Contribution of Credit Rating Agencies to the US Subprime Mortgage Crisis 2007-2009
Nowadays the contribution of Credit Rating Agencies (CRAs) to development of the US Sub-prime Mortgage Crisis is discussed widely. Is their role in creation of the sub-prime mess really significant?
CRAs are the intermediaries in advancement of securities on the market between the issuers and investors. CRA is a necessary link in a chain of life cycle of residential mortgage-backed securities (RMBSs) and collateralized debt obligations (CDOs). Their activity is based on, firstly, providing estimations of a security (ratings), issuing by firms and enterprises, secondly, rendering of consulting and advisory services.
The existence of CRAs is natural because of presence of great number of consumers that need CRAs' services. Enterprises and firms that are going to issue securities need to rate them for selling to investors. As higher rating helps to sell security faster and for a higher price, lower rating complicates such a deal. So, this is the reference point of conflicts of interest appearance (Rom, 2009).
There are different opinions about the basis of the CRA's ratings. First is based on the following: Strier (2008) argues that credit agencies are involved by issuers to estimate securities are going to be sold to the investors. In this case, suggesting valuable compensation, issuers simply carry out the purchase of the exceeding ratings.
“Unlike the smaller agencies, the Big Three - Standard & Poor's, Moody's, and Fitch - are paid almost all of their fees by the issuers of the bonds being evaluated… Simply put, the suspicion is that CDO issuers may have essentially bought their AAA ratings from the Big Three” (Strier, 2008).
Looking on this problem on the other hand, Rom (2009) argues that the main stimulus of CRAs activity is to keep their reputation of providing accurate, reliable and authentic (truthful) ratings of securities on the level, corresponding to inquiries of the market. Rom (2009) considers, that CRAs undertake numerous actions to avoid conflicts of interest.
“The CRAs also argued that, in order to protect against conflicts of interest, they have established appropriate policies and procedures (e.g., ratings were made by committees; fees were based on a fixed schedule; and analyst compensation was based on accuracy, not commission) to ensure that their ratings were independent and objective.
Moreover, they noted, individual issuers tend to be small, generating less than 1 percent of the CRAs' revenues, so that losing an issuer to a competitor CRA would have little impact on the bottom line” (Rom, 2009).
Rom (2009) also conform, that CRAs seem to be public organisations as their activity is equitable to public interests, but they are in a private property. In this case, for Securities and Exchange Commission (SEC) it is impossible to check the correctness and accuracy of the providing ratings to ensure, that credible ratings correspond to the validity.
“Moreover, an SEC review determined that none of the major CRAs had specific written procedures for rating RMBSs and CDOs. As a result, the SEC was unable to determine whether the CRA ratings were consistent with their own internal policies, and there is substantial evidence that ratings were at times ad hoc. Finally, the CRAs did not have specific policies or procedures to lean about and correct flaws in their rating models” (Rom, 2009).
The potential users of ratings, such as mutual funds and broker-dealers, take the rating CRAs' information with a view of carrying out their internal analyses and decision making on capital investment (SEC, 2003).
“Representatives of users of credit ratings - mutual funds and broker-dealers - explained the importance of credit ratings to their business. Credit ratings are used by these institutions both for informational and regulatory purposes. These firms typically have their own internal credit research department staffed with analysts who use rating issued by credit rating agencies as one of several valuable “inputs” to their independent credit analysis” (SEC, 2003).
It is important for users to receive authentic credit ratings. Champsaur (2005) argues, that CRAs perform their work effectively, providing fair, adequate credit ratings. The responsibility of information quality, used by CRAs, almost lies on issuers, and CRA's staff does not have to check the sources, they use, as their duty. So, the question is following: Are the credit ratings of CRA's really accurate and reliable? Champsaur's arguments are following:
“Studies conducted by CRAs themselves as well as other empirical studies tend to show that credit ratings are usually reliable, in the sense that they generally provide a correct assessment of an issuer's or debt instrument's credit risk. In addition, in cases such as the Enron collapse, CRA argued they should not be held responsible for failing to detect fraud, since verifying the accuracy of financial and other information through a due diligence process was not part of their work” (Champsaur, 2005).
Rom (2009) argues, that among the participants, contributed to development of US Sub-prime Mortgage Crisis, there are investors, who unconditionally accept CRAs' credit ratings without any checking, make decisions of purchases under the ratings in absence of any own research. So, there is a train of errors, made first by CRAs, then by investors, that has led to aggravation on the market.
“Given the securities' complexity, many investors undoubtedly relied on the ratings rather then doing their own due diligence on the composition and quality of the products they were bying. But even if the investors had sought to conduct due diligence, it would have been difficult for them to do so. During the sub-prime boom, the CRAs were not specifically obligated to disclose their detailed ratings methodologies or complete information about the underlying assets, and they did not to do so. They did not always even follow their own methods. At times making “out of model” adjustments” (Rom, 2009).
Lot of errors
SEC (2008) has found a lot of errors (which generated troubles and mess), that CRAs have done in the course of their activity. There is no public performance of the rating process; information data, used by CRAs, puting estimates down; explanation the results, if they are unexpected by issuers.
“Buy-side representatives generally felt there should be more public disclosure from rating agencies about the reasons of their rating decisions. They would like more information about the assumptions underlying the rating (e.g., company and industry expectations, time horizons for achieving certain financial goals, specific events or financial triggers that would prompt a rating action), as well as more specific disclosure about the information and documents reviewed by the rating agency. In addition, some suggested that rating agencies that issue unsolicited ratings clearly designate coverage of an issuer. Finally, some believed there should be regular public disclosure of performance information by rating agencies” (SEC, 2003).
Conflicts of interest between issuers and CRAs are wildly discussed by economists. SEC (2003) has noticed, that conflict of interest is based on “issuer-fee-model”, that means, that the amount of CRAs' compensation (fee) is in a conclusive dependence on credit ratings, they provide. Also, there is a conclusion, that issuer-agency conflict should be successfully operated by CRAs.
“While the issuer-fee-model naturally creates the potential for conflict of interest and ratings inflation, most were of the view that this conflict is manageable and, for the most part, has been effectively addressed by the credit ratings agencies” (SEC, 2003).
- conflicts of interest - is also considered in the papers of Strier (2008). He allocates three types of conflict of interest. The first type is concerned to providing consulting services to issuers, securities of which will be rated in future. The second conflict is about giving by CRAs higher ratings to their customers. And the third one is connected with the statement, that there is a great CRAs unwillingness to correct origin rating in the side of downgrade.
“Most prominent is that the issuer pays the rating agency that is assessing the issuer's bonds. Beyond merely rating the issuer's bonds, the rating agency often works with the issuer in designing CDOs and other structured financing that the very same rating agency will later rate. Investment banks used software distributed by the rating agencies to show them how to meet the requirements for AAA ratings, then paid the agencies to have the securities rated. In other words, the agencies have not only been paid by the people they rate, they were also working with them. Though a service distinct from rating, it patently calls into question the objectivity of an agency that rates a financial product it has helped construct” (Strier, 2008).
There is a great necessity of credit rating market changes to minimize its negative influence on the mortgage crises. There are a lot of approaches, suggested by economists to create a health credit rating market.
A great attention is paid to the question of possibility for new agencies to enter the market to reduce monopoly of the Big Three. The appearance of competition on the market will impact on CRAs' activity by limiting their privilege state. The influence of competition could be positive (favorable variant) and negative.
Champsaur is convinced that credit rating market will receive an opportunity to reduce and control (to a lesser degree) the conflicts of interest.
“Issuers would be provided with more choice in terms of selecting NRSROs to rate their debt securities, which could lower their costs for this service. The greater competition on the market for credit ratings and analysis could provide for more credible and reliable ratings. Greater competition also could stimulate innovation in the technology and methods of analysis of issuing credit ratings, which could further lower barriers to entry” (Champsaur, 2005).
The opposite opinion belongs to Partnoy (2008). He argues, that measures on competition increase are not effective; here are no considerable advantages to pay attention for.
“Nor is it clear that opening the market to competition would generated any new information value. Even absent consolidation, there is an argument that opening the market to competition could make regulatory licenses more important, by creating incentives for rate shopping among issuers. Overall, opening the market to new NRSROs seems a weak, and perhaps counterproductive, choice, even if it would be superior to the current approach” (Partnoy, 2008).
In order to reduce the conflict of interest Barwick (2008) suggests a new form of CRA's compensation to adopt. It seems ratings, provided by CRAs, to be more independent from incentive to give favorable ratings in order to be paid by issuers.
“Each NRSRO must adopt a fee-for-service model in place of its traditional contingency fee model. Under the old model, NRSROs were only compensated where they were selected by an issuer to rate a transaction; under the new fee-for-service model, they will be compensated for work performed regardless of whether they ultimately are selected to rate the deal” (Barwick, 2008).
Rom (2009) argues, that the restriction of the securities amount rated by CRA, the establishment the limit of services, provided by CRAs, would protect issuers and investors from unfair performance of their rating activity.
“…the government should assume responsibility for issuing ratings, at least for the kinds of securities that other regulated institutions such as pension funds can hold” (Rom, 2009).
One more theory about how to react to the mortgage crises is offered by Diomande, Heintz and Pollin (2009). They argue, that a creation of a public credit rating agency would help to avoid conflicts of interest, incentives to receive an incredible fee; to allow issuers and investors be assured of the quality of their securities ratings.
“We propose that all private business issuing securities that are to be traded publicly in U. S. financial markets would be required to obtain a rating by the public agency before could be conducted legally. They (agencies) would remain accountable to Congress, including through providing annual public reports on their operations. The staff of the public agency would be compensated as high-level civil servants. They would receive no benefits as such from providing either favorable or unfavorable ratings”(Diomande, Heintz, Pollin, 2009).
Barwick, P., (2008). Rating agency reform: a preliminary assessment. Securities litigation and regulation [online] Available from: http://www.alston.com/files/Publication/584391d1-702f-4a02-89bd-a20af95d47de/Presentation/PublicationAttachment/f26110df-7423-4201-90e2-a22f44bd67bf/Barwick.pdf
Champsaur, A., (2005). The regulation of credit rating agencies in the U. S. and the E. U.: recent initiatives and proposals. Seminar in international finance, LL.M. paper [online] Available from:
Diomande, M. A., Heintz, J., Pollin, R., (2009). Why U. S. financial markets need a public credit rating agency. The economists' voice [online] Available from: http://www.peri.umass.edu/fileadmin/pdf/other_publication_types/magazine___journal_articles/Why_U_S_Financial_Markets_Need_a_Public_Credit_Rating_Agency.pdf
Partnoy, F., (2008). How and why credit rating agencies are not like other gatekeepers? [online] Available from: http://www.tcf.or.jp/data/20050928_Frank_Partnoy.pdf
Rom, M. C., (2009). The credit rating agencies and the subprime mess: greedy, ignorant, and stressed? Public administration review. [online] Available from:
Securities and Exchange commission (SEC), (2003). Report on the role and function of Credit Rating Agencies in the Operation of the Securities Market. [online] Available from: http://www.sec.gov/news/studies/credratingreport0103.pdf
Strier, F., (2008). Rating the raters: conflicts of interest in the credit rating firms. Business and Society review. Vol. 113, No. 4, pp. 533-553.