Last Friday, Carl Levin, chair of the Senate Permanent Subcommittee On Investigations rang the alarm. Congress has aimed a spotlight on critical issues such as moral hazard engendered by a “too big to fail policy.” The ability of large financial institutions to employ products or strategies that recklessly or intentionally create excessive risk is a national and arguably global concern. Senator Levin warned, however, that effective reform of financial markets will also require addressing the role of secondary actors, like credit rating agencies. (See here.)Between 2002 and 2007, each of the three largest credit rating agencies earned more than $6 billion a year, double their annual revenues for years past. (See here.) The increased revenues came largely from rating complex credit derivative instruments. While testimony continues to emerge from various legislative committees, few contest the need to address the central and critical role that credit rating agencies played in the most recent financial crisis. The creation of collateralized debt obligation (CDO) introduced a nascent industry centered on pooling and packaging home mortgage debt. The CDOs offered rights to receive periodic payments from the cash flows associated with specified bundles of home mortgages. Each CDO received a rating from two nationally recognized credit rating agencies. Investors viewed credit rating agencies as gatekeepers who issued independent, fair and accurate assessments of the value of these instruments. Last Friday’s hearing charged credit rating agencies with recklessly assigning ratings. Some have alleged collaboration with the banks that packaged and sold the bonds.
The current financial reform bills in the House and the Senate do address some of these concerns – requiring credit rating agencies to register with the SEC and to offer greater transparency regarding their rating methodologies. There is also a call to adopt an express private right of action to allow investors to sue credit rating agencies – a path that had been closed by judicial decisions protecting credit ratings under the First Amendment.
Ultimately, however, it seems that the stickiest issue underlying the role of the credit rating agencies in the crisis may be the conflict of interest inherent in the issuer pay model. Bond issuers pay credit rating agencies for the ratings issued on the bonds that the issuers hope to distribute. When dissatisfied with the ratings, issuers may shop for a different opinion.
Failing to address the conflict of interest created by the issuer pay model creates an opportunity for continued market manipulation. Arguing that we cannot adopt legislation unless we can contemporaneously fix every open issue may undermine reform because legislators lack the crystal ball required to predict the antecedents of all future crises. Reform should, however, address identified and correctable issues from a comprehensive perspective, or else we will find ourselves reacting to the next crisis or running to shove our fingers and toes into each new hole in the buckling dam of financial markets regulation.
Credit Rating Agencies were unbelievably conflicted and thoroughly understaffed in attempting to deal with the subprime securitization explosion. Receiving payment from the clients whose instruments they were being pressed to rate (issuer pay model) is just fraught with disaster. Additionally, I believe that they also failed to conduct due diligence into the underlying CDOs they were being asked to rate, including relying on unrelated or outdated data and risk modeling.
ReplyDeleteWhat a mess.
It doesn't surprise me the the credit card ratings are under suspicion. Credit Card companies are major bureaucratic entities where politics will inevitable come into play.
ReplyDeleteEspecially in the tighter economy of today, anything these companies can do to put themselves ahead, whether ethical or not, they will consider doing it.
More oversight is needed, but of course that leads to even more government...
The ratings agencies were absolutely conflicted. These people were willing to say anything in order to make a quick dollar. The ongoing and lasting fraud perpetuated by the agencies willingness to place a AAA rating on securities which should have been given junk status exposed investors to unreasonably high risks disproportionate to the amount these investors paid for what should have been a safe investment. These agencies have tarnished their reputation as independent and reputable calculators of market risk. This is a fundamentally flawed system. Profit motivated companies cannot be impartial while competing for customers. Risk calculation should not be left to the private sector. The analysis is too easily swayed by profit motives, bought by the highest bidder. The costs of this charade have been felt globally while the profit has been made by the few. In response to the title of this blog post, yes, we need to abandon the business model that played a substantial role in bringing about the current recession.
ReplyDeleteA credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history.[1] A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau at the request of the lender (Black's Law Dictionary). Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.
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