The Emergence, Actions and Accountability of the Rating Agencies.
The exact causes and nature of the 2007 Global Financial Crisis (GFC) and the subsequent reforms far exceeds the scope of this essay. Rather, this essay intends to investigate one of the key players in the crisis; the Credit Rating Agencies (CRAs). We will approach this investigation chronologically; firstly, identifying the features and processes that allowed the CRAs to become a fundamental feature of the financial system. Secondly, we will introduce the charge sheet – these are the accusations against the CRAs which explain the role they played in the 2007 GFC. Thirdly, once their role in the GFC is clear, we will look at what reforms have been introduced or suggested. Then, finally, we will assess; the effectiveness of these reforms, explanations for why many have stalled and what more needs to be done before concluding in light of the argument presented herein – to what extent have the credit agencies been held to account for their role played in the 2007 global financial crisis.
The Global Financial Crisis “began as a housing crisis” (Nan Ellis, 2012, p. 192) due to irresponsible lending to sub-prime borrowers on the assumption that asset prices would continue to rise. However, when asset prices ceased to rise further, these borrowers subsequently defaulted on their mortgages. Due to the process of securitization which combined and transformed these individual debts into diversified assets, when “the default rates on the mortgages underlying these securities rose sharply…The price declines and uncertainty surrounding these widely-held securities then helped to turn a drop in housing prices into a wide spread crisis in the U.S. and global financial systems” (Lawrence J. White, 2010, p. 212)
Credit Rating Agencies, in theory “act as neutral third parties providing information with respect to the creditworthiness of investments offered” (Nan Ellis, 2012, p. 179). Their job involves assessing, then grading complicated financial assets compiled by investment banks in order to provide investors with an appropriate knowledge of the risk involved when investing in these products. Although vast amounts of CRAs exist, due to the oligopolistic nature of the industry this essay will narrow its scope further to concentrate solely on three; Moody’s, Standard & Poor’s (S&P) and Fitch. This is because “these agencies have long dominated the marketplace and account for between 95% and 98% of all outstanding NRSRO ratings” (Josh Wolfson & Corinne Crawford, 2010, p. 85).
“There are two superpowers in the world today in my opinion. There’s the United States, and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me; it’s not clear sometimes who’s more powerful” (Thomas L. Friedman, 1996)
This section aims to briefly uncover how these CRAs emerged as major actors within the financial system. Establishing this will aid our understanding of how they could play such a major role in the 2007 GFC.
The CRAs emerged as key financial actors when bank regulators decided to strongly encourage banks to invest solely in ‘safe’ assets, as a result of this “rating became a standard requirement to sell any issue in the US after many state governments incorporated rating standards into their prudential rules for investment by pension funds in the early 1930s” (Timothy J. Sinclair, 2010, p. 97). The implication of this was that to ‘prove’ the safeness of investments, banks were “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” (Lawrence J. White, 2010, p. 213). This ‘recognised rating manual’ status in 1975 was replaced by Nationally Recognized Statistical Rating Organizations (NRSROs) “by the SEC…through the no-action letter process” (Deniz Coskun, 2008, p. 265). This enshrinement of the role of the CRAs in law transformed them from information providing bodies to significant Gatekeepers to Finance. Their approval was required for financial institutions to invest in assets and also importantly, for these companies and financial assets being floated – “access to capital markets became increasingly difficult without the quality assurance from the rating agencies” (Josh Wolfson & Corinne Crawford, 2010, p. 87). What this section aims to have illustrated is that undoubtedly, by 2007, CRAs had become an established, protected, integral and powerful part of the financial system.
We have, above, defined the 2007 GFC as a housing crisis, magnified by the securitization of the underlying mortgages into Collateralised Debt Obligations (CDOs) and Mortgage Backed Securities (MBSs). This section aims to identify the specific role played by the CRAs which contributed to causing and magnifying the crisis.
The CRAs performed a major role in causing the crisis by providing the initial rating for these securities. White explains; “the securitization of these subprime mortgages was only able to succeed – that is, the resulting securities were only able to be widely marketed and sold – because of the favourable ratings bestowed on the more-senior tranches” (Lawrence J. White, 2010, p. 220). With their word as good as law, a Senate review concluded that “credit rating agencies were responsible for contributing to the housing bubble by awarding AAA ratings to complex, unsafe asset back securities and other derivatives, thereby magnifying the financial shock when the housing bubble finally burst” (Josh Wolfson & Corinne Crawford, 2010, p. 85). By proscribing AAA ratings, CRAs exposed unknowing investors to worrying levels of risk. A major implication of these AAA ratings was the exposure of these CDOs and MBS’ to risk averse financial institutions such as pension funds who are by law only allowed to invest in the safest, AAA securities. Without these high ratings, it would have been impossible for these toxic assets to become major components of so many portfolios.
The CRAs also performed a major role in magnifying the crisis by downgrading their ratings of these securities in the run up to the crash. As the housing bubble grew, the AAA ratings were mostly maintained. “However, in the summer of 2007, mounting evidence of widespread defaults on mortgages, declining home prices, and outright mortgage fraud led the agencies to downgrade thousands of bonds in a short period of time. Many institutional investors were forced to sell their holdings because they were forbidden from investing in anything but low-risk securities. In addition, their appetite for purchasing the securities evaporated as well.” (Scott J. Boylan, 2012, p. 358) By rapidly, irresponsibly downgrading the assets, this forced the hand of financial institutions that, by law, could no longer hold the securities and subsequently flooded the market. Simple macroeconomic theory of markets explains that by the CRAs decreasing demand and simultaneously increasing supply would significantly reduce the market value of CDOs and MBs’. This caused the prices of the securities to plummet, many of which were still largely held on bank balance sheets which further reduced confidence in the system and massively contributed to the global crash. By June 2009, 90% of the CDOs, graded AAA by Standard & Poors, issued between 2005 and 2007 were downgraded. 80% of these were downgraded to below investment grade (International Monetary Fund,, 2009, p. 88).
In the run up to the 2007 crash “according to the Financial Crisis Inquiry Commission, which is investigating the causes of the financial crisis, Moody’s alone rated $4,700bn of residential mortgage-backed securities between 2000 and 2007, and $736bn of CDOs.” During this same period “Phil Angelides, chairman of the FCIC, said… that Moody’s was a ‘triple A factory’ whose expansion drove a sixfold jump in its stock price from 2000 to 2007” (Duyn, 2010). What this indicates is that, CRAs were not innocent bystanders or pawns of the big banks at the time, but their decisions were driven by their incentive for profit – what allowed this incentive to magnify into a global financial crisis was the alignment of incentives for the investment banks producing these securities and the CRAs regulating their securities.
One explanation as to why the CRAs acted in this way comes from the ‘Issuer pays’ model used by the CRAs. This meant that Rating Agencies were paid by the Banks to rate the securities they were producing. This model “created significant conflicts of interest, namely the challenge for NRSRO’s to remain neutral while rating the companies that were generating their revenue” (Josh Wolfson & Corinne Crawford, 2010, p. 86). In addition to this, the CRAs were also being “paid to assist in structuring a security that they will be paid to rate” (Josh Wolfson & Corinne Crawford, 2010, p. 87). Naturally, both of these processes are extremely profitable for the CRAs, and with stiff competition amongst the big three in the oligopoly of the credit rating market, CRAs were influenced that, upon issuing undesired ratings, the risk that investment banks would “move all of its securitization business to a different rating agency” (Lawrence J. White, 2010, p. 221), therefore the CRAs undoubtedly held a stronger incentive to please the investment banks than to insure appropriate ratings. Less pessimistic explanations as to why the CRAs got it so drastically wrong in the lead up to the 2007 GFC focus on irresponsible Rating Agencies rating extremely complex CDOs and MBSs, far more complex than the traditional financial securities.
During the period surrounding the GFC, there have been multiple attempts to reform the industry for Credit Rating Agencies. This section seeks to address the attempts by regulators to reform the CRAs in wake of the financial crisis.
This was one of the first major attempts to regulate the Credit Rating Agencies just prior to the Global Financial Crisis. This act aimed to foster “accountability, transparency and competition in the credit rating agency” (Credit Rating Agency Reform, 2006, p. 1327). It attempted to achieve this by “replacing the anti-competitive NRSRO designation standards with an application process” and also gave “the SEC the authority to amend or revise rules and regulations that reference NRSROs… The SECs final rules, adopted in June of 2007, require[d] NRSROs to make and retain detailed financials, records of past ratings and ancillary service activity” (Paul Lasell Bonewitz, 2010, p. 412/413) and “instructed the SEC to cease being a barrier to entry” (Timothy J. Sinclair, 2010, p. 222).
This act, in the wake of the GFC, aimed to provide “broader powers to the U.S SEC to regulate NRSROs. The bill also creates a new regime of enhanced corporate governance for NRSROs and addresses concerns about the integrity of the procedures and methodologies underlying credit ratings. Additionally, the legislation increases the information available to the public and investors by requiring a variety of disclosures by NRSRO” (Mr. FRANK of Massachusetts, 2010, p. 14). This act also required NRSROs to form a Board of Directors, one third of which would be made up of independent members with the board being responsible for “the development, maintenance and enforcement of policies, procedures and methodologies for determining credit ratings” (Josh Wolfson & Corinne Crawford, 2010, p. 88). This act attempted to return due diligence and accountability to the industry by obligating the Rating Agencies to report their justifications for providing their ratings. Not only does this encourage CRAs to provide quality and sound ratings, by following the required procedures which they are aware will be publically available for scrutiny, they are encouraged to follow the processes diligently but furthermore this allows investors, rival CRAs and formal regulators to accurately and independently process ratings for financial products without the skewed incentive of the issuer-pays model to discover discrepancies which acts as a check and balance on other CRAs.
This was, arguably, the most significant act attempting to reform the financial system, of which the CRAs were recognised as a significant actor, since the 2007 GFC. A major evolvement of this act was the acknowledgement that “CRAs are ‘fundamentally commercial in character’. Thus, the ratings they produce are now excluded from First Amendment protections” (Carrie Guo, 2016, p. 197). This removed their entitlement to journalistic freedoms and rather, appropriately, holds them to the same expert standards as other ‘gatekeepers to finance’. The legal implications of this were that “investors can sue CRAs for knowingly or recklessly failing to conduct a reasonable investigation of the facts or for failing to obtain an analysis from an independent source” (Nan Ellis, 2012, p. 209). This legal liability should encourage more responsible ratings as CRAs attempt to protect their reputation, position and finances. However, “since the enactment of the provision, very few federal class action suits have been brought against rating agencies” (Carrie Guo, 2016, p. 187). This indicates the limitations of Dodd-Frank in truly holding the CRAs to account. Furthermore, it has been found that “CRAs issue lower, less accurate, and less informative credit ratings following Dodd-Frank when their reputation costs are greater” (Valentin Dimitrov, 2014, p. 507). Thus, rather than holding the CRAs to account, the liability assigned to them has caused them to act more cautiously when issuing ratings and subsequently has significantly weakened the market for information exchange. This would have had negative implications for investment banks because, as we already noted, high ratings has been essential to provide access to the major financial markets. Similarly, investors are no better off as the ratings of the CRA are no more accurate in assessing appropriately the risk involved in investing in these assets. Finally, as the reputation and credibility of the CRAs weaken, although some may argue this ‘holds the CRAs to account’, it also severely undermines the real value of these financial assets and induces serious levels of uncertainty into the financial markets. Many of the reforms highlighted in Dodd-Frank have remained incomplete, or abandoned entirely thus we can see the act has majorly underachieved in its attempts to hold the CRAs to account.
Seven years on from Dodd-Frank – the Financial Choice Act, although not yet enshrined in law, has passed through the House. “This bill repeals provisions of…Dodd-Frank” (115th Congress, 2017-2018) and if passed, this reversal could be extremely harmful to holding the CRAs to account. The act “proposes rolling back Dodd-Frank’s accountability measures over these companies, no longer requiring that the chief executive of a ratings agency attest to the company’s internal controls over the processes it uses to determine credit grades. The bill would also rescind the Dodd-Frank requirement that a ratings agency confirm in its disclosures that a rating was not influenced by its business activities” (Morgenson, 2017). If this were to be enacted, not only would this reverse any prior attempts to hold the CRAs to account, this would also eliminate the opportunity to hold them to account in the future.
Reforms have aimed to address the business model of the CRAs, the lack of completion in the market and increase liability upon the rating agencies. This section will assess to what extent the attempts at reforms have been successful in holding the CRAs to account.
First let’s assess the business model used by the CRAs. When assessing the lasting legacy of Dodd-Frank we recognise that “the SEC took no further action since 2013 and has neither endorsed a business model for the NRSROs nor implemented the random assignment model” (Alice M. Rivlin & John B. Soroushian, 2017). The implication of this is that the issuer-pay model has remained, “in the US, eight of the nine registered credit rating agencies follow the issuer-pays model, with only Egan-Jones, the tiniest, holding out as an investor subscription service” (Foley, 2013). The conflict of interest that arises from this business model is widely acknowledged, however how to tackle it has been a topic of hot debate. One suggestion is to return to the subscriber-pays model used by the CRAs in the 1970s. “This change would break the financial ties between the agencies and the issuers, leading to a realignment of interests. Under this scenario, credit rating agencies would feel less pressure to placate issuers” (Scott J. Boylan, 2012, p. 363). However, many dispute this model as this “may not be economically feasible due to the public good quality of credit ratings” (Carrie Guo, 2016, p. 198) as “a shift to subscriber-pays would make it hard to maintain the practice of publishing ratings to everyone in the market all at once, which regulators view as important to maintaining a fair market” (Foley, 2013). Due to these issues, a more viable alternative I believe is put forward by Boylan which retains the current issuer-pay model but rather than negotiating deal-by-deal, which has fuelled the conflict of interest highlighted throughout, issuers will hire a rating agency for a fixed period with no option for renewal (Scott J. Boylan, 2012, p. 364). This retains the public nature of the ratings but also alleviates any incentive for the CRAs to provide favourable ratings and should instead promote honest, accurate ratings which would return stability to the market. However, thus far, little has been done practically to reform this major dynamic of the Rating Agencies – to truly hold the Rating Agencies to account; regulators must take action to address this.
Secondly, let’s assess the introduction of competition into the market. The chart below indicates that there has been a shift in the dynamics of the NRSRO market share, from the 95-98% dominance of the big 3 highlighted above. “Chart 11 shows that smaller NRSROs, in particular DBRS and KBRA, appear to have built significant market share rating U.S. ABS” (U.S. Securities and Exchange Commission, 2017, p. 21). This could highlight the success of the SECs reforms to introduce more competition into the market for CRAs.
(U.S. Securities and Exchange Commission, 2017, p. 20)
This increase in competition in the market could have increased the accountability of the large Credit Rating Agencies as there are now more reputable CRAs competing for contracts. However, as we have identified above – the business model has not been changed during the reforms. By increasing competition, yet retaining the ‘issuer-pays’ business model in its current form, could in fact hold negative implications for the industry. This is because the CRAs would be competing, not to provide the most accurate ratings, but rather to win contracts from the investment banks. This would most likely lead to a race to the bottom on rating standards to maximise profitability.
Thirdly, let’s assess to what extent liability has been placed upon the CRAs. Dodd-Frank provided the SEC with the ability to impose liability to the Rating Agencies by removing first amendment protections, however historically the SEC has shunned away from its power to hold the CRAs to account. Despite this, eight years on from Dodd-Frank “for the first time, a specific section of the Dodd Frank Act of 2010 has been utilised to initiate regulatory action against a credit rating agency” (Financial Regulation International,, 2018). This came in the form of a $16.25million settlement between Moody’s and the SEC for their failures of internal controls and inconsistent ratings in the lead up to 2007. This came a year on from Moody’s $864million penalty paid to the US authorities in 2017 for their ratings prior to the GFC (Reuters, 2017). This has acknowledged the fault of the CRAs and illustrated a willingness to punish the CRAs, however genuine accountability must exceed strictly financial liability – particularly in light of the monstrous profits attained by the Rating Agencies in the run up to 2007.
Above we highlighted how Credit Rating Agencies emerged to become key gatekeepers to the financial system. Once their positions were cemented and protected by the law, either intentionally or through gross negligence, their actions played a defining role in causing and magnifying the 2007 Global Financial Crisis. Despite this widely acknowledge fault, subsequent legislation attempting to reform the Rating Agencies has fallen short in creating a substantive change to the industry. When we take into account the global implications of the actions by the Credit Rating Agencies to leave the industry substantially unchanged is a major injustice. Over ten years on from the GFC, and eight years since Dodd-Frank action has started to be taken against the CRAs. The fines placed upon the CRAs are recent developments, and although late, this is certainly a positive step. However, to truly hold the Credit Rating Agencies to account I believe there needs to be a major structural change to the market for ratings. In the aftermath of a Global Financial Crisis, where “5 trillion dollars in pension money, real estate value, 401k, savings, and bonds had disappeared” and “8 million people lost their jobs, 6 million lost their homes… just in the USA” (McKay, 2015), to reverse Dodd-Frank with the Financial CHOICE act and remove liability from the CRAs would be unjust, and unjustifiable. It is only a significant restructuring to the model which can induce genuine competition, accountability and liability to the CRAs for their actions going forward. Have the Credit Rating Agencies been held to account? The process is underway, but there are still significant components of Dodd-Frank which need to be implemented, namely addressing the business model by the SEC, before genuine accountability can be announced. This should be prioritised over the introduction of the Financial CHOICE act. This article, by reiterating the key role played by the CRAs hopes to highlight the real short coming of attempts at reform, and as future reform stands in the balance at a vulnerable point due to the progressing Financial CHOICE act seeks to remind legislators why true accountability for the CRAs is essential.
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Student of International Political Economy at City, University of London.