A scene from the Oscar-nominated movie The Big Short depicts the important role of credit ratings agencies during the Great Recession. It shows Melissa Leo as an employee of Standard & Poor’s (one of the big three credit ratings agencies) explaining to Steve Carell (who plays a hedge fund manager) why S&P continues to give AAA ratings to mortgage-backed securities (consisting of junk loans). The answer given by her is: “They’ll just go to Moody’s.”
During the 2008 financial crisis, a lot of worthless mortgage-related securities were given AAA ratings: the highest and safest investment grade.
The role of the credit ratings agencies during the financial crisis remains highly criticized and mostly unaccountable. The agencies have been blamed for exaggerated ratings of risky mortgage-backed securities, giving investors false confidence that they were safe for investing. While criticizing the ratings by credit ratings agencies in an op-ed for The New York Times, columnist Paul Krugman wrote, “The skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle.” In 2011, the Financial Crisis Inquiry Commission found that these ratings agencies “were key enablers of the financial meltdown.”
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Reforms for credit ratings agencies have been given importance in the 2016 presidential primary debates. In his financial reform proposal, Bernie Sanders aims to change the business model used by the credit ratings agencies to a nonprofit model, keeping it independent of Wall Street. On the other hand, in her vision of financial reforms, Hillary Clinton keeps the credit ratings agencies untouched.
However, since the global financial crisis, not much has changed. While strict reforms under the Dodd-Frank Act have been successful in dedicating an entire chapter to fix the credit ratings agencies, much of the rules have yet to be implemented, since the private sector continues to rely on the same companies for investment opinions. The big three credit ratings agencies continue to control 95 percent of the credit ratings market, with major companies like Pimco (the world’s largest bond investor) and Calpers (the nation’s biggest pension fund) relying on at least one of these big three agencies’ ratings.
The Crucial Role of Credit Ratings Agencies
Credit ratings agencies exist in our society because there is information asymmetry between borrowers and lenders. These agencies are considered crucial to both parties, as they reduce information gaps concerning investment products and sovereign nations. The function of rating agencies has been critical to the financial system, as they help investors in deciding the quality of financial products or indebtedness of a sovereign nation. The riskiness of investing in these securities is determined by the possibility of the debt issuer (corporation, bank-created entity, sovereign nation or local government) failing to make timely interest payments on the debt.
A sovereign credit rating gives investors an insight into the level of risk associated with investing in a particular country, which includes political risk. Similarly, a bond rating helps in providing an informed analysis of debt securities and risks associated with financial instruments. Banks, insurance companies and pension managers have to purchase only high-quality debts, and they rely on the credit ratings agencies to know the quality of debt. Thus, the accuracy and transparency of these ratings hold significance to international investors looking to invest in an external debt market or in a certain financial instrument.
Criticism of Credit Ratings Agencies During the Great Recession
During the 2008 financial crisis, a lot of worthless mortgage-related securities were given AAA ratings: the highest and safest investment grade. This led to a series of events that contributed to the global financial meltdown. The credit ratings agencies aimed for increasing profits and market share by giving inaccurately strong ratings to underperforming assets. This conduct fueled the meltdown that ultimately led to tens of thousands of foreclosures. The credit ratings agencies were blamed for conflicts of interest and the flawed methodologies they adopted for rating financial products during the Great Recession.
Credit ratings agencies use two methods to assess risk and rate the creditworthiness of financial products and sovereign nations: “issuer pays” and “subscriber pays.” In 2016, the big three credit ratings agencies continue to work under the “issuer pays” model that led to the subprime mortgage crisis in 2008. The system allows a bond issuer to pay the ratings agencies for initial and ongoing ratings of a security. The credit ratings agencies tend to overrate the credibility of the debtors so as to not lose established clients. This, in turn, can lead to a biased analysis and faulty ratings.
But while credit ratings agencies were criticized for faulty ratings, their methodology and conflicts of interests, investors were blamed for over-relying on these ratings. According to a New York Times article, institutional investors continue to trust these ratings given to securities. In 2014, the Basel Committee on Banking Supervision significantly reduced the banks’ reliance on external ratings during the calculation of capital requirements. This was done to force banks to improve their own evaluations of the risks of loans going bad.
Criticism of Credit Ratings Agencies During the Eurozone Debt Crisis
The role of credit ratings agencies was not only confined to the United States; such lofty ratings also became a serious concern for Europe. According to the European Central Bank (ECB), the inaccurate sovereign ratings by the credit ratings agencies led to the worsening of the eurozone debt crisis. It was believed that the downgrade of Greece could have a spillover effect on the entire eurozone. The European Union (EU) and ECB accused the big three credit ratings agencies of excessively providing negative sovereign ratings to countries that had been approved for EU-International Monetary Fund bailouts.
Following the sovereign downgrades, the EU suggested that the oligopoly of the three major ratings agencies should be challenged in Europe by the creation of a European credit ratings agency. Moreover, the EU decided on establishing an independent body for regulation of credit ratings agencies and laid down rules that made it mandatory for credit ratings agencies to disclose their rating methodology. As a result, in 2011, the European Securities and Markets Authority (ESMA) in Europe made credit ratings agencies accountable so as to safeguard investors’ interests.
Regulations and Reforms
In 2006, Congress passed the Credit Rating Agency Reform Act, which gave the Securities and Exchange Commission (SEC) the power to regulate the internal processes of credit ratings agencies regarding record-keeping. In addition, the act controlled how the agencies guard against conflicts of interest. But the law specifically prohibited the SEC from regulating the rating methodologies of nationally recognized statistical rating organizations (NRSROs) — credit ratings agencies registered with the SEC.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act adopted new rules that allowed the SEC to annually examine the 10 credit ratings agencies operating in the United States. The regulatory act required the SEC to adopt new rules that concerned issues like conflicts of interest with respect to sales and marketing practices; “look-backs” when credit analysts leave the NRSRO (in order to join the firms they may have rated in the past); fines and penalties; the disclosure of performance statistics; application and disclosure of credit ratings methodologies etc. Such rules have allowed the SEC to administer regulations, examine credit ratings agencies for any biased behavior in credit ratings and penalize them in case of any discrepancy with the guidelines.
Current Situation of Credit Ratings Agencies
In a report released on December 28, 2015, the SEC said the credit ratings agencies continue to pose a threat to the existing financial system. According to the SEC staff’s findings, “On numerous occasions, two large NRSROs and one small NRSRO failed to adhere to their ratings policies and procedures, methodologies, or criteria, or to properly apply quantitative models.” In addition to this, the report found instances where “substantive statements in its rating publications directly contradicted substantive statements in its internal rating records.” According to The New York Times, the SEC has been successful in reporting frauds committed by some of the leading ratings agencies like S&P, which cost $58 million to settle the SEC’s charges and an additional $19 million to settle parallel cases by the New York attorney general’s office ($12 million) and the Massachusetts attorney general’s office ($7 million).
Although the SEC has been successful in evaluating credit ratings agencies to some extent, much of the information in the SEC reports that go public remains highly vague, basic and unexplained. For example, the SEC only refers to the agencies as “larger” or “smaller,” without disclosing the names of the involved credit rating agencies that are problematic. The report refers to Fitch Ratings, Moody’s and S&P as “larger NRSROs” and eight other “smaller NRSROs” (A.M. Best Co. Inc. – AMB; DBRS Inc. – DBRS; Egan-Jones Ratings Co. – EJR; HR Ratings de México; S.A. de C.V. – HR; Japan Credit Rating Agency Ltd. – JCR; Kroll Bond Rating Agency Inc. – KBRA; and Morningstar).
In connection with the financial crisis, the big three global credit ratings agencies have faced heavy fines and have come under scrutiny for playing a pivotal role in the 2008 meltdown. After the Great Recession period, many credit ratings agencies grabbed headlines for facing lawsuits for their alleged involvement in the subprime mortgage crisis. On February 5, 2013, the US Department of Justice filed a civil lawsuit against the credit ratings agency Standard & Poor’s (S&P) Rating Services, asserting that “S&P engaged in a scheme to defraud investors in structured financial products known as Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs).”
The complaint charged S&P with “limited, adjusted and delayed updates to the rating criteria” so as to avoid losing market share and profits. On February 3, 2015, the Department of Justice, 19 states and the District of Columbia reached an agreement with S&P. The credit ratings agency agreed to pay $1.375 billion in a settlement. Half of this amount was paid to the federal government as a penalty, which was regarded as the “largest penalty of its type ever paid by a ratings agency” by the Department of Justice.
According to a report by CNBC, Moody’s Investors Service was under scrutiny by the Department of Justice for its supposed contribution to the subprime mortgage crisis. During the period of 2004 to 2007, Moody’s provided flawed AAA ratings to residential mortgage-backed securities that were backed up by subprime loans later deemed as risky. As housing prices began to fall, Moody’s downgraded 83 percent of the $869 billion in mortgage securities it had rated at the AAA level in 2006. Upon default on these mortgages, the negative returns led to huge losses, costing billions of dollars to even the most conservative investors.
But the fines paid for misrepresentation seem insignificant when compared to the profits generated by some of the large credit ratings agencies. According to The New York Times, Moody’s earned almost $1 billion in 2014. That same year, The Economist reported that the revenues from the big three ratings services (US-based S&P, Moody’s and Fitch Ratings) surpassed pre-crisis levels in 2013.
Many banking crimes are penalized with fees instead of criminal lawsuits, and the story for credit ratings agencies is no different. Though the formation of regulatory bodies like the SEC is a step in the right direction to impose adequate supervision on credit ratings agencies, the public information regarding the agencies involved in any faulty ratings remains undisclosed. At the same time, investors should rely less on such ratings, especially when these credit ratings agencies have already been a part of one of the biggest financial crises in the world.