.e s.e.le.ction In a.ddition, fina.ncia.l inte.rm.e.dia.rie.s ha.ve high e.a.rnings be.ca.us.e the.yde.ve.lop e.xpe.rtis.e in m.onitoring the pa.rtie.s the.y le.nd to, thus re.ducing los.s.e.s due tom.ora.l ha.za.rd The re.s.ult is tha.t fina.ncia.l inte.rm.e.dia.rie.s ca.n a.fford to pa.y le.nde.r-s.a.ve.rs.inte.re.s.t or provide s.ubs.ta.ntia.l s.e.rvice.s a.nd s.till e.a.rn a profit.

A.s we ha.ve s.e.e.n, fina.ncia.l inte.rm.e.dia.rie.s pla.y a.n im.porta.nt role in the e.conom.y be.ca.us.e.the.y provide liquidity s.e.rvice.s., prom.ote ris.k s.ha.ring, a.nd s.olve inform.a.tion proble.m.s.,the.re.by a.llowing s.m.a.ll s.a.ve.rs a.nd borrowe.rs to be.ne.fit from the e.xis.te.nce of fina.ncia.lm.a.rke.ts The s.ucce.s.s of fina.ncia.l inte.rm.e.dia.rie.s in pe.rform.ing this role is e.vide.nce.d bythe fa.ct tha.t m.os.t A.m.e.rica.ns inve.s.t the.ir s.a.vings with the.m a.nd obta.in loa.ns from the.m Fina.ncia.l inte.rm.e.dia.rie.s pla.y a ke.y role in im.proving e.conom.ic e.fficie.ncy be.ca.us.e the.yhe.lp fina.ncia.l m.a.rke.ts cha.nne.l funds from le.nde.r-s.a.ve.rs to pe.ople with productive.inve.s.tm.e.nt opportunitie.s Without a we.llfunctioning s.e.t of fina.ncia.l inte.rm.e.dia.rie.s., it is.ve.ry ha.rd for a.n e.conom.y to re.a.ch its full pote.ntia.l

1.2 Credit rating agencies

Cre.dit ra.ting bus.ine.s.s firs.tly e.m.e.rge.d in the Unite.d S.ta.te.s (US.) in 1900s a.nd be.ca.m.e a.nim.porta.nt pa.rt of inte.rna.tiona.l fina.ncia.l m.a.rke.ts in pa.ra.lle.l with the globa.liza.tion offina.ncia.l m.a.rke.ts a.s of m.id-1970s Cre.dit ra.ting a.ge.ncie.s (CRA.) contribute to the.e.fficie.ntly functioning of fina.ncia.l m.a.rke.ts by re.ducing the inform.a.tion a.s.ym.m.e.trybe.twe.e.n borrowe.rs a.nd le.nde.rs (A.de.ls.on, 2012) But inve.s.tors a.nd countrie.s be.ga.n toinve.s.tiga.te the re.lia.bility of cre.dit ra.tings e.s.pe.cia.lly a.fte.r the re.ce.nt cris.e.s a.nd the CRA.s.a.ls.o we.re s.e.e.n a.s a pa.rt of the.s.e cris.e.s Thus., in this s.e.ction the a.uthor will pre.s.e.nt a.na.ve.rvie.w a.bout CA.R a.nd ra.ting indus.try

1.2.1 The formation of credit rating agencies and rating industry

In 1909, John M.oody publis.he.d the frs.t publicly a.va.ila.ble bond ra.tings., focus.e.d e.ntire.ly

on ra.ilroa.d bonds M.oody’s frm wa.s followe.d by Poor’s Publis.hing Com.pa.ny in 1916,the S.ta.nda.rd S.ta.tis.tics Com.pa.ny in 1922, a.nd the Fitch Publis.hing Com.pa.ny in 1924.The.s.e frm.s.’ bond ra.tings we.re s.old to bond inve.s.tors in thick m.a.nua.ls The.s.e frm.s.e.volve.d ove.r tim.e Dun & Bra.ds.tre.e.t bought M.oody’s in 1962, but the.n s.ubs.e.que.ntlys.pun it off in 2000 a.s a fre.e.-s.ta.nding corpora.tion Poor’s a.nd S.ta.nda.rd m.e.rge.d in 1941;S.ta.nda.rd & Poor’s wa.s the.n a.bs.orbe.d by M.cGra.wHill in 1966 Fitch m.e.rge.d with IBCA.(a Britis.h frm., which wa.s a s.ubs.idia.ry of FIM.ILA.C, a Fre.nch bus.ine.s.s s.e.rvice.s.conglom.e.ra.te.) in 1997 A.t the e.nd of the ye.a.r 2000, a.t a.bout the tim.e tha.t the m.a.rke.t fors.tructure.d s.e.curitie.s tha.t we.re ba.s.e.d on s.ubprim.e re.s.ide.ntia.l m.ortga.ge.s be.ga.n growingra.pidly, the is.s.ue.rs of the.s.e s.e.curitie.s ha.d only the.s.e thre.e cre.dit-ra.ting a.ge.ncie.s to whom.the.y could turn to obta.in the.ir a.ll-im.porta.nt ra.tings.: M.oody’s., S.ta.nda.rd & Poor’s (S.&P),a.nd Fitch

Fa.vora.ble ra.tings from the.s.e thre.e cre.dit a.ge.ncie.s we.re crucia.l for the s.ucce.s.s.ful s.a.le ofthe s.e.curitie.s ba.s.e.d on s.ubprim.e re.s.ide.ntia.l m.ortga.ge.s a.nd othe.r de.bt obliga.tions The.s.a.le.s of the.s.e bonds., in turn, we.re a.n im.porta.nt unde.rpinning for the fna.ncing of the s.e.lf-re.inforcing price.-ris.e bubble in the U.S hous.ing m.a.rke.t Whe.n hous.e price.s ce.a.s.e.dris.ing in m.id 2006 a.nd the.n be.ga.n to de.cline., the de.fa.ult ra.te.s on the m.ortga.ge.s.unde.rlying the.s.e s.e.curitie.s ros.e s.ha.rply, a.nd thos.e initia.l ra.tings prove.d to be e.xce.s.s.ive.lyoptim.is.tic The price de.cline.s a.nd unce.rta.inty s.urrounding the.s.e wide.ly-he.ld s.e.curitie.s.the.n he.lpe.d to turn a drop in hous.ing price.s into a wide.s.pre.a.d cris.is in the U.S a.ndgloba.l fna.ncia.l s.ys.te.m.s

A ce.ntra.l conce.rn of a.ny le.nde.r - including the le.nde.rs./inve.s.tors in bonds - is whe.the.r a.pote.ntia.l or a.ctua.l borrowe.r is like.ly to re.pa.y the loa.n A.long with colle.cting the.ir owninform.a.tion a.bout borrowe.rs., a.nd im.pos.ing re.quire.m.e.nts like colla.te.ra.l, co-s.igne.rs., a.ndre.s.trictive cove.na.nts in bond inde.nture.s or le.nding a.gre.e.m.e.nts., thos.e who le.nd m.one.y

m.a.y a.ls.o s.e.e.k outs.ide a.dvice a.bout cre.ditworthine.s.s The purpos.e of cre.dit ra.tinga.ge.ncie.s is to he.lp pie.rce the fog of a.s.ym.m.e.tric inform.a.tion by offe.ring judgm.e.nts.—the.ypre.fe.r the word “opinions.” – a.bout the cre.dit qua.lity of bonds tha.t a.re is.s.ue.d bycorpora.tions., U.S s.ta.te a.nd loca.l gove.rnm.e.nts., “s.ove.re.ign” gove.rnm.e.nt is.s.ue.rs of bonds.a.broa.d, a.nd (m.os.t re.ce.ntly) m.ortga.ge s.e.curitize.rs

In the e.a.rly ye.a.rs of M.oody’s., S.ta.nda.rd, Poor’s., a.nd Fitch, the.y e.a.rne.d re.ve.nue bys.e.lling the.ir a.s.s.e.s.s.m.e.nts of cre.ditworthine.s.s to inve.s.tors This occurre.d in the e.ra be.fore.the S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion (S.E.C) wa.s cre.a.te.d in 1934 a.nd be.ga.n re.quiringcorpora.tions to is.s.ue s.ta.nda.rdize.d fna.ncia.l s.ta.te.m.e.nts The.s.e judgm.e.nts com.e in the.form of “ra.tings.,” which a.re us.ua.lly a le.tte.r gra.de The be.s.t-known s.ca.le is tha.t us.e.d byS.ta.nda.rd & Poor’s a.nd s.om.e othe.r ra.ting a.ge.ncie.s.: A.A.A., A.A., A., BBB, BB, a.nd s.o on,with plus.e.s a.nd m.inus.e.s a.s we.ll

Howe.ve.r, a m.a.jor cha.nge in the re.la.tions.hip be.twe.e.n the cre.dit ra.ting a.ge.ncie.s a.nd the.U.S bond m.a.rke.ts occurre.d in the 1930s Ba.nk re.gula.tors we.re e.a.ge.r to e.ncoura.ge ba.nks

to inve.s.t only in s.a.fe bonds The.y is.s.ue.d a s.e.t of re.gula.tions tha.t culm.ina.te.d in a 1936de.cre.e tha.t prohibite.d ba.nks from inve.s.ting in “s.pe.cula.tive inve.s.tm.e.nt s.e.curitie.s.” a.s.de.te.rm.ine.d by “re.cognize.d ra.ting m.a.nua.ls ” “S.pe.cula.tive.” s.e.curitie.s (which nowa.da.ys.would be ca.lle.d “ junk bonds.”) we.re be.low “inve.s.tm.e.nt gra.de ” Thus., ba.nks we.re.re.s.tricte.d to holding only bonds tha.t we.re “inve.s.tm.e.nt gra.de.”—in m.ode.rn ra.tings., this.would be e.quiva.le.nt to bonds tha.t we.re ra.te.d BBB– or be.tte.r on the S.ta.nda.rd & Poor’s.s.ca.le With the.s.e re.gula.tions in pla.ce., ba.nks we.re no longe.r fre.e to a.ct on inform.a.tiona.bout bonds from a.ny s.ource tha.t the.y de.e.m.e.d re.lia.ble (a.lbe.it within ove.rs.ight by ba.nkre.gula.tors.) The.y we.re ins.te.a.d force.d to us.e the judgm.e.nts of the publis.he.rs of the

“re.cognize.d ra.ting m.a.nua.ls.”—which we.re only M.oody’s., Poor’s., S.ta.nda.rd, a.nd Fitch

E.s.s.e.ntia.lly, the cre.ditworthine.s.s judgm.e.nts of the.s.e third-pa.rty ra.te.rs ha.d a.tta.ine.d the force of la.w

In the following de.ca.de.s., the ins.ura.nce re.gula.tors of the 48 (a.nd e.ve.ntua.lly 50) s.ta.te.s.followe.d a s.im.ila.r pa.th S.ta.te ins.ura.nce re.gula.tors e.s.ta.blis.he.d m.inim.um ca.pita.l

re.quire.m.e.nts tha.t we.re ge.a.re.d to the ra.tings on the bonds in which the ins.ura.nce.com.pa.nie.s inve.s.te.d - the ra.tings., of cours.e., com.ing from the s.a.m.e s.m.a.ll group of ra.tinga.ge.ncie.s Once a.ga.in, a.n im.porta.nt s.e.t of re.gula.tors ha.d de.le.ga.te.d the.ir s.a.fe.ty de.cis.ions.

to the cre.dit ra.ting a.ge.ncie.s In the 1970s., fe.de.ra.l pe.ns.ion re.gula.tors purs.ue.d a s.im.ila.rs.tra.te.gy The S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion crys.ta.llize.d the ce.ntra.lity of the thre.e.ra.ting a.ge.ncie.s in 1975, whe.n it de.cide.d to m.odify its m.inim.um ca.pita.l re.quire.m.e.nts forbroke.r-de.a.le.rs., who include m.a.jor inve.s.tm.e.nt ba.nks a.nd s.e.curitie.s frm.s Following the.pa.tte.rn of the othe.r fna.ncia.l re.gula.tors., the S.E.C wa.nte.d thos.e ca.pita.l re.quire.m.e.nts to be.s.e.ns.itive to the ris.kine.s.s of the broke.rde.a.le.rs.’ a.s.s.e.t portfolios a.nd he.nce wa.nte.d to us.e.bond ra.tings a.s the indica.tors of ris.k But it worrie.d tha.t re.fe.re.nce.s to “re.cognize.d ra.tingm.a.nua.ls.” we.re too va.gue a.nd tha.t a bogus ra.ting frm m.ight a.ris.e tha.t would prom.is.e.A.A.A ra.tings to thos.e com.pa.nie.s tha.t would s.uita.bly re.wa.rd it a.nd “DDD” ra.tings tothos.e tha.t would not

To de.a.l with this pote.ntia.l proble.m., the S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion cre.a.te.d a.ne.w ca.te.gory—“na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion” (NRS.RO)—a.ndim.m.e.dia.te.ly gra.ndfa.the.re.d M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch into the ca.te.gory The.S.E.C de.cla.re.d tha.t only the ra.tings of NRS.ROs we.re va.lid for the de.te.rm.ina.tion of the.broke.r-de.a.le.rs.’ ca.pita.l re.quire.m.e.nts Othe.r fna.ncia.l re.gula.tors s.oon a.dopte.d the NRS.ROca.te.gory a.nd the ra.ting a.ge.ncie.s within it In the e.a.rly 1990s., the S.E.C a.ga.in m.a.de us.e ofthe NRS.ROs.’ ra.tings whe.n it e.s.ta.blis.he.d s.a.fe.ty re.quire.m.e.nts for the com.m.e.rcia.l pa.pe.r(s.hort-te.rm de.bt) he.ld by m.one.y m.a.rke.t m.utua.l funds

Ta.ke.n toge.the.r, the.s.e re.gula.tory rule.s m.e.a.nt tha.t the judgm.e.nts of cre.dit ra.ting a.ge.ncie.s.be.ca.m.e of ce.ntra.l im.porta.nce in bond m.a.rke.ts Ba.nks a.nd m.a.ny othe.r fna.ncia.lins.titutions could s.a.tis.fy the s.a.fe.ty re.quire.m.e.nts of the.ir re.gula.tors by jus.t he.e.ding the.ra.tings., ra.the.r tha.n the.ir own e.va.lua.tions of the ris.ks of the bonds Be.ca.us.e the.s.e.re.gula.te.d fna.ncia.l ins.titutions we.re s.uch im.porta.nt pa.rticipa.nts in the bond m.a.rke.t, othe.rpla.ye.rs in the m.a.rke.t - both buye.rs a.nd s.e.lle.rs - ne.e.de.d to pa.y pa.rticula.r a.tte.ntion to the.bond ra.te.rs.’ pronounce.m.e.nts a.s we.ll The irony of the re.gula.tors.’ re.lia.nce on the

judgm.e.nts of cre.dit ra.ting a.ge.ncie.s is powe.rfully re.ve.a.le.d by a line in S.ta.nda.rd & Poor’s.

s.ta.nda.rd dis.cla.im.e.r a.t the bottom of its cre.dit ra.tings.: “a.ny us.e.r of the inform.a.tion

conta.ine.d he.re.in s.hould not re.ly on a.ny cre.dit ra.ting or othe.r opinion conta.ine.d he.re.in

in m.a.king a.ny inve.s.tm.e.nt de.cis.ion.” (M.oody’s ra.tings ha.ve a s.im.ila.r dis.cla.im.e.r)

A.lthough the.re a.ppe.a.r to be roughly 150 loca.l a.nd inte.rna.tiona.l cre.dit ra.ting a.ge.ncie.s.worldwide (Ba.s.e.l Com.m.itte.e on Ba.nking S.upe.rvis.ion, 2000; La.ngohr a.nd La.ngohr,2008), M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch a.re cle.a.rly the dom.ina.nt e.ntitie.s A.ll thre.e.ope.ra.te on a worldwide ba.s.is., with offce.s on s.ix contine.nts.; e.a.ch ha.s ra.tings outs.ta.nding

on te.ns of trillions of dolla.rs of s.e.curitie.s Only M.oody’s is a fre.e.-s.ta.nding com.pa.ny, s.othe m.os.t inform.a.tion is known a.bout tha.t frm.: Its 2008 a.nnua.l re.port lis.te.d the.com.pa.ny’s tota.l re.ve.nue.s a.t $1.8 billion, its ne.t re.ve.nue.s a.t $458 m.illion, a.nd its tota.la.s.s.e.ts a.t ye.a.r-e.nd a.t $1.8 billion (M.oody’s., 2009) Fifty-two pe.rce.nt of its tota.l re.ve.nue.ca.m.e from the Unite.d S.ta.te.s.; a.s re.ce.ntly a.s 2006 tha.t fra.ction wa.s two-thirds S.ixty-nine.pe.rce.nt of the com.pa.ny’s re.ve.nue.s com.e.s from ra.tings.; the re.s.t com.e.s from re.la.te.ds.e.rvice.s A.t ye.a.r-e.nd 2008, the com.pa.ny ha.d a.pproxim.a.te.ly 3,900 e.m.ploye.e.s., withs.lightly m.ore tha.n ha.lf loca.te.d in the Unite.d S.ta.te.s

Be.ca.us.e S.ta.nda.rd & Poor’s a.nd Fitch’s ra.tings ope.ra.tions a.re com.pone.nts of la.rge.re.nte.rpris.e.s tha.t re.port on a cons.olida.te.d ba.s.is., com.pa.ra.ble re.ve.nue a.nd a.s.s.e.t fgure.s a.re.not pos.s.ible But S.ta.nda.rd & Poor’s ra.ting ope.ra.tions a.re roughly the s.a.m.e s.ize a.s.M.oody’s., while Fitch is s.om.e.wha.t s.m.a.lle.r Ta.ble 1 provide.s a s.e.t of roughly com.pa.ra.ble.da.ta on e.a.ch com.pa.ny’s a.na.lytica.l e.m.ploye.e.s a.nd num.be.rs of is.s.ue.s ra.te.d A.ll thre.e.com.pa.nie.s e.m.ploy a.bout the s.a.m.e num.be.rs of a.na.lys.ts.; howe.ve.r, M.oody’s a.nd S.ta.nda.rd

& Poor’s ra.te a.ppre.cia.bly m.ore corpora.te a.nd a.s.s.e.t-ba.cke.d s.e.curitie.s tha.n doe.s Fitch.The m.a.rke.t s.ha.re.s (ba.s.e.d on re.ve.nue.s or is.s.ue.s ra.te.d) of the thre.e frm.s a.re com.m.onlye.s.tim.a.te.d to be a.pproxim.a.te.ly 40, 40, a.nd 15 pe.rce.nt for M.oody’s., S.ta.nda.rd & Poor’s.,a.nd Fitch, re.s.pe.ctive.ly (White., 2010)

Ta.ble 1: Da.ta from Form NRS.RO for 2009 for M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch

M.oody's S.ta.nda.rd & Poor's Fitch

Num.be.r of a.na.lys.is e.m.ploye.e.s.:

Num.be.r of bond is.s.ue.s ra.te.d

S.ource.: Form NRS.RO 2009, for e.a.ch com.pa.ny, a.s found on e.a.ch com.pa.ny’s we.bs.ite

During the 25 ye.a.rs tha.t followe.d the S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion’s 1975cre.a.tion of the “na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion” ca.te.gory, the S.E.C(S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion) de.s.igna.te.d only four a.dditiona.l frm.s a.s.NRS.ROs.: Duff & Phe.lps in 1980; M.cCa.rthy, Poon (2003) in 2003 Howe.ve.r, m.e.rge.rs.a.m.ong the e.ntra.nts a.nd with Fitch ca.us.e.d the num.be.r of NRS.ROs to re.turn to the.origina.l thre.e by ye.a.r-e.nd 2000 Of cours.e., the cre.dit ra.ting indus.try wa.s ne.ve.r going to

be a com.m.odity bus.ine.s.s with hundre.ds of s.m.a.ll-s.ca.le produce.rs The m.a.rke.t for bondinform.a.tion is one whe.re pote.ntia.l ba.rrie.rs to e.ntry like e.conom.ie.s of s.ca.le., the.a.dva.nta.ge.s of e.xpe.rie.nce., a.nd bra.nd na.m.e re.puta.tion a.re im.porta.nt fe.a.ture.s Ne.ve.rthe.le.s.s., in cre.a.ting the NRS.RO de.s.igna.tion, the S.e.curitie.s a.nd E.xcha.nge.Com.m.is.s.ion ha.d be.com.e a s.ignifca.nt ba.rrie.r to e.ntry into the bond ra.ting bus.ine.s.s in its.own right Without the be.ne.ft of the NRS.RO de.s.igna.tion, a.ny would-be bond ra.te.r wouldlike.ly re.m.a.in s.m.a.ll-s.ca.le Ne.w ra.ting frm.s would ris.k be.ing ignore.d by m.os.t fna.ncia.lins.titutions (the “buy s.ide.” of the bond m.a.rke.ts.); a.nd s.ince the fna.ncia.l ins.titutions.would ignore the would-be bond ra.te.r, s.o would bond is.s.ue.rs (the “s.e.ll s.ide.” of the.m.a.rke.ts.)

In a.ddition, the S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion wa.s re.m.a.rka.bly opa.que in its.de.s.igna.tion proce.s.s It ne.ve.r e.s.ta.blis.he.d form.a.l crite.ria for a frm to be de.s.igna.te.d a.s a

“na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion,” ne.ve.r e.s.ta.blis.he.d a form.a.la.pplica.tion a.nd re.vie.w proce.s.s., a.nd ne.ve.r provide.d a.ny jus.tifca.tion or e.xpla.na.tion forwhy it “a.nointe.d” s.om.e frm.s with the de.s.igna.tion a.nd re.fus.e.d to do s.o for othe.rs

Howe.ve.r, it is im.porta.nt to note tha.t while the m.a.jor cre.dit ra.ting a.ge.ncie.s a.re a m.a.jors.ource of cre.ditworthine.s.s for bond inve.s.tors., the.y a.re fa.r from the only pote.ntia.l s.ource

A fe.w s.m.a.lle.r ra.ting frm.s.—nota.bly KM.V, E.ga.n-Jone.s., a.nd La.ce Fina.ncia.l, a.ll of whichha.d “inve.s.tor pa.ys.” bus.ine.s.s m.ode.ls.—we.re a.ble to s.urvive., de.s.pite the a.bs.e.nce ofNRS.RO de.s.igna.tions (a.lthough KM.V wa.s a.bs.orbe.d by M.oody’s in 2002) S.om.e bondm.utua.l funds do the.ir own re.s.e.a.rch, a.s do s.om.e he.dge funds “Fixe.d incom.e a.na.lys.ts.” a.tm.a.ny fna.ncia.l s.e.rvice.s frm.s offe.r re.com.m.e.nda.tions to thos.e frm.s.’ clie.nts with re.s.pe.ct tobond inve.s.tm.e.nts

1.2.2 The role of CRA in rating mortgage securities and their shortcomings

A ce.ntra.l is.s.ue in fina.nce – pe.rha.ps the ce.ntra.l is.s.ue in fina.nce – is the unce.rta.inty of a.le.nde.r a.s to whe.the.r a borrowe.r will re.pa.y a loa.n The critica.l proble.m is one ofa.s.ym.m.e.tric inform.a.tion: The borrowe.r us.ua.lly knows m.ore a.bout the pros.pe.cts forre.pa.ym.e.nt tha.n doe.s the le.nde.r A.s a cons.e.que.nce., be.fore e.xte.nding a loa.n, le.nde.rs willga.the.r e.xte.ns.ive inform.a.tion a.bout pros.pe.ctive borrowe.rs., s.o a.s to try to de.te.rm.ine.which a.re the m.ore cre.ditworthy borrowe.rs a.nd which a.re the le.s.s cre.ditworthy; a.nd e.ve.na.fte.r e.xte.nding a loa.n, the le.nde.r will us.ua.lly wa.nt to m.onitor the borrowe.r’s a.ctions., s.oa.s to be re.a.s.s.ure.d tha.t the borrowe.r’s a.ctions a.re not putting re.pa.ym.e.nt in je.opa.rdy

It will be im.porta.nt to ke.e.p in m.ind tha.t bonds a.re jus.t a.nothe.r form of a loa.n A.lthoughthe te.rm.inology (e g., “inve.s.tors.”, “inve.s.ting”, “purcha.s.ing”; “is.s.ue.rs.”, “is.s.uing”,

“s.e.lling”) of bonds m.a.y m.a.ke the.m s.ound diffe.re.nt, a bond is funda.m.e.nta.lly a loa.n: The.bond is.s.ue.r is the borrowe.r; the bond buye.r (or inve.s.tor) is the le.nde.r Cre.dit ra.tinga.ge.ncie.s a.re one pote.ntia.l s.ource of he.lp for pie.rcing the fog of a.s.ym.m.e.tric inform.a.tionfor bonds A.fte.r colle.cting inform.a.tion a.bout bond is.s.ue.rs., the.y offe.r judgm.e.nts – the.y

pre.fe.r the word “opinions.” A.ccordingly, tha.t ce.ntra.l que.s.tion of fina.nce – will I ge.tre.pa.id? – a.pplie.s jus.t a.s im.porta.ntly to bonds a.bout the cre.ditworthine.s.s of bonds tha.t a.re.is.s.ue.d by corpora.tions., gove.rnm.e.nts (including s.ta.te a.nd loca.l gove.rnm.e.nts., a.s we.ll a.s.na.tiona.l – “s.ove.re.ign” – is.s.ue.rs.), a.nd s.e.curitize.rs of m.ortga.ge (a.nd othe.r) loa.ns The.s.e.judgm.e.nts a.re in the form of “ra.tings.,” the be.s.t known s.ym.bols of which a.re.thos.e us.e.d by S.&P a.nd a num.be.r of othe.r ra.ting a.ge.ncie.s.: A.A.A., A.A., A., BBB,e.tc., with plus.e.s a.nd m.inus.e.s a.s we.ll.

It is im.porta.nt to e.m.pha.s.ize tha.t the cre.dit ra.ting a.ge.ncie.s a.re not the only pote.ntia.ls.ource of s.uch cre.ditworthine.s.s inform.a.tion M.a.ny fina.ncia.l ins.titutions a.re ca.pa.ble ofdoing the.ir own re.s.e.a.rch The.re a.re s.m.a.lle.r fina.ncia.l s.e.rvice.s firm.s tha.t m.a.y not de.s.cribe.the.m.s.e.lve.s a.s “ra.ting a.ge.ncie.s.” but tha.t ne.ve.rthe.le.s.s provide a.dvice a.boutcre.ditworthine.s.s to (ins.titutiona.l) bond inve.s.tors Furthe.r, m.a.ny fina.ncia.l s.e.rvice.s.com.pa.nie.s., including la.rge inve.s.tm.e.nt ba.nks a.nd com.m.e.rcia.l ba.nks., e.m.ploy “fixe.dincom.e a.na.lys.ts.” whos.e re.com.m.e.nda.tions with re.s.pe.ct to bond inve.s.tm.e.nts (ba.s.e.d onthe.ir judgm.e.nts a.bout thos.e bonds.’ cre.ditworthine.s.s.) a.re provide.d to thos.e com.pa.nie.s.’(ins.titutiona.l) clie.nts

How the.n did the thre.e la.rge cre.dit ra.ting a.ge.ncie.s ga.in the.ir prom.ine.nce a.t the ce.nte.r ofthe bond m.a.rke.ts.? It is to the his.tory of the cre.dit ra.ting a.ge.ncie.s., a.nd the.ir e.ntwine.m.e.ntwith the prude.ntia.l re.gula.tion of m.a.ny fina.ncia.l ins.titutions.’ bond portfolios., to which

we now turn

For the be.tte.r pa.rt of the pa.s.t ce.ntury, ra.ting a.ge.ncie.s ha.ve publis.he.d opinions on the.cre.ditworthine.s.s of firm.s a.nd s.e.curitie.s To re.a.ch the.ir opinions., which a.re la.be.le.d a.s.ra.tings., the.y ga.the.r a.nd a.na.lyze a wide ra.nge of fina.ncia.l, indus.try, a.nd e.conom.icinform.a.tion This inform.a.tion is s.ynthe.s.ize.d a.nd publis.he.d to offe.r inde.pe.nde.nt, cre.dible.a.s.s.e.s.s.m.e.nts of cre.ditworthine.s.s In e.xcha.nge for this s.e.rvice., the a.ge.ncie.s typica.lly e.a.rnfe.e.s pa.id by is.s.ue.rs inte.re.s.te.d in ha.ving the.ir s.e.curitie.s ra.te.d By he.lping re.s.olve.inform.a.tion a.s.ym.m.e.trie.s be.twe.e.n the s.e.lle.r a.nd pote.ntia.l buye.rs., ra.tings ca.n de.e.pe.n a.s.e.curity’s pool of pote.ntia.l inve.s.tors a.nd the.re.by im.prove pricing a.nd liquidity

M.ore.ove.r, to the e.xte.nt tha.t a firm fa.ce.s the ris.k of be.ing downgra.de.d, ra.tings a.ls.o ha.ve.the pote.ntia.l to dis.cipline m.a.na.ge.r be.ha.vior a.nd lim.it the.ir a.bility to s.hift ris.ks

During the pa.s.t s.e.ve.ra.l de.ca.de.s., cre.dit ra.tings ha.ve com.e to pla.y a ce.ntra.l role in the.fina.ncia.l s.ys.te.m a.nd a.re re.lie.d upon by a num.be.r of ke.y m.a.rke.t pa.rticipa.nts M.a.nyinve.s.tors us.e ra.tings a.s a s.ta.rting point for cla.s.s.ifying a.nd unde.rs.ta.nding s.e.curitie.s a.ndthe.ir a.s.s.ocia.te.d ris.ks Le.nde.rs or counte.rpa.rtie.s inte.re.s.te.d in im.pos.ing gre.a.te.rre.s.pons.ibility on a firm m.a.y inde.e.d re.quire it to be ra.te.d Buy-s.ide firm.s s.uch a.s pe.ns.ionfunds., m.utua.l funds., a.nd ins.ura.nce com.pa.nie.s will ofte.n us.e ra.tings in a.iding the.irinve.s.tm.e.nt proce.s.s The.y m.ight us.e ra.tings to corrobora.te., e.nha.nce., or e.ve.n s.ubs.titute.for in-hous.e a.na.lys.is The.y m.a.y inve.s.tiga.te the re.a.s.oning be.hind a ra.ting to unde.rs.ta.nda.nd a.nticipa.te the like.lihood of future a.ctions tha.t m.ight im.pa.ct price.s A.nd m.a.nyins.titutions us.e ra.tings in the.ir inve.s.tm.e.nt policie.s – for e.xa.m.ple., a.s pa.rt of a.s.s.e.ta.lloca.tion rule.s tha.t re.quire a s.pe.cific fra.ction of ca.pita.l to be inve.s.te.d in s.e.curitie.s withce.rta.in ra.tings Fina.lly, the.y a.re like.ly to us.e ra.tings to ide.ntify a.cce.pta.ble counte.rpa.rtie.s

in ce.rta.in tra.ns.a.ctions a.nd to e.ns.ure com.plia.nce with re.gula.tions

Re.gula.tors a.ls.o re.ly on ra.tings For e.xa.m.ple., Rule 2a.-7 of the Inve.s.tm.e.nt Com.pa.ny A.ct(prom.ulga.te.d by U.S S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion) s.pe.cifie.s tha.t m.one.y m.a.rke.tfunds ca.n only purcha.s.e com.m.e.rcia.l pa.pe.r if it is of s.ufficie.ntly high ra.ting M.a.nycountrie.s us.e cre.dit ra.tings to re.s.trict the kinds of fixe.d-incom.e inve.s.tm.e.nts public a.ndpriva.te pe.ns.ion funds ca.n m.a.ke Ba.s.e.l II ha.s be.e.n m.odifie.d to a.llow ce.rta.in ba.nks to us.e.e.xte.rna.l cre.dit ra.tings to de.te.rm.ine a.ppropria.te ca.pita.l re.quire.m.e.nts (Be.nford & Nie.r,2007) Fina.lly, priva.te contra.cts ofte.n re.ly on ra.tings to provide e.xte.rna.l s.igna.ls tha.ttrigge.r ce.rta.in a.ctions For e.xa.m.ple., a firm m.ight give counte.rpa.rtie.s the right to de.m.a.ndca.s.h colla.te.ra.l in the e.ve.nt of a downgra.de a.nd le.nde.rs the right to de.m.a.nd re.pa.ym.e.nt ofloa.ns (Bha.not & M.e.llo, 2006)

In s.pite of the.ir wide us.e., cre.dit ra.tings ha.ve s.e.ve.ra.l s.hortcom.ings Firs.t, cre.dit ra.tings.only conta.in inform.a.tion a.bout ca.s.h flow ris.k – de.fa.ult like.lihood a.nd e.xpe.cte.d re.cove.ry– but nothing a.bout s.ys.te.m.a.tic ris.k e.xpos.ure This inform.a.tion, while im.porta.nt, is

ins.ufficie.nt for pricing, s.ince it ne.gle.cts how pa.yoffs cova.ry with e.conom.ic s.ta.te.s A.s a.re.s.ult, ra.tings cre.a.te a wide window within which s.e.curitie.s of a give.n ra.ting ca.n ha.ve.m.a.rke.dly diffe.re.nt yie.lds A.nd a.lthough this ha.s his.torica.lly not be.e.n a m.a.jor is.s.ue in the.s.ingle.-na.m.e m.a.rke.t, with m.os.t corpora.te bonds ha.ving s.im.ila.r s.ys.te.m.a.tic ris.k e.xpos.ure.s.(Fa.m.a & Fre.nch, 1993), a.s we dis.cus.s.e.d a.bove a.nd will de.m.ons.tra.te be.low, s.tructure.dfina.nce cre.a.te.s la.rge dis.tortions in s.e.curitie.s.’ s.ys.te.m.a.tic ris.k e.xpos.ure.s re.la.tive tos.im.ila.rly-ra.te.d s.ingle corpora.te bonds

A s.e.cond criticis.m of cre.dit ra.tings tha.t ha.s be.e.n a.round a.lm.os.t a.s long a.s ra.tings.the.m.s.e.lve.s is tha.t the.y a.re s.om.e.thing of a “s.ide.s.how” whe.n it com.e.s to pricing a.ndpe.rha.ps e.ve.n ris.k a.s.s.e.s.s.m.e.nt its.e.lf In fa.ct, e.ve.n a.t the tim.e tha.t the US S.e.curitie.s a.ndE.xcha.nge Com.m.is.s.ion gra.nte.d the ra.ting a.ge.ncie.s the.ir s.pe.cia.l de.s.igna.tion of Na.tiona.llyRe.cognize.d S.ta.tis.tica.l Ra.ting Orga.niza.tion (NRS.RO) the.re wa.s conce.rn ove.r the de.a.rth

of e.vide.nce tha.t the.y we.re e.ffe.ctive (Grie.r & Ka.tz, 1976) S.ince the.n, la.rge lite.ra.ture.s.e.m.e.rge.d tha.t e.xa.m.ine the e.xte.nt to which cre.dit ra.tings conta.in inform.a.tion not a.lre.a.dyincorpora.te.d in s.tock a.nd bond price.s (Hite & Wa.rga., 1997) A.s a whole., the e.vide.nce.pa.ints a.t be.s.t a m.ixe.d picture of the va.lue of ra.tings For e.xa.m.ple., s.pre.a.ds on cre.ditde.fa.ult s.wa.ps re.a.ct m.ode.s.tly to ra.tings a.ctivity (Hull & Pre.de.s.cu a.nd White., 2004) a.ndcre.dit ra.tings do not s.e.e.m to include m.uch inform.a.tion tha.t is he.lpful in pre.dictingde.fa.ult be.yond tha.t which is a.lre.a.dy conta.ine.d in yie.ld s.pre.a.ds Inde.e.d, the be.s.t m.ode.ls

of de.fa.ult like.lihood a.re option-ba.s.e.d m.ode.ls tha.t a.re drive.n by s.tock price.s (Bha.ra.th a.ndS.hum.wa.y, 2007)

A third conce.rn e.m.e.rge.d during inve.s.tiga.tions of the colla.ps.e of E.nron – the la.ck oftra.ns.pa.re.ncy in the ra.tings proce.s.s M.a.ny re.gula.tors a.nd is.s.ue.rs a.rgue.d tha.t incre.a.s.e.dtra.ns.pa.re.ncy would a.llow for gre.a.te.r public s.crutiny of the a.ctivitie.s of ra.te.d com.pa.nie.s.a.nd re.duce the pote.ntia.l for conflicts of inte.re.s.t a.nd the us.e of fra.udule.nt a.ccountingpra.ctice.s This re.s.ulte.d in a.n e.nvironm.e.nt in which is.s.ue.rs de.s.igning com.ple.x s.e.curitie.s.ha.d a.n e.xce.lle.nt ide.a of wha.t m.ode.ls a.nd m.e.thods the ra.ting a.ge.ncie.s would us.e tode.te.rm.ine the.ir ra.tings A.nd, of cours.e., this pla.ce.d a he.a.vy burde.n on the ra.ting a.ge.ncie.s

to a.void a.ny m.is.ta.ke.s in the.ir proce.s.s tha.t could be ide.ntifie.d a.nd e.xploite.d by s.a.vvyis.s.ue.rs

A fina.l conce.rn is the pos.s.ibility of conflicts of inte.re.s.t tha.t m.a.y a.ris.e be.ca.us.e the is.s.ue.rra.the.r tha.n the inve.s.tor pa.ys for the ra.ting M.a.s.on a.nd Ros.ne.r (2007) a.rgue tha.t the.proce.s.s of cre.a.ting s.tructure.d fina.nce products re.quire.s ra.ting a.ge.ncie.s to e.s.s.e.ntia.lly

“be.com.e pa.rt of the unde.rwriting te.a.m.,” cre.a.ting la.rge conflicts a.nd producing little.tra.ns.pa.re.ncy for the e.nd inve.s.tor The Com.m.itte.e on the Globa.l Fina.ncia.l S.ys.te.m from.the Ba.nk of Inte.rna.tiona.l S.e.ttle.m.e.nts (BIS.) inve.s.tiga.te.d this conce.rn in 2005, a.ndconclude.d tha.t this pote.ntia.l proble.m wa.s no m.ore s.e.ve.re for s.tructure.d fina.nce products.tha.n for s.ingle.-na.m.e cre.dit products., a.rguing tha.t re.puta.tion wa.s a s.trong force a.ga.ins.tba.d be.ha.vior in both m.a.rke.ts “In fa.ct, the.re a.ppe.a.r to be no funda.m.e.nta.l diffe.re.nce.s inthe ra.ting proce.s.s.e.s for s.tructure.d fina.nce products a.nd tra.ditiona.l bonds The pote.ntia.lconflicts of inte.re.s.t a.ris.ing in s.tructure.d fina.nce a.re thus unlike.ly to be m.a.te.ria.llydiffe.re.nt from thos.e in the tra.ditiona.l s.e.gm.e.nts of the a.ge.ncie.s.’ bus.ine.s.s.”

With the re.ce.nt e.m.e.rge.nce of s.tructure.d fina.nce in inte.rna.tiona.l ca.pita.l m.a.rke.ts., the role.a.nd im.porta.nce of cre.dit ra.ting a.ge.ncie.s e.xpa.nde.d dra.m.a.tica.lly Be.ca.us.e s.tructure.dfina.nce typica.lly e.nta.ils s.e.curitiza.tions of cre.dit s.e.curitie.s (bonds., loa.ns., m.ortga.ge.s.),which a.re the.m.s.e.lve.s ofte.n ra.te.d, the cre.dit ra.ting a.ge.ncie.s we.re na.tura.lly ca.lle.d upon tora.te the de.riva.tive s.e.curitie.s Inde.e.d, is.s.ue.rs we.re e.a.ge.r to ha.ve the.ir ne.w products ra.te.d

on the s.a.m.e s.ca.le a.s bonds s.o tha.t inve.s.tors s.ubje.ct to ra.tings.-ba.s.e.d cons.tra.ints by the.irinve.s.tm.e.nt m.a.nda.te.s would be a.ble to purcha.s.e the s.e.curitie.s By ha.ving the s.e.curitie.s.ra.te.d, the is.s.ue.rs cre.a.te.d a.n illus.ion of com.pa.ra.bility to e.xis.ting s.ingle.-na.m.e s.e.curitywhich na.tura.lly incre.a.s.e.d the pool of pote.ntia.l buye.rs for wha.t othe.rwis.e would ha.ve.be.e.n pe.rce.ive.d a.s ve.ry com.ple.x s.e.curitie.s

Ra.ting s.tructure.d s.e.curitie.s be.ca.m.e a big pa.rt of ra.ting a.ge.ncie.s.’ bus.ine.s.s., a.nd nowa.ccounts a.s m.uch re.ve.nue a.s the.ir tra.ditiona.l ra.ting of s.ingle.-na.m.e s.e.curitie.s A.ccording

to M.oody’s Corpora.tion, 32% of the.ir 2006 re.ve.nue.s ca.m.e from ra.ting corpora.te bonds.,while 44% of the.ir re.ve.nue.s ca.m.e from ra.ting s.tructure.d fina.nce products This fa.ct is

pa.rticula.rly im.pre.s.s.ive in the conte.xt of the re.la.tive a.m.ount of tim.e it took to de.ve.lope.a.ch re.ve.nue s.ource.: ra.ting a.ge.ncie.s ha.ve e.s.s.e.ntia.lly a de.ca.de.’s e.xpe.rie.nce ra.tings.tructure.d fina.nce products whe.re.a.s the.y built the.ir s.ingle.-na.m.e ra.ting bus.ine.s.s ove.r the.pa.s.t ce.ntury

1.2.3 The credit rating market on the eve of the recent crises

The CRA ra.te de.bt s.e.curitie.s by gove.rnm.e.nts a.nd corpora.te a.nd a.ls.o s.tructure.d fina.nce.obliga.tions A cre.dit ra.ting is opinion of the CRA a.bout the cre.ditworthine.s.s of a.nobligor with re.s.pe.ct to a pa.rticula.r de.bt s.e.curity or othe.r fina.ncia.l obliga.tion Cre.ditra.tings ha.ve four functions.:

 Re.s.olving inform.a.tion a.s.ym.m.e.try be.twe.e.n is.s.ue.rs a.nd inve.s.tors by m.e.a.s.uring the.cre.dit ris.k of the is.s.ue.r obje.ctive.ly,

 incre.a.s.ing e.fficie.ncy a.nd functioning of fina.ncia.l m.a.rke.ts.,

 providing a m.e.a.ns of com.pa.ris.on for a.ll is.s.ue.s of e.m.be.dde.d cre.dit ris.k a.ndproviding a cons.is.te.nt globa.l ra.ting s.ca.le to he.lp build a portfolio,

 providing m.a.rke.t pa.rticipa.nts with a com.m.on s.ta.nda.rd or la.ngua.ge to re.fe.r tocre.dit ris.k

Cre.dit ra.tings a.s.s.igne.d to s.e.curitie.s indica.te the ris.k le.ve.l of the unde.rlying s.e.curitie.s The.re.fore cre.dit ra.ting is a.ls.o a.n im.porta.nt de.te.rm.ina.nt of inte.re.s.t ra.te.s whichgove.rnm.e.nts., corpora.te.s., ba.nks a.nd ins.ura.nce com.pa.nie.s fa.ce in the fina.ncia.l m.a.rke.ts.(A.fons.o e.t a.l., 2007) S.ince gove.rnm.e.nts a.nd corpora.te.s with lowe.r cre.dit ra.ting ha.ve.m.ore ris.k pre.m.ium., the.y borrow from highe.r inte.re.s.t ra.te.s re.la.tive to the one.s withhighe.r cre.dit ra.tings Cre.dit ra.tings a.ls.o e.na.ble or dis.a.ble gove.rnm.e.nts a.nd corpora.te.s toa.cce.s.s to inte.rna.tiona.l fina.ncia.l m.a.rke.ts be.ca.us.e of na.tiona.l re.gula.tions which prohibitinve.s.ting in de.bt s.e.curitie.s with s.pe.cula.tive gra.de (E.lkhoury, 2008)

The.re ha.ve be.e.n m.ore tha.n 150 CRA on na.tiona.l, re.giona.l or globa.l s.ize a.ll ove.r the.world But the s.ha.re of m.a.jor CRA., na.m.e.ly M.oody’s., S.ta.nda.rd a.nd Poor’s (S.&P) a.nd

Fitch in cre.dit ra.ting m.a.rke.t is a.bout 94% (OE.CD, 2010) The s.ha.re of S.&P, M.oody’s.a.nd Fitch in cre.dit ra.ting m.a.rke.t re.s.pe.ctive.ly is 40%, 39% a.nd 15% (Iva a.nd Vuka.šin,2010) The.re.fore the cre.dit ra.ting m.a.rke.t a.ls.o ha.s ha.d a.n oligopolis.tic m.a.rke.t s.tructure The.re we.re two m.a.jor ca.us.e.s of this oligopolis.tic s.tructure Firs.tly re.gula.tions e.s.pe.cia.lly

in the US lim.ite.d the ne.w CRA.’s e.ntrie.s to the cre.dit ra.ting m.a.rke.t Be.ca.us.e the.S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion (S.E.C) de.s.igna.te.d M.oody’s., S.&P, a.nd Fitch a.s.Na.tiona.lly Re.cognize.d S.ta.tis.tica.l Ra.ting Orga.niza.tions (NRS.ROs.) a.nd NRS.ROde.s.igna.tion be.ca.m.e a s.ignifica.nt ba.rrie.r to e.ntry into the bond-ra.ting bus.ine.s.s for a longtim.e a.nd only the.s.e thre.e firm.s ope.ra.te.d a.s NRS.ROs until 2000 S.e.condly a s.trongre.puta.tion is ne.ce.s.s.a.ry to ope.ra.te in the cre.dit ra.ting m.a.rke.t Be.ca.us.e S.&P, M.oody’s a.ndFitch ha.ve e.xis.te.d in the indus.try for a long tim.e a.nd this m.a.de ne.w com.pa.nie.s with le.s.s.e.xpe.rie.nce difficult to e.nte.r the cre.dit ra.ting m.a.rke.t (White., 2001) The oligopolis.tics.tructure of the cre.dit ra.ting m.a.rke.t e.na.ble.d the CRA.s to ta.ke a.dva.nta.ge of the m.a.rke.tpowe.r a.nd a.ls.o pre.ve.nte.d the e.fficie.ntly functioning of the cre.dit ra.ting m.a.rke.t

CRA us.e.d inve.s.tor-pa.ys m.ode.l until 1970s In this m.ode.l cre.dit ra.tings we.re provide.dfre.e of cha.rge to is.s.ue.rs., a.nd s.old to inve.s.tors for a fe.e CRA be.ga.n to us.e is.s.ue.r-pa.ys.m.ode.l from the US re.ce.s.s.ion of e.a.rly 1970s to the pre.s.e.nt In this m.ode.l, is.s.ue.rs whos.e.s.e.curitie.s the CRA ra.te pa.y for a ra.ting A.lthough inve.s.tor-pa.ys m.ode.l e.na.ble.d the CRA

to be inde.pe.nde.nce from the is.s.ue.r be.ing ra.te.d, it did not provide s.ufficie.nt re.ve.nue forthe CRA Cons.e.que.ntly CRA pa.s.s.e.d to the is.s.ue.r-pa.ys pricing m.ode.l Thus the CRA.be.ga.n to be de.pe.nde.nt on is.s.ue.rs On the othe.r ha.nd the cre.dit ra.tings we.re us.e.d a.s.re.gula.tory purpos.e.s e.s.pe.cia.lly by the US public a.uthoritie.s a.nd this ca.us.e.d the CRA toga.in re.gula.tory s.ta.tus., thus fina.ncia.l ins.titutions a.nd inve.s.tors thus be.ca.m.e ove.rde.pe.nde.nt on CRA

Cons.e.que.ntly a m.utua.l inte.rde.pe.nde.nce s.urfa.ce.d a.m.ong the CRA., s.e.curity is.s.ue.rs a.ndinve.s.tors The CRA ha.ve a.n ince.ntive to ove.rra.te the cre.dibility of the de.btors for notlos.ing pre.s.e.nt clie.nts a.nd a.ls.o a.ttra.cting m.ore clie.nts (Ra.fa.ilov, 2011), but the CRA.fa.ce.d little or no ris.k of los.s from ina.ccura.te ra.tings., while the pote.ntia.l ga.ins from

ina.ccura.te ra.tings incre.a.s.e.d ove.r tim.e (Pa.rtnoy, 2009) S.e.curity is.s.ue.rs ne.e.de.d highcre.dit ra.tings in orde.r to cre.a.te a.nd s.e.ll the com.ple.x fina.ncia.l ins.trum.e.nts S.ince the.ins.titutiona.l a.nd individua.l inve.s.tors could not m.a.ke va.lua.tion a.bout the ris.kine.s.s of ne.wcom.ple.x s.e.curitize.d a.s.s.e.ts toge.the.r with la.ck of tra.ns.pa.re.ncy, the.y re.lie.d on the cre.ditra.tings without a.ny que.s.tioning (Hull, 2010).

The CRA provide.d ra.ting a.nd cons.ulting s.e.rvice.s s.im.ulta.ne.ous.ly be.fore the re.ce.nt cris.e.s S.o conflicts of inte.re.s.t a.ros.e whe.n the CRA.s offe.re.d cons.ulting or othe.r a.dvis.orys.e.rvice.s to the is.s.ue.rs the.y ra.te.d (Ra.fa.ilov, 2011) This m.e.a.nt tha.t the CRA firs.tly toldis.s.ue.rs wha.t the.y did a.nd the.n the.y ra.te.d the is.s.ue.rs in que.s.tion This s.itua.tion a.ls.ocontribute.d to e.m.e.rge.nce of conflicts of inte.re.s.t in the cre.dit ra.ting m.a.rke.t Cre.dit ra.ting

is a bila.te.ra.l proce.s.s which the CRA de.te.rm.ine ra.tings ba.s.e.d on the inform.a.tion provide.dvolunta.rily by the is.s.ue.rs Howe.ve.r the CRA do not ha.ve powe.r to e.ns.ure a.nd e.xa.m.ine.the inform.a.tion a.nd the.y ca.nnot re.quire a.ny a.dditiona.l inform.a.tion by force (Ra.fa.ilov,2011) S.o the.re is a ris.k tha.t the is.s.ue.r ca.n conce.a.l or m.a.nipula.te inform.a.tion

The CRA firs.tly ra.te.d the tra.ditiona.l de.bt ins.trum.e.nts but la.te.r the.y de.pa.rte.d from the.irtra.ditiona.l bus.ine.s.s by be.ginning to incre.a.s.ingly ra.te s.tructure.d fina.nce a.nd ne.w com.ple.xde.bt products., pa.rticula.rly cre.dit de.riva.tive.s a.nd be.ga.n to us.e com.ple.x s.ta.tis.tica.l ra.tings.tools in orde.r to ga.uge cre.dit ris.k (Pa.rtnoy, 2006) The ra.tings of the s.tructure.d fina.nce.s.e.curitie.s fa.ile.d to re.fle.ct the cre.ditworthine.s.s of the s.e.curity be.ing ra.te.d due to fa.ultyda.ta., fla.we.d a.s.s.um.ptions of the m.ode.l a.nd the tra.nche.d s.tructure of the CDO(Colla.te.ra.lize.d De.bt Obliga.tion) s.e.curitie.s (Pa.rtnoy, 2006)

1.2.4 Criticism of credit rating agencies

His.torica.lly, the a.ctivitie.s of cre.dit ra.ting a.ge.ncie.s ha.d be.e.n confine.d

to the corpora.te fina.nce m.a.rke.t, whe.re the.y would a.s.s.e.s a s.e.curity’s.qua.lity on the ba.s.is of e.s.tim.a.te.s of its a.nticipa.te.d ca.s.h flows – its.like.lihood of de.fa.ult a.nd its e.xpe.cte.d los.s in the e.ve.nt of de.fa.ult Fora.n individua.l firm., the two prim.a.ry cons.ide.ra.tions in cre.dit ris.k

a.s.s.e.s.s.m.e.nt a.re the vola.tility of firm ca.s.h flows a.nd the le.ve.l ofouts.ta.nding de.bt (M.e.rton, 1974) Im.porta.ntly, the pre.cis.e s.ource ofris.k in the firm.’s ca.s.h flows – be it firm.-s.pe.cific, indus.try-wide or from.the e.conom.y a.t la.rge – is irre.le.va.nt for de.te.rm.ining the ultim.a.te.ra.ting This is nota.ble for two re.a.s.ons Firs.t, the s.ource of the ris.kde.te.rm.ine.s the le.ve.l of dive.rs.ifica.tion tha.t ca.n be a.tta.ine.d in la.rge.s.e.curitiza.tions which unde.rlie s.tructure.d ins.trum.e.nts A.nd, s.e.cond,unde.rs.ta.nding the na.ture of the ris.k is crucia.l for the purpos.e ofde.te.rm.ining a.n a.s.s.e.t’s va.lue., a.s inve.s.tors will de.m.a.nd la.rge pre.m.ia.for e.xpos.ure to s.ys.te.m.a.tic ris.ks

Be.ca.us.e s.tructure.d products s.uch a.s m.ortga.ge.s a.re e.s.s.e.ntia.llyde.riva.tive.s writte.n on la.rge portfolios of cre.dit-s.e.ns.itive ins.trum.e.nts.,e.s.tim.a.ting ca.s.h flows a.nd a.s.s.igning ra.tings for s.tructure.d products.be.com.e.s fa.r m.ore com.plica.te.d A.s.ide from a.s.s.igning a proba.bility ofde.fa.ult for the individua.l s.e.curitie.s in the unde.rlying portfolio, the.cre.dit ra.ting a.ge.ncie.s a.re force.d to ta.ke a s.ta.nd on the joint like.lihood

of m.ultiple de.fa.ults In e.ffe.ct, in orde.r to a.s.s.ign a ra.ting to a m.ortga.ge.the ra.ting a.ge.ncy ha.s to be a.ble to m.ode.l the e.ntire portfolio los.s.dis.tribution, or e.quiva.le.ntly, the de.pe.nde.nce s.tructure of de.fa.ults (e g.corre.la.tion) This ha.s force.d ra.ting a.ge.ncie.s to ta.ke vie.ws on the.a.m.ount of s.ys.te.m.a.tic (or undive.rs.ifia.ble.) ris.ks inhe.re.nt in va.rious.unde.rlying a.s.s.e.ts By s.te.pping into this ne.w m.a.rke.t, the cre.dit ra.tinga.ge.ncie.s we.re re.quire.d to de.ve.lop ne.w ca.pa.bilitie.s re.la.te.d to the.e.s.tim.a.tion of de.fa.ult corre.la.tion, with which the.y ha.d little priore.xpe.rie.nce

The s.ys.te.m.a.tic ris.k e.xpos.ure.s of s.tructure.d fina.nce products give ris.e

to a s.e.cond, a.nd pote.ntia.lly m.ore proble.m.a.tic, dis.tinction vis.-à-vis.s.ingle.-na.m.e cre.dit s.e.curitie.s Be.ca.us.e the pa.yoffs of s.tructure.d