ip2023final

Gregory Kenter29/04/2015

IP2023Assessing the Blame of the Credit Rating Agencies in the Financial Crisis

Introduction

In the financial world, progress is largely determined by the quality of information

obtained by a specific party. Plans are formulated around various streams of intuition,

evidence, and other sources of intelligence to take advantage of lucrative investment

opportunities and to fundamentally create low-risk scenarios with the loaning of money.

The information is a vital component in the valuing of an asset, and in finance, investment

opportunities are only as valuable as people are led to believe that they are. However,

investors will not utilize just any report claiming that their money is safe – they need official

appraisals and proven experts to review their prospective moves and give a

recommendation based on their findings. These services are the primary function of credit

rating agencies, private institutions that provide their professional insight and opinions on

various investment situations. Their work assists investors of all levels in helping them

determine what are appropriate and safe ways to allocate wealth in opportunities all over

the world. Essentially, they issue a professional stamp of approval in the investment world.

Through this institutional framework, it would then seem that it would be in the

agencies’ best interest to provide complete and accurate reports as well as untarnished data

to the investing public, who, prior to the financial crisis, took the word of these companies

as the proverbial word of God. The common investor, disadvantaged by his access to

limited information, must, in essence, blindly trust the expertise of the credit rating agencies

when they want to invest. In the financial meltdown, that sense of trust was grossly abused

by the inherent conflicts of interest that drove the credit rating agencies to conduct

business irresponsibly and unfairly. But as investigations have shown, their shortcomings

were not solely highlighted before the crisis. There are plenty of indications that the credit

rating agencies have made it increasingly difficult for the recession to be corrected after its

unravelling. This paper will provide appropriate context in understanding the motivations

for the business of credit rating agencies as well as insight into their faults during and after

the financial crisis.


IP2023Functionality and Context

Credit rating agencies exist as a way to “assess the creditworthiness of bond issuers

– companies or countries who borrow money by issuing IOUs known as bonds.” (Marston,

2014) When a loan is made from one party to another, a credit agency’s job is to determine

how risky a loan is of not returning to the lender, or what is called ‘defaulting on a loan’. In

determining this riskiness, there are a series of possible rankings that a major agency can

bestow upon a particular investment situation. The highest of the grades, AAA, signifies “an

extremely strong capacity to meet financial commitments…[that exist] within a universe of

credit risk,” meaning essentially that there is no such thing as a zero-percent risk of

defaulting, but the chances of that investment doing so are still considerably low (Wearden,

2011). Typically, there are only a handful of AAA ratings in principle that should be given

out to large-scale entities. For example, there are a select handful of countries that

correspond to AAA-rated sovereign debt consistent with the rating agencies, such as

Denmark, France, Germany, Singapore, and the United States (Wearden, 2011). Each

country exhibits, in theory, stable markets, low-risk financial transactions, and developed

infrastructure. For many investor groups such as retirement funds, insurance companies,

and banks, it was typically “forbidden to purchase securities with a lower rating than BBB as

determined by recognized rating agencies” (Vukovic, 2011). Therefore, in order for

investment banks to purchase and sell more securities as collateralized debt obligations or

bet against using the credit default swap framework, the credit rating agencies were very

quick to issue out significantly high amounts of optimal ratings. From the beginning of the

decade to the start of the crisis in 2007, the amount of these top-rated securities nearly

doubled, representing hundreds of billions of dollars being approved as the safest

investment grade possible (Ferguson, 2010).

One issue that inevitably rises from this framework is the determining of which

institutions are qualified to make these ratings. In 1975, the SEC “gave oligopoly status to

three rating agencies in the United States. Standard and Poor’s, Moody’s, and Fitch became

the only agencies that had the right to give out official ratings to various market securities”

(Vukovic, 2011). This was also the birth of a new business classification, called “Nationally

Recognized Statistical Rating Organizations” – also known as NRSRO’s – which were meant

to eliminate any tampering of the true value of investment opportunities (Marston, 2014).


IP2023As a consequence, these companies were “able to enjoy special status in the law”, operate

with little-to-no regulation of their work, and conduct business within a monopolistic market

structure (Zhang, Xing, 2012). This would eventually lead these agencies to continue their

surges of high ratings, and, combined with the majority of the private shares of these

businesses being owned by major financial institutions, these businesses seem to have been

operating on an agenda. Other competitors, based on this monopolistic market structure,

were not able to enter into fair competition environments, which gave the Big Three free

reign to set the ratings they each saw fit.

The simplest explanation for this unprecedented rise in AAA ratings seems to lie

within the way these agencies make money themselves. According to hedge fund manager

Bill Ackman, the rating agencies would receive higher compensation based on the overall

amount of ratings reports distributed, particularly ones that garnered favourable reviews of

the assets discussed. This dynamic led to massive increases in the profits of the “Big Three”.

Moody’s recorded a quadrupling of earnings from 2000 to 2007, catapulting from less than

one billion to well over two billion, with the other two agencies following similar trajectories

(Ferguson, 2010). What is even more conflicting than the firms’ method of compensation,

however, is the apparent conflict of interest in each company’s stockholder community.

According to recent shareholder reports, JP Morgan owns “5.2% of shares in Fitch’s parent

company, Fimalac; Morgan Stanley owns 2.27% of Moody’s shares; and State Street owns

both 4.28% of McGraw-Hill Shares (McGraw-Hill is S&P’s parent company) and 3.3% of

Moody’s shares.” (Fraser, 2011). To own such large proportions of stock in companies that

basically rate their own performance is considered to a significant breach in professionalism

and, for lack of a better term, cheating the system.

Collapse and Drastic Revaluation

One would logically assume that in the months leading up to the crisis, the writing

was on the wall for many of the institutions that would soon implode, and the ratings given

by the Big Three would accurately convey this. Sadly this was not the case, and the Big

Three continued to cultivate a charade of just the opposite. In order to portray an attractive

forecast to the investor public as well as keep profits at high levels, there were hardly any

indications from the agencies that the major firms were in serious trouble. In fact, by the


IP2023time the major financial institutions were on the brink of collapse, many of them were still

rated with solid investment grades. Jerome Fons, a former managing director of Moody’s,

claims that many of the largest firms on Wall Street were rated as high as AAA up until the

days leading up to their collapse. “Bear Sterns [and Lehman Brothers were] rated A2 within

days of failing, AIG was AA within days of being bailed out, and Fannie Mae and Freddie Mac

were both AAA-rated when they were rescued by the government” (Ferguson, 2010). But as

the housing bubble burst and the cards began to fall in the mortgage-backed security

market, the credit rating agencies could no longer hide the hollow nature of their reports

and were forced to massively condemn the very investment opportunities that were

considered top-tier, all at the same time. The results of this eventuality were catastrophic,

and it is believed that this After a US Senate investigation, it was determined by

investigation leaders Carl Levin and Tom Coburn that “perhaps more than any other single

event, the sudden mass downgrades of residential mortgage-backed securities and

collateralized debt obligation ratings were the immediate trigger for the financial crisis.”

(Younglai, Lynch, 2011).

Such drastic errors in judgement beg the question of whether these agencies were

deliberately trying to mislead the investor public or they were just simply incompetent in

their jobs. According to the Senate report, it seemed that the answer was both – internal

documents circulated amongst Moody’s and S&P employees showed continued concerns

regarding the dangers of the mortgage market, and “failed to heed their own warnings.”

Ironically, if the agencies had listened to their own professional expertise, they would have

“issued more conservative ratings [connected to] shoddy mortgages” but instead “had no

financial incentive to assign tougher ratings to the very securities that, for a short while,

increased their own revenues, boosted stock prices, and expanded their executive

compensation” (Younglai, Lynch, 2011). This report essentially revealed the sad truth of

these companies – they had an opportunity to stop this kind of shady business and decided

to look the other way for higher profits. They proved to be too incompetent to understand

the ripple effects of their actions in the long term and decided to vie for short-term gains at

the cost of billions of dollars spent on subprime investments.


IP2023Post-Crisis Fallout

Even more infuriating in the eyes of many is the underwhelming aftermath of the

collapse. The credit rating agencies, by definition, provide their expert “opinions” when

they submit their reports and evaluations, and they have maintained this framework during

numerous testimonies and congressional investigations. This defence is an automatic

failsafe, which “protects the credit rating agencies from being sued due to wrong or

misjudged ratings as they are protected under the First Amendment of the US Constitution”

(Vukovic, 2011). Frank Partnoy, a professor of law and finance at the University of California

at San Diego, has testified before the Senate and the House of Representatives on the faults

of the credit rating agency. “Both times [Partnoy testified in front of congress] the agencies

trot out prominent First Amendment lawyers,” he claims, “and they argue that when [the

agencies] say something is rated AAA, it is merely an opinion – [the investor] shouldn’t rely

on it.” The agency representatives continue to use this point to their advantage, and they

state that “their opinions do not speak to the market value of a security, the volatility of its

price, or its suitability as an investment” (Ferguson, 2010). This ‘opinionated dynamic’,

which some consider fundamentally flawed, has also been a driving force behind court

action. In February of 2013, Standard and Poor’s was taken to court by the Department of

Justice on grounds of fraud and financial deception. All too familiarly, the Department of

Justice claimed that Standard and Poor’s caused the “loss of billions of dollars on

collateralized debt obligations and residential mortgage-backed securities [due to] the

inflated ratings that misrepresented the securities’ true credit risks.” The lawsuit

additionally stated that Standard and Poor’s “falsely represented that its ratings were

objective, independent, and uninfluenced by relationships with investment banks”

(Kaufman, 2013).

Despite the defensive maneuvers of the agencies to uphold their claims of

opinionated (and therefore unchecked) assertions, the government’s findings became

increasingly transparent as time progressed. The credit rating industry became a major

scapegoat in the consequent forensic analysis of the crisis, and became a prominent

example of a business that would be primed to face significant changes. The most glaring

issue of the credit rating agency fiasco was the lack of real regulatory procedures, both

internally and externally, that would keep the companies from over-issuing top tier ratings.


IP2023This realization was one of the main points in the creation of the ‘Dodd-Frank Wall Street

Reform and Consumer Protection Act’, also referred to as the ‘Dodd-Frank Act’, a law passed

in 2008 that was meant to stimulate the regulation protocols of the major financial

institutions (Carbone, 2010). Under this law, the Securities and Exchange Commission, the

government agency primarily in charge of regulating the financial institutions of the country,

was given “stronger enforcement mechanisms, and [added] a number of requirements on

NRSRO’s that [were] immediately effective” (Securities and Exchange Commission, 2014).

The topics addressed in the act concerned annual reports on internal controls, conflicts of

interest in selling and marketing methods, accurate records of third party due diligence, and

the overall submission of generalized data and assumptions of credit ratings (Securities and

Exchange Commission, 2014). Unfortunately, the Dodd-Frank Act has faced little support to

help regulate this industry. The Department of Justice’s lawsuit was met with a request by

Standard and Poor’s to dismiss the suit altogether, and a proposed bill that would “prevent

the securities industry from shopping around among the credit rating agencies to get a

product’s initial rating” was promptly shot down in the proverbial “sausage machine that

makes laws in Washington” (Kaufman, 2013).

Conclusion

In retrospect, the credit rating agency problem needs to be thought of in three

sections – before, during, and after the crisis. In each of these periods, there were severe

and controversial policies implemented by the agencies that helped ignite, further amplify,

and sustain the effects of the financial recession. Before the implosion, credit rating

agencies were too quick to give out top tier ratings to investments that would be otherwise

considered subprime. This, combined with the financial ownership and compensation of the

agencies themselves, laid a foundation for irresponsible, risky loans and investments being

issued at record-breaking rates. The agencies were forced to relinquish their earlier ratings

when the situation became too drastic to ignore and massively downgrade previously

spotless prospects, which is now considered by many prominent government

representatives to be the single most important catalyst during the entire recession. And

after the worst years of the crisis had passed, the credit rating industry was called to answer

for their faulty reports, the major companies hid under the protection of the First

Amendment, giving them no real threat of punishment for shoddy performance.


IP2023So the question remains – how much blame do the credit rating agencies truly

deserve for the financial crisis? Considering the fact that this issue is merely a cog in a much

larger, more expansive scheme, one could make an argument that the NRSRO’s are

deserving of only a small portion of guilt. They, ultimately, were not the parties that pushed

for deregulation of derivative trades in Congress like Senator Phil Gramm, or guided

individual financial firms to create record numbers of collateralized debt obligations like

Merrill CEO Stan O’Neill, or abused the credit default swap market with insurance funds like

AIG executive Joe Cassano (Time, 2015). Without the credit rating agencies, however, none

of these other pieces would have gone forward with their risky business deals and impulsive

gambling with taxpayer dollars. They were one of the few groups of institutions that could

have stood up - not just with strong moral backing, but with cold, hard, facts – and brought

the mess to a halt before it spiralled out of control. They decided to keep functioning for

high profits and for the benefit of their own investor community. Even if they were simply

giving their ‘opinions’ on different assets, they failed to understand the magnitude of their

work in a long-term sense, and, according to the SEC, “may have encouraged investors to

place undue reliance on the credit ratings issued by those entities” (Kiviat, 2009). The entire

situation is an interesting insight into the notion that certain items are only as valuable as

people think they are, even the items themselves are worthless. The blame of the credit

rating agencies is strongest in this regard – they violated the economic trust of the investor

public in an obscene way and knowingly fooled millions into believing that certain

investment options were not simply solid choices, but the highest rated choices possible.

The bottom line of the credit rating agency issue is that there are very few entities that can

be trusted anymore. The information used to invest responsibly and carefully has been

deemed untrustworthy. This feeling of insecurity is unfortunate legacy that the credit rating

agencies have left in the wake of the recession, and it will no doubt be quite a long time

before this stigma goes away.


IP2023Works Cited

Carbone, Danielle. "The Impact of the Dodd-Frank Act’s Credit Rating Agency Reform on Public

Companies." Insights: The Corporate & Securities Law Advisor 24.9 (2010): Web. 25 Apr.

2015. <http://www.shearman.com/~/media/Files/NewsInsights/Publications/2010/09/The-

Impact-of-the-DoddFrank-Acts-Credit-Rating-A__/Files/View-full-article-The-Impact-of-the-

DoddFrank-Ac__/FileAttachment/CM022211InsightsCarbone.pdf>.

"Credit Rating Agencies - The Dodd-Frank Act." SEC.gov. Securities and Exchange Commission, 9 May

2014. Web. 27 Apr. 2015.

<http://www.sec.gov/spotlight/dodd-frank/creditratingagencies.shtml>.

Fraser, Mhairi. "US SEC Report Reveals Failings at Rating Agencies." ABI/INFORM Archive [ProQuest].

Purdue University, Nov. 2011. Web. 16 Apr. 2015.

<http://search.proquest.com.ezproxy.lib.purdue.edu/abiglobal/docview/

905919301/91403B1D37924856PQ/6?accountid=13360>.

Inside Job. Dir. Charles Ferguson. Sony Pictures Classics, 2010. DVD.

Kaufman, Ted. "Political Will Falters On Fixing Credit Ratings Agencies." Forbes. Forbes Magazine, 30

July 2013. Web. 27 Apr. 2015.

<http://www.forbes.com/sites/tedkaufman/2013/07/30/political-will-falters-on-fixing-

credit-ratings-agencies/>.

Lu, Zhang, and Xing Yanyan. "Brief Analysis on Conflicts of Interest of Credit Rating Agencies."

ABI/INFORM Archive [ProQuest]. Purdue University, 2012. Web. 16 Apr. 2015.


1038960544/220F2204726D4B8DPQ/1?accountid=13360>.

Marston, Rebecca. "What Is A Rating Agency?" BBC News. BBC, 20 Oct. 2014. Web. 10 Apr. 2015.

<http://www.bbc.com/news/10108284>.

Vukovic, Vuk. "Political Economy of the US Financial Crisis 2007-2009." ABI/INFORM [ProQuest].

Purdue University, 2011. Web. 16 Apr. 2015.


869134652/220F2204726D4B8DPQ/9?accountid=13360>.

Wearden, Graeme. "AAA Credit Ratings Explained." TheGuardian.com. The Guardian, 27 July 2011.

Web. 10 Apr. 2015. <http%3A%2F%2Fwww.theguardian.com%2Fbusiness%2F2011%2Fjul

%2F27%2Ftriple-aaa-credit-ratings-explained>.


IP2023"25 People to Blame for the Financial Crisis." TIME Magazine. Time, Inc., 2015. Web. 25 Apr. 2015.

<http://content.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877

339,00.html>.

ip2023final

Documents