Abstract
There is a widespread agreement on the proposition that the performance of the credit rating agencies has not been that great and that their ratings and downgrades played pivotal roles in the global financial crisis and the European sovereign debt crisis. Yet most of the regulatory proposals to deal with them are no more than tweaks around the edges because of the belief that it is difficult to disentangle the regulatory process from the views of the rating agencies in a framework that was put in place in the 1930s. In this paper it is argued that taking the rating agencies out of the regulatory framework is not as problematic as it is portrayed to be and that the task should not carried out without other fundamental regulatory changes.
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Notes and References
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A settlement was reached in February 2015 whereby Standard and Poor’s paid over $1 billion in compensation.
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According to David Sicilia (2012), the criteria for achieving NRSRO status were not defined for many years.
In its report on the global financial crisis, the Financial Crisis Inquiry Commission presents some interesting facts and figures about Moody’s performance in the heyday of structured products when rating CDOs was a lucrative business. Moody’s rated 220 deals in 2004, 363 in 2006, 749 in 2006 and 717 in 2007. The value of those deals rose from $90 billion in 2004 to $162 billion in 2005, $337 billion in 2006 and $326 billion in 2007. The reported revenues of Moody’s from structured products grew from $199 million in 2000, or 33 per cent of Moody’s revenues, to $837 million in 2006 or 44 per cent of overall corporate revenue. The boom years of structured finance coincided with a company-wide surge in revenue and profits. From 2000 to 2006, Moody’s revenues surged from $602 million to $2 billion while its profit margin climbed from 26 to 37per cent.
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Naturally, the probability of default is determined not only by the accounts of the issuer but also by the overall macroeconomic and financial environment. It is not clear if the rating agencies take into consideration anything more than the financial statements of the rated firms because of the lack of transparency about their models.
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It is interesting to note that the CRAs do not charge sovereign borrowers for rating their debt but they make the information publicly available. This is the ‘public relations’ part of the business.
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This reminds me of similar stories in sport. For example, a footballer earning half a million dollars a week misses penalty kicks regularly because he is ‘nervous under pressure’. Another example is a golfer who gets paid $2 million as an appearance fee for missing the hole from a distance of 2 feet because ‘putting is difficult’ or ‘it was windy’. One would imagine that these people get paid exuberant amounts and elevated to celebrity status (financed by ordinary people) because they can do what ordinary people cannot do. The footballer is paid half a million dollars a week to convert a penalty kick under pressure. The golfer is paid what he is paid presumably because he can putt the ball even though putting is difficult, particularly under windy conditions.
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It is not clear why the demise of Lehman Brothers and other financial institutions was blamed mostly on short sellers. It was actually caused by the strategic error of accumulating billions of dollars worth of structured products, believing in the wisdom of the CRAs, which in turn inflicted tremendous damage on those institutions which became insolvent as a result of abrupt downgrading. Merrill Lynch suffered a similar fate for the same strategic error, having fired anyone with a dissenting voice who dared oppose the ‘strategic vision’ of senior management (typically one person who happens to be the ‘king of the mountain’).
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As pointed out earlier, the CRAs do not get paid for soverign ratings, which means that they do not have to please a paying customer. This is why the CRAs (particularly S&P) have been quicker in downgrading sovereign borrowers than paying corporate borrowers such as Enron.
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It has been suggested that there is a real independent and transparent alternative to the common rating agencies, which is Wikirating, https://www.youtube.com/watch?v=eErg78D6GoA.
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Moosa, I. The regulation of credit rating agencies: A realistic view. J Bank Regul 18, 180–200 (2017). https://doi.org/10.1057/jbr.2015.9
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DOI: https://doi.org/10.1057/jbr.2015.9