Credit Rating Agencies

One of many groups of financial institutions that were thoroughly embarrassed by the financial crisis were the big credit rating agencies, like Standard &  Poors, Moody\’s and Fitch. They had rated some of the financial securities that were based on pooling together subprime mortgages as AAA safe, which is what made it legally OK for banks to hold such securities, thus creating a situation where popping the bubble in housing prices caused banks to suffer severe losses. For some history on how the U.S. government financial regulators outsourced their judgment on riskiness of financial securities to the credit rating agencies, see my post from last August: \”Where Did S&P Get Its Power? The Federal Government (Of Course).\”

Nicolas Véron discusses \”What Can and Cannot Be Done About Credit Rating Agencies\” in a Policy Brief written for the Peterson Institute of International Economics. Here are some highlights (citations and footnotes omitted):

Credit rating agencies (CRAs) have some successes, and some very prominent failures.

\”From this standpoint there was a clear failure of CRAs when it came to US mortgage-based structured products in the mid-2000s. Many mortgage-based securities were highly rated but had to be downgraded in large numbers following the housing market downturn in 2006–07, especially in
the subprime segment. Subsequent enquiries, in particular the Securities and Exchange Commission and Financial Crisis Inquiry Commission, have convincingly linked the CRAs’ failure to a quest for market share in a rapidly growing and highly profitable market segment. Under commercial pressure, CRAs failed to devote sufficient time and resources to the analysis of individual transactions, and also neglected to back single transaction assessments with top-down macroeconomic analysis that could have alerted them to the possibility of a US nationwide property market downturn. …

\”[T]here have been several past cases in which rating agencies clearly failed to spot deteriorations of sovereign or corporate creditworthiness in due time. This was particularly true of Lehman, AIG, and Washington Mutual, which kept investment-grade credit ratings until September 15, 2008. CRAs were similarly criticized for their failure to anticipate the Asian crisis of 1997–98 or the Enron bankruptcy in  late 2001. It appears fair to conclude that all three main CRAs have a decent though far from spotless record in sovereign and corporate ratings, but that their hardly excusable failure on
rating US residential mortgage-based securities in the mid- 2000s has lastingly damaged their brands and reputations.\”

Credit rating agencies typically follow the market, rather than leading it.

\”Since the beginning of the crisis, CRAs have frequently been accused of timing their downgrades badly and of precipitating sudden negative shifts in investor consensus. However, it is infrequent that rating downgrades surprise markets—generally they follow degradations of market sentiment rather than precede it. When CRAs do anticipate, they are often not given much attention by investors, such as when S&P started downgrading Greece in 2004.\”

The most useful reforms of credit rating agencies may focus on those issuing the securities in the first place.

Véron offers an exceptionally level-headed discussion of what might be done about the credit rating agencies. For example, one could forbid such ratings, either in general or when markets are turbulent, but along with the issues of suppressing freedom of speech, it\’s hard to see how suppressing information is workable or would help to calm a panic. Some in Europe have suggested the creation of a new non-profit quasi-governmental credit rating agency. But could it have any legitimacy among investors? There have been calls to regulate specifically how credit ratings are done. But the difficulty here is that the credit rating agencies did not know how to rate certain financial securities, and it\’s not clear that government regulators knew any more. If anything, we need more innovative and insightful measures of credit risk to be created, not for certain methods to be set in concrete. Also, tighter regulation probably would make it more costly and thus unlikely for any firms seeking to enter this market.

Thus, Veron emphasizes that it may be most useful to require those issuing securities, and asking to have them rated, \”to disclose more standardized and audited information about their risk factors and financial exposures.\” This new regulatory rule would apply to ratings for corporate bond issues, for financial securities being rated, and also for sovereign debt being rated. Credit rating agencies could be required to conduct their ratings with whatever methods they choose–but based only on the publicly available information. He concludes:

\”To put it in a simplistic but concise way, what is needed is “a John Moody for the 21st century.” CRAs themselves can perhaps be somewhat improved by adequate regulation and supervision, but public policy initiatives that focus only on CRAs are unlikely to adequately address the need for substantially better financial risk assessments. If real progress is to be made towards a better public understanding of financial risks, it will have to involve innovative approaches that even well-regulated
CRAs, on the basis of recent experience, may not be the best placed to deliver.\”

Finally, here\’s a useful table showing the dominance of S&P, Moody\’s and Fitch in the market for credit rating services.

Where Did S&P Get Its Power? The Federal Government (Of Course)

When Standard & Poor\’s downgraded the credit rating of the U.S. government on August 5, and the global economy trembled, a natural question is: \”Who gave them all this power, anyway?\” The same question arises when Fitch announced earlier this week that it would not issue a similar downgrade. The answer to who made the credit rating agencies so powerful is: The federal government. Lawrence White encapsulates the history in the Spring 2010 issue of my own Journal of Economic Perspectives, in an article on \”The Credit Rating Agencies.\” Larry writes: 

\”However, a major change in the relationship between the credit rating agencies and the U.S. bond markets occurred in the 1930s. Bank regulators were eager to encourage banks to invest only in safe bonds. They issued a set of regulations that culminated in a 1936 decree that prohibited banks from investing in “speculative investment securities” as determined by “recognized rating manuals.” “Speculative” securities (which nowadays would be called “ junk bonds”) were below “investment grade.” Thus, banks were restricted to holding only bonds that were “investment grade”—in modern ratings, this would be equivalent to bonds that were rated BBB– or better on the Standard & Poor’s scale. With these regulations in place, banks were no longer free to act on information about bonds from any source that they deemed reliable (albeit within oversight by bank regulators). They were instead forced to use the judgments of the publishers of the “recognized rating manuals”—which were only Moody’s, Poor’s, Standard, and Fitch. Essentially, the creditworthiness judgments of these third-party raters had attained the force of law.\”

\”In the following decades, the insurance regulators of the 48 (and eventually 50) states followed a similar path. State insurance regulators established minimum capital requirements that were geared to the ratings on the bonds in which the insurance companies invested—the ratings, of course, coming from the same small group of rating agencies. Once again, an important set of regulators had delegated their safety decisions to the credit rating agencies. In the 1970s, federal pension regulators pursued a similar strategy.\”

\”The Securities and Exchange Commission crystallized the centrality of the three rating agencies in 1975, when it decided to modify its minimum capital requirements for broker-dealers, who include major investment banks and securities firms. Following the pattern of the other financial regulators, the SEC wanted those capital requirements to be sensitive to the riskiness of the broker-dealers’ asset portfolios and hence wanted to use bond ratings as the indicators of risk. But it worried that references to “recognized rating manuals” were too vague and that a bogus rating fifi rm might arise that would promise AAA ratings to those companies that would suitably reward it and “DDD” ratings to those that would not.\”

\”To deal with this potential problem, the Securities and Exchange Commission created a new category—“nationally recognized statistical rating organization” (NRSRO)—and immediately grandfathered Moody’s, Standard & Poor’s, and Fitch into the category. The SEC declared that only the ratings of NRSROs were
valid for the determination of the broker-dealers’ capital requirements. Other financial regulators soon adopted the NRSRO category and the rating agencies within it. In the early 1990s, the SEC again made use of the NRSROs’ ratings when it established safety requirements for the commercial paper (short-term debt) held by money market mutual funds.\”

\”Taken together, these regulatory rules meant that the judgments of credit rating agencies became of central importance in bond markets. Banks and many other financial institutions could satisfy the safety requirements of their regulators by just heeding the ratings, rather than their own evaluations of the risks of the bonds.\”

White goes on to discuss how the NRSRO category has evolved over time, and how Congress more-or-less bludgeoned the Securities and Exchange Commission into allowing some additional NRSROs in the last decade. His article, written in 2010, also points out that one reason why the housing bubble spread through mortgage-backed securities and into the banking system was that the NRSRO\’s like Standard & Poor\’s gave some of that debt a tremendously misguided AAA rating. Far too many banks and bank regulators just accepted that rating, although S&P and the other credit rating agencies had no particular history or expertise in evaluating these somewhat complex financial instruments based on subprime mortgage debts. White and others have long argued that while it\’s perfectly fine to have firms which sell their expertise and opinions about the riskiness of bonds, there\’s no reason to anoint some of them in such a way that banks and bank regulators legally outsource judgment and prudence to them.

Maybe S&P is wrong to downgrade the U.S. credit rating. But after it whiffed so spectacularly and totally missed the riskiness of the subprime-related mortgage backed securities, it\’s seems a bit unsporting to turn around and criticize them for being too vigilant now. And if the U.S. government doesn\’t like the power wielded by S&P–well, it has only itself to blame for bestowing so much of that power in the first place.