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The Financial and economic catastrophe 2007 - ...

Something is foul in the current system of credit rating agencies


NRSRO Nationally-Recognized Statistical Ratings Organization (USA)
SEC Securities and Exchange Commission (US national financial market regulator)
securities Debt papers, bonds, stocks, shares, banknotes, ...
sovereign debt Debt of countries. Sovereign credit ratings take into account the overall economic conditions of a country, and the political conditions

Origins of the dominant players

Today three US companies dominate (to 85%) the market for credit ratings. This is called an oligopoly:

- Standard and Poor's:
A forerunner of securities analysis and reporting was the publication of "History of Railroads and Canals in the US", from 1860. Standards Statistics was formed 1906 to publish corporate bond, sovereign debt and municipal bond ratings. In 1941 Standard and Poor's merged. In 1966 the agency was purchased by McGraw Hill.

- Fitch:
Founded 1913 to publish financial statistics. In 1924 Fitch introduced the rating code AAA through D. This became the industry standard. In the 1990s Fitch merged with UK and French companies, and expanded by further acquisitions into the 2000s.

- Moody's:
From 1900 Moody's published a manual on basic statistics and general information about stocks and bonds. From 1909 added a publication on the value of securities. 1914-1924 Moody's expanded into ratings for government bonds, and by the 1970s began rating commercial papers.

Change of the business model from 1970

Previously, investors subscribed to the agencies publications, and the securities issuers paid no fees for their papers to appear in those publications.
From now on, the agencies began to charge issuers of securities fees for the service.

Registration of agencies with the (US) financial market regulator SEC from 1975

By accepting certain supervision conditions, agencies could register with the SEC. The greater trust bestowed on these agencies means that financial institutes (banks etc) could satisfy their capital requirements more easily with securities that were favourably rated by a registered agency (NRSRO).

The SEC now began explicitly using (registered) rating agencies' statements to define the creditworthiness for various purposes under the federal securities laws.
Over time the NRSRO concept was incorporated into a number of SEC regulations including those from securities/investment laws of 1933, 1934, 1940. Congress also began using the NRSRO concept in legislation, as did other (not only US) banking regulatory bodies.
From now credit rating agencies had a double character : they were (and are) private companies with a regulation mandate.

Expansion of (US) regulatory supervision of credit rating agencies in 2006

In 2006 a Rating Agency (Reform) Act was passed to give the SEC greater (statutary) power to supervise the activities of NRSROs, with the goal of more protection for investors.
In particular, the SEC is to watch over
1. the possibility of conflicts of interest, and the maintenance and management of independence between the agencies on the one side, and the issuers and underwriters of securities being rated on the other side,
2. (general) procedures and methods, and performance measurement statistics,
3. external and internal communications of NRSROs relating to credit ratings.

The sudden downward jumps in ratings after the 2007 US subprime mortgage crisis had begun brought sharp criticism of the rating system.

The situation today

A before-after view of the financial crisis reveals that 93% (!) of top-rated (AAA) subprime mortgage-backed securities issued in 2006 have since been downgraded to junk status. [9]
This is the result of
1. the statistical model used in the ratings being faulty or too restricted (methodical shortcoming), and/or
2. a fundamental fault in the business model, whereby securities issuers choose the rating agency that promises the most favourable rating (conflict of interest).

Yet neither the 2006 Rating Agency Reform, nor the rating debacle at the beginning of the financial crisis have had any major effect on the enormous authority given to S&P, Moody's and Fitch by governments, central banks and regulators.
The US Congress is obviously not prepared to undertake a major reform of the rating system. It appears that politicians are afraid of 'rocking the boat' because the system is ingrained in so much legislature. However, “if the dysfunctional regulatory structure stays put, the rating agencies soon will be back to business as usual, which will mean a continuing monopoly and sky-high operating margins approaching 50 percent”. [6]
Quite apart from the cosmetic efforts by the Congress, one can ask: why the SEC has been inactive regarding the (glaring) conflict of interest problem of the business model, despite being empowered by the Ratings Act of 2006 to do something about it.

If the Congress were to overcome its paralysis, possible solutions could be:
1. creation of a fee-financed, independent credit rating agency, or
2. removal of the special status of these ratings to make them less important.

A couple of comments on the current credit rating system

Concerning the rating system in general, Mr. Macey of Yale Law School said:
"The ratings system as it currently stands encourages bubbles. You have to ask yourself this question, in any matter of financial reform: Does the change increase the chances of lemming-like behavior? Because that is the root of all great busts. The price of tulips doesn’t soar because a newspaper says that tulips are undervalued. It soars because everyone is buying them. And that’s the problem with ratings. They turn investors into lemmings". [6]

Concerning the rating of sovereign debt (rating of the debt of entire countries), Robert Preston of the BBC meant:
"It doesn't feel democratic or sustainable that the fiscal fate of nations and currency zones - and indeed the perceived strength of the financial system - rests on the analytical verdict of three private-sector research firms, the financial record of which has in recent years not been unblemished". [11]

After the dust that was stirred by the recent S&P downgrading of the Greece debt has begun to settle, ideas are being voiced concerning the creation of a European rating agency. Hopefully the faults of the US system will not be repeated.


[1] MPRA UniMuenchen (pdf) Draft "Sovereign Credit Ratings Before and After Financial Crises", IMF, 26.10.2001

[2] FPF (pdf) "Credit Rating Agencies: Their Impact on Capital Flows to Developing Countries", Financial Policy Forum Report, Apr 2003

[3] IOSCO (pdf) "Code of Conduct Fundamentals for Credit Rating Agencies", Internat. Organization of Securities Commissions, Dec 2004

[4] SEC "Testimony before the U.S. Senate: The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets", 26.09.2007

[5] SSRN "Non-U.S. Asset-Backed Securities: Spread Determinants and Over-Reliance on Credit Ratings", Yale ICF Working Paper 30.06.2009

[6] NY Times "Debt Raters Avoid Overhaul After Crisis", 07.12.2009

[7] NY Times "Documents Show Internal Qualms at Rating Agencies", 22.04.2009

[8] NY Times "Former Employees Criticize Culture of Rating Firms", 23.04.2009

[9] NY Times "Berating the Raters", 25.04.2009

[10] NY Times "Ratings Agencies Are Overrated", 28.04.2010

[11] BBC "Rating agencies: Who made them so powerful?", 29.04.2010