Running head: THE NEED FOR CREDIT RATING AGENCIES POST

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Post Financial Crisis: A Question on The Need for Credit Rating Agencies

Foreign Trade University Ho Chi Minh City Campus

TCHE 303: Money and Banking

Nguyen Thi Hoang Anh

April 2, 2020
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Abstract

For the last decade, credit rating agencies have received heavy skepticisms on the credibility of

them, who did not properly disclose risk associated with the securities they rate and thus

contributed to the collapse of the financial system. This report analyzes the faults of credit rating

agencies in the credit crisis and provides an opinion on the need of the public for credit rating

agencies. In this respect, we offer our opinion based on our research and various previous studies.

The paper finding show that people still need credit rating agencies. Numerous factors are believed

to be the reasons. It is their irreplaceable functions in the capital market that make them needed.

The market demand for credit ratings, the convenience they offer and the fact that there are other

exemplary agencies that decently do their job are the remaining reasons, which will be further

explained in the following sections.

Keywords: credit rating agencies, financial crisis, the public’s need for credit rating agencies
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Post Financial Crisis: A Question on The Need for Credit Rating Agencies

The public debate about the role of credit rating agencies in the generation of financial crisis

has revolved around an idea that credit rating agencies were of the main reasons that result in the

meltdown of the economy. It is not difficult to realize that the idea now seems deeply entrenched

in popular, and that people still question the credibility of the credit rating agencies themselves.

Credit rating agencies have flaws, undoubtedly. But the questions are whether they take

measures to solve those flaws so that they can regain trust from the public, and whether the public

still need the credit rating agencies or not.

In this paper, we try to assess the reputational crisis of the credit rating agencies and answer

the questions mentioned above by applying information we gather that based upon related,

previous studies.

This report is divided into five major sections. The following part is where we represent the

faults of credit rating agencies in the financial crisis. Coming up next is section two which includes

the behaviors of regulators and credit rating agencies after the crisis. The third part consists of our

opinion on whether the public still need the credit rating agencies or not and the explanation given

to that opinion through five main reasons. The last two parts provide recommendation on

improving credit rating agencies and the conclusion for the report.

Discussion

Faults of Credit Rating Agencies

The 2008 economic crisis, also known as the global financial crisis, was considered by many

economists to have been the most serious financial crisis since the Great Depression of the 1930s.

The "Big Three" global credit rating agencies (“CRAs”) - U.S-based Standard and Poor’s

(S&P), Moody’s, and Fitch Ratings - have come under intense scrutiny in the wake of the global
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financial crisis. Meant to provide investors with reliable information on the riskiness of various

kinds of debt, these agencies have instead been accused of defrauding investors by offering overly

favorable evaluations of insolvent financial institutions and approving extremely risky mortgage-

backed securities.

The agencies have been mainly blamed for giving investors false confidence that they were

safe for investing. In an op-ed for The New York Times, columnist Paul Krugman (2010a, para.

9) agued: “The skewed assessments, in turn, helped the financial system take on far more risk than

it could safely handle”.

To be more concise, the faults of credit rating agencies are believed to be those listed below:

1. Failure in transparency and timeliness.

The lack of adequate information about the characteristics and limitation of the ratings,

especially of structured product, and the fact that the CRAs did not provide sufficient

information on critical model assumptions, was pointed out one of the main problems detected.

In this sense, the SEC (the U.S. Securities and Exchange Commission) staff examinations

highlighted that, in some instances, relevant rating criteria, which is crucial for investors to

correctly understand the real meaning and value of the ratings, were not fully disclosed (Raquel

García Alcubilla & Javier Ruiz del Pozo, 2012, p. 30).

2. Flawed methodologies.

The CRAs were also blamed for the methodologies they adopted to rate financial products.

The “issuer-pay” business model creates conflicts of interest that result in an incentive to overrate

the creditworthiness of the borrowers, which in turn helps CRAs to not lose their established clients.

Thus, a biased rating can easily happen. Specifically, CRAs gave AAA ratings for hundreds of
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mortgage-backed securities, which then turned out to be approximately 93% of junk status (Paul

Krugman, 2010b, para. 3).

Besides, failure in integrity and reliability are the other two faults of CRAs as mentioned by

Raquel García Alcubilla and Javier Ruiz del Pozo (2012, pp. 28-30).

Credit Rating Agencies after the Financial Crisis

After the depression time of the economy, there have been some reforms coming from both

the regulators and credit rating agencies themselves.

In October 2008, the President of the European Commission, JoséManuel Barroso, mandated

Jacques de Larosière to chair a committee about the future of European financial regulation and

supervision. Also in the same time, Otmar Issing, former Chief Economist at the European Central

Bank, chaired another committee to “draw up recommendations first for the Group of Twenty (G-

20) summit in Washington and then for the follow-up summit in London” (Siegfried Utzig, 2010,

p. 3). The committees’ outline of the ratings dilemma would be inaccurate if it were to focus only

on shortcomings of CRAs. According to them, it is also true that investors often accepted ratings

uncritically and overestimated their significance. Not enough attention was paid to the fact that

ratings are only estimates of the relative probability of default or expected loss on a debt instrument.

Regarding the regulators’ actions, the Consumer Protection Act and Dodd-Frank Wall Street

Reform also put forth new regulation about on-site supervision of the agencies as well as the

additional disclosure requirement for ratings of asset-backed securities.

From the CRAs’ side, Moody’s, for instance, has agreed to pay approximately $864 million in

settlement with the US Federal and state authorities, according to the US Department of Justice.

Also in the settlement, Moody’s agreed to keep analytic employees out of commercial-related
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discussions. Moody’s later also noted that there is no finding of a violation of law or admission of

liability (The Associated Press, 2017).

Meanwhile, S&P was in the same situation and eventually had to pay a $1.5 billion fine. In

addition, S&P pointed out in one of its statement after the crisis:

S&P has taken to heart the lessons learned from the financial crisis. In the past five years, we

have spent approximately $400 million to reinforce the integrity, independence and

performance of our ratings. We also brought in new leadership, instituted new governance and

enhanced risk management (Jeannette Neumann, 2013).

All of this has led to an essential question, which is, after the financial crisis and all the

measures that they have taken so far, do we still need credit rating agencies?

It is clear that credit ratings are still somehow relevant to companies and governments. Take

Cook County Government, Illinois, for example. In 2014, they issued $90 million in sales tax

bonds. “Years ago we would have done all three agencies”, says their Chief Financial Officer Ivan

Samstein (as cited in Liz Farmer, 2015). “But we thought that we could go with one rating, and

we chose to use S&P.”

Obviously, the need for credit ratings, even though has now decreased compared to the past, is still

there. A government’s upgrade or downgrade on its credit rating still gets economic journalists

writing about it, and that has just emphasized the importance of CRAs in the marketplace.

Therefore, the answer is yes, we still need CRAs, and set forth below is the brief description

of the five main reasons.

Reasons

1. The market demand for CRAs.

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Take another perspective into the conflicts of interest and information asymmetric problem.

Assume, all companies who issue the securities rate their very own securities. Without doubt, these

kinds of ratings can be very biased. Assume, all banks internally rate the securities based on their

connection with the companies and pass those ratings to investors. In order to have the investors

interested in investing in the securities, investment banks, in this case, have full incentive to overate

the securities. On the other hand, assume investors do research themselves and rate the securities

based on the research they do. Obviously, they do not have enough resources to valuable

information about the creditworthiness of the securities.

Investors want an independent third-party to evaluate credit quality, and since credit rating

agencies are not involved in this trading, therefore there is a lot less conflict, there has been demand

for third-party credit analysis ever since. Simply put, as long as conflicts of interest and

information asymmetry between borrowers and lenders exist, there is still demand for credit rating

agencies.

2. Regulation function.

In 1936, the Office of the Comptroller of the Currency decided to use credit ratings for

regulatory purposes. They mandated for banks to hold assets of a certain credit quality. Later on,

in the 1970s, the Nationally Recognized Statistical Ratings Organizations (NRSROs) were

designated. Federal and state regulators required the use of NRSRO credit ratings to satisfy certain

regulations. For example, commercial banks, mutual funds and pension funds are often restricted

to investing in only certain grades of bond, investment-grade to be more precise.

CRAs also play a role in the supervision of financial institutions. In the EU, to cover various risks,

financial institutions are required to hold a minimum level of own financial resources, i.e., capital,

which serves as a buffer against unexpected losses, thereby protecting depositors and providing
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financial stability. “The EU Capital Requirements Directive, which effectively implements the

Basel II framework, provides for the use of external credit assessments to determine capital

requirements applied to a bank or investment firm’s exposure.” (Panagiotis Delimatsis & Nils

Herger, 2011, p. 100).

Needless to say, CRAs’ judgements define a globally uniform benchmark for credit risk, which

makes them an attractive reference for international regulatory standards.

3. CRAs provide issuers with easier access to the international financial market.

A favorable rating enables governments and companies to raise capital in the international

financial market. CRAs are the ones that can provide issuers with more access to financial market

segments and cheaper cost of borrowing than permitted by traditional bank lending. Thanks to this,

issuers can structure their financing more efficiently, and, therefore, can minimize the capital cost.

Otherwise stated, to attract investors with deep pockets to get access to the capital market, you

can’t avoid having a credit rating. And a good one at that.

4. The convenience they offer.

Another reason why we still need the credit rating agencies is simply because they are

convenient, especially for private contracts. The increasing use of credit ratings in private contracts

has enhanced the importance of them in the marketplace, in which rating triggers are one of the

most frequent types of credit rating being used.

Rating triggers are “the covenants in bond or loan documentation that obliges the borrower, or

the country where it is incorporated, to maintain its rating above a certain level. If the rating is not

maintained, specific measures are adopted” (“Fingers on the Rating Triggers”, 2016, para. 4).

Rating triggers help protect the lender from asset substitution problems. Undeniably, if there were
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no credit rating agencies, no such convenient thing to protect the lender like rating triggers would

exist.

Besides, it is a lot easier for fund managers to communicate with their investors regarding

portfolios holdings using credit ratings rather than their own in-depth credit analysis. Instead of

using a more subjective provision, it is also a less complicated process for companies if they make

use of the credit ratings as a conditional clause in the contract. In fact, there are “Credit and

Guaranty Agreement” by Autocam International Ltd, “Term Loan Agreement” by Kite Realty

Group and several other examples about credit ratings being used as clauses that we can obtain

from “Law Insider” (“Credit Ratings Sample Clauses”, n.d.).

In short, credit rating agencies offer a more objective, less time-consuming way to be used as

clauses in contracts. Put differently, it is the convenience from using credit ratings that intrigue

companies, even after the financial crisis.

5. The decent ones.

Finally, besides wrongdoers in the market, there are still other credit rating agencies that

accurately rate the securities.

Consider the case of Egan-Jones, a small ratings company in Pennsylvania. Egan-Jones is most

known for the bold act of calling out shaky credit prospects of mortgage-backed securities that the

“Big Three” consider risk-free. Egan-Jones was prescient on declining the credit ratings of both

Bear Stearns and Lehman Brothers just ahead of the news that the two firms went bankrupt in the

wake of the financial meltdown.

More remarkably, Egan-Jones also beat other rating agencies in the famous cases of

WorldCom and Enron. Later in 2008, the title “The first person to warn about the 2008 financial

crisis” was given to Sean Egan, co-founder of Egan-Jones, by Fortune magazine (Lee Brodie,
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2009). The agency, thus, can be considered, along with other people and agencies, as the whistle-

blowers of the mortgage and structured finance bubble. Their prediction about the market, although

not very much appreciated at that time, was at least the signal given to the public that there are

smaller credit rating agencies that do their job decently.

But this is not just about Egan Jones. Lace Financial Ratings also impose strict methods on its

employees to ensure its proper rating performance (Gianluca Mattarocci, 2013). And there are

even more to count. Their trustworthy actions towards credit ratings, hence, are the very reason

why we, the public, should restore trust in the CRAs.

Measures on Improving Credit Rating Agencies

It is undeniable that until now, several years after the financial crisis, credit rating agencies are

still on their way to regain trust from the public. Several measures have been taken already, but it

seems to not be enough. In this report, we strongly believe that the nature of credit rating agencies

is good, it is the way we use them that makes them flawed. And the only way to tackle this problem

is to take stronger methods.

First, a business model that includes full and public disclosure of the methodology used,

thorough and independent analyses is what the credit rating agencies need to adopt.

Also, many finance-related crimes are charged with fees instead of criminal lawsuit, so is the

story for credit rating agencies. Thus, imposing discipline, especially criminal lawsuit, on violators

for them to suffer from reputational cost is what need to be done next.

Conclusion

In the generation of financial downturn, credit rating agencies are the ones getting heavy

criticisms for not properly disclosing adequate information and offering favorable evaluations for
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financial products. It is clear that they, together with other factors, contributed to the meltdown of

the market.

Nevertheless, as this paper shows, despite them being criticized, the public is still in need of

credit rating agencies due to five main reasons. First and foremost, since there is information

asymmetric between issuers and investors, the demand for credit rating agencies is understandable.

Besides, their indispensable functions in the capital market and the convenience from using credit

ratings are the other factors that have enhanced their importance in the market. Lastly, the fact that

there are other trustworthy credit rating agencies is the remaining reason as to why we still need

them.

With that being said, it does not mean that credit rating agencies have now been perfect. They

still need to adapt to stricter regulation. A business model with transparency and public disclosure

of performance statistics and methodologies will help. In addition, fines and criminal penalties in

case of any discrepancy with guidelines are what believed to be the next necessary measure.
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References

Alcubilla, R. G., & Pozo, J. R. (2012a). Failures in transparency. Credit rating agencies on the

watch list: Analysis of European regulation. Oxford University Press.

Alcubilla, R. G., & Pozo, J. R. (2012b). Failures in integrity. Credit rating agencies on the watch

list: Analysis of European regulation. Oxford University Press.

Alcubilla, R. G., & Pozo, J. R. (2012c). Failures in reliability. Credit rating agencies on the watch

list: Analysis of European regulation. Oxford University Press.

Brodie, L. (2009). Sean Egan: He saw it coming. Retrieved from

https://www.cnbc.com/id/32859198

Delimatsis, P., & Herger, N. (2011). Financial regulation at the crossroads: Implications for

supervision, institutional design and trade. (International Banking and Finance Law Series;

No. 12). Alphen aan den Rijn: Kluwer Law International.

Farmer, L. (2015). Do credit ratings matter anymore? Retrieved from

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Hogan Lovells. (2016). Fingers on the rating triggers. Retrieved from

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Krugman, P. (2010a). Berating the raters. Retrieved from

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Law Insider. (n.d.). Credit rating sample clauses. Retrieved from

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Mattarocci, G. (2013). The independence of credit rating agencies: How business models and

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The Associated Press. (2017). Moody’s to pay $864 million to settle inquiry into inflated ratings.

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inquiry.html

Utzig, S. (2010). The financial crisis and the regulation of credit rating agencies: A European

banking perspective. Asian Development Bank Institute, ADBI Working Paper No. 188.