Rating agencies – annotated links
There are innumerable blogs, articles and research contributions on rating agencies. Here are some materials I came upon writing my last blog which I found particularly useful, timely or stimulating.
Australian Treasury/ASIC (2008): Review of credit rating agencies and research housesContents The Review Background to paper Credit rating agencies Research houses Credit rating agencies—background and international developments Role of credit rating agencies Australian market context Role of CRAs in recent global market turmoil International regulatory responses Regulation of credit rating agencies in Australia Current regulatory position Key regulatory issues Key issues and the Australian financial services licensing regime Prudential regulation Research houses What is a research house? Users of research reports and product ratings Australian market context Research houses and recent collapses Regulation of research houses in Australia Key regulatory issues Licensing and disclaimers
Becker, Bo and Todd Milbourn (2010): How did increased competition affect credit ratings?, Harvard Business School WPAbstract: The credit rating industry has historically been dominated by just two agencies, Moody’s and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how in fact increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.
Caporale, Guglielmo Maria et al. (2011): EU Banks Rating Assignments: Is There Heterogeneity between New and Old Member Countries?, Review of International EconomicsAbstract: We model EU countries’ bank ratings using financial variables and allowing for intercept and slope heterogeneity. Our aim is to assess whether “old” and “new” EU countries are rated differently and to determine whether “new” ones are assigned lower ratings, ceteris paribus, than “old” ones. We find that country-specific factors (in the form of heterogeneous intercepts) are a crucial determinant of ratings. Whilst “new” EU countries typically have lower ratings than “old” ones, after controlling for financial variables we also discover that all countries have significantly different intercepts, confirming our prior belief. This intercept heterogeneity suggests that each country’s rating is assigned uniquely, after controlling for differences in financial factors, which may reflect differences in country risk and the legal and regulatory framework that banks face (such as foreclosure laws). In addition, we find that ratings may respond differently to the liquidity and operating expenses to operating income variables across countries. Typically ratings are more responsive to the former and less sensitive to the latter for “new” EU countries compared with “old” EU countries.
Courtois, Renee (2009): Reforming the Raters, Federal Reserve Bank of Richmond, Region FocusFrom the introduction: … In the last decade, rating agencies have been an essential part of the process of mortgage securitization, or turning home mortgages into bonds that were sold throughout the global financial market. Ratings opened up securities backed by mortgages, including many subprime mortgages, to a larger pool of investors than ever before, especially ones constrained by regulations to hold only assets of a certain safety level. This allowed profits from the booming housing market to be shared throughout the financial system. Like lenders and investors, rating agencies shared in that profit. The “Big Three” rating agencies of Standard & Poor’s (S&P), Moody’s Investors Service, and Fitch Ratings, which together represent more than 95 percent of the market share in the rating industry, made record profits rating mortgagebacked securities: The Big Three’s revenue from ratings doubled from $3 billion to $6 billion during the 2002 to 2007 heyday of subprime lending and securitization. In hindsight, many of these ratings did not do a good job of predicting the performance of the securities. … Rating agencies were by no means the only parties that underestimated the riskiness of these securities. Nonetheless, the role that rating agencies played in the securitization process has led to an intense discussion about reform within the rating industry, which will depend critically on understanding the incentives these agencies face to produce accurate ratings.
De Haan, Jakob and Fabian Amtenbrink (2011): Credit Rating Agencies, DNB Working PaperAbstract: This paper critically reviews the debate on CRAs and, in the light thereof, analyses the European regulatory approach to CRAs, thereby combining insights from economics and law. We first provide some basic background on the function of CRAs. Thereafter, we focus on the two main tasks for which CRAs have come under criticism, namely the issuing of sovereign ratings and the rating of structured instruments. Finally, we zoom in on the question of whether and how CRAs should be regulated given their function, focusing on recent European legislation that aims to standardize the conduct of CRAs.
European Commission (2010): Public Consultation on Credit Rating AgenciesContents Introduction 1. Overreliance on External Credit Ratings 1.1. Reference to external ratings in regulatory capital frameworks for credit institutions, investment firms, insurance and reinsurance undertakings 1.2. Use of external ratings for internal risk management purposes 1.3. Use of external ratings in the mandates and investment policies of investment managers 2. Sovereign Debt Ratings 2.1. Enhance transparency and monitoring of sovereign debt ratings 2.2. Enhanced requirements on the methodology and the process of rating sovereign debt 3. Enhancing Competition in the Credit Rating Industry 3.1. European Central Bank or National Central Banks 3.2. New National Entrants 3.3. Public/Private structures 3.4. European Network of Small and Medium-sized Credit Rating Agencies 4. Civil Liability of Credit Rating Agencies 5. Potential Conflicts of Interest due to the “Issuer-Pays” Model 5.1. “Subscriber/Investor-Pays” model 5.2. “Payment-upon-results” model 5.3. “Trading venues Pay” model 5.4. Government as Hiring Agent model 5.5. Public Utility model Annex 1 – References to ratings in EU financial Regulation
European Securities Markets Expert Group (2008): The Role of Credit Rating AgenciesContents 1. Introduction, background and answers to the general questions 2. Responses to the European Commission’s specific questions 3. ESME’s conclusions and recommendations 4. Appendix I: US regulation of CRAs 5. Appendix II: ESME’s Mandate 6. Appendix III: ESME membership 7. Bibliography
Financial Stability Board (2010): Principles for Reducing Reliance on CRA RatingsContents Principle I: Reducing reliance on CRA ratings in standards, laws and regulationsPrinciple II: Reducing market reliance on CRA ratings Application of the basic principles to particular financial market activities Principle III.1: Central bank Principle III.2: Prudential supervision of banks Principle III.3: Internal limits and investment policies of investment managers and institutional investors Principle III.4: Private sector margin agreements Principle III.5: Disclosures by issuers of securities Next steps
Hill, Claire A. (2010): Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?, University of Minnesota Law School Legal Studies Research PaperAbstract: As of February 2008, Moody’s had downgraded at least one tranche of 94.2% of the subprime RMBS issues it rated in 2006, including 100% of the 2006 RMBS backed by second-lien loans and 76.9% of the issues rated in 2007. Overall, Moody’s has downgraded 53.7% and 39.2% of all of its 2006 and 2007 subprime tranches, respectively. As of March 2008, S&P had downgraded 44.3% of the subprime tranches it rated between the first quarter of 2005 and the third quarter of 2007. This included 87.2% of securities backed by second-lien mortgages. As of December 2007, Fitch had downgraded approximately 34% of the subprime tranches it rated in 2006 and in the first quarter of 2007. In February 2008, Fitch placed all of the RMBS it rated in 2006 and the first quarter of 2007 backed by subprime first-lien mortgages on Ratings Watch Negative.
John P. Hunt (2009): Credit Rating Agencies and the ‘Worldwide Credit Crisis’: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement” Columbia Business Law ReviewAbstract: The “worldwide credit crisis” has thrust credit rating agencies into the spotlight, with attention focused on their ratings of novel structured finance products. Policymakers have undertaken a number of initiatives intended to address perceived problems with such ratings – enhancing competition, promoting transparency, reducing conflicts of interest, and reducing ratings-dependent regulation. These approaches are all broadly consistent with the dominant academic theory of rating agencies, the “reputational capital” model, which is taken to imply that under the right circumstances a well-functioning reputation mechanism will deter low-quality ratings. The policy initiatives currently under consideration can be seen as efforts to fix discrete problems with the rating market so that the reputation mechanism can work properly. This Article argues that these efforts are fundamentally incomplete, because even a well-functioning reputation mechanism does not generate optimum rating quality on new products: When a new product is introduced, agencies do not have a reputation for high quality in that product so they have nothing to lose from issuing the rating. Even if low quality for a specific product type harms the agency’s reputation for rating other product types, the agency still will be induced to issue low-quality ratings if the new product type in question is large enough in volume. And as long as rating quality across new product types is high enough on average, it is rational for investors to rely on new-product ratings even if they know that some are of low quality. The incentive problem can be corrected by requiring an agency to disgorge profits on ratings that are revealed to be of low quality by the performance of the product type over time, unless the agency discloses that the ratings are of low quality. Such a system would be superior both to the current regime, which relies on market forces backed by antifraud rules, and to other alternatives, such as the recent proposal to forbid new-product ratings absent prior SEC approval of the products.
Katz, Jonathan et al. (2009): Credit Rating Agencies – No Easy Regulatory Solutions, World Bank crisisresponse Note Number 8Abstract: In the United States and Europe faulty credit ratings and flawed rating processes are widely perceived as being among the key contributors to the global financial crisis. That has brought them under intense scrutiny and led to proposals for radical reforms. The ongoing debate, while centered in major developed markets will also influence policy choices in emerging economies: whether to focus on strengthening the reliability of ratings or on creating alternative mechanisms and institutions that can perform more effectively the role that in developed markets has traditionally been conferred on credit rating agencies.
Mason, Joseph R. and Josh Rosner (2007): Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market DisruptionsAbstract: Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings.
Packer, Frank and Nikola Tarashev (2011): Rating methodologies for banks, BIS Quarterly ReviewAbstract: The three major rating agencies are reassessing banks’ credit risk in the light of the recent crisis. So far, this has resulted in material downgrades, especially of European and US institutions, and increased agreement about banks’ overall level of creditworthiness and their greater dependence on public support than in the past. The agencies are also making efforts to enhance the transparency of bank ratings and the role of official support. Agency assessments of regulatory initiatives may affect policymakers’ communication with financial markets.
Partnoy, Frank (2009): Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective, University of San Diego School of Law, San Diego Legal Studies PaperAbstract: This white paper was commissioned by the Council of Institutional Investors for the purpose of educating its members, policymakers, and the general public about important credit rating agency regulation proposals and their potential impact on investors. It offers an institutional investor perspective of the pros and cons of several proposals for redesigning credit rating agency regulation. It focuses on two areas of primary importance – oversight and accountability – and offers specific recommendations in both areas.
First, Congress should create a new Credit Rating Agency Oversight Board (CRAOB) with the power to regulate rating agency practices, including disclosure, conflicts of interest, and rating methodologies, as well as the ability to coordinate the reduction of reliance on ratings. Alternatively, Congress could enhance the authority of the Securities and Exchange Commission (SEC) to grant it similar power to oversee the rating business. Second, Congress should eliminate the effective exemption of rating agencies from liability and make rating agencies more accountable by treating them the same as banks, accountants, and lawyers.
As financial gatekeepers with little incentive to “get it right,” credit rating agencies pose a systemic risk. Creating a rating agency oversight board and strengthening the accountability of rating agencies is thus consistent with the broader push by U.S. policymakers for greater systemic risk oversight. Over the long term, other measures for assessing credit risk may become more acceptable and accessible to regulators and investors. Meanwhile, a more powerful overseer and broader accountability would help reposition credit rating agencies as true information intermediaries.
Shorter, Gary and Michael V. Seitzinger (2009): Credit Rating Agencies and Their Regulation, CRS Report for CongressContents Evolution of the Issuer-Pays ModelThe Nationally Recognized Statistical Rating Organization Designation and Its Potential Impact The Credit Rating Agency Reform Act of 2006 The Rating Agencies and Structured Finance First Amendment Issues and the Rating Agencies Various Responses to the Perceived Rating Agency Failings The July 2008 SEC Study on Moody’s, S&P, and Fitch Voluntary Reforms Adopted by the Rating Agencies The Settlement with the New York Attorney General Reforms Adopted by the SEC The European Union’s Reforms The SEC’s April 2009 Credit Rating Agency Roundtable The Obama Administration’s Legislative Draft on Rating Agency Reform CRA-Related Legislation
Utzig, Siegfried (2010): The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective, ADBI Working PaperAbstract: Credit rating agencies (CRAs) bear some responsibility for the financial crisis that started in 2007 and remains ongoing. This is acknowledged by policymakers, market participants, and by the agencies themselves. It soon became clear that, given the depth of the crisis, CRAs would not be able to satisfy policymakers by eliminating flaws in their rating methods and improving corporate governance. Although the CRAs were more or less unregulated before the outbreak of the financial crisis, after the crisis started, politicians became increasingly vocal in demanding regulation. Initially, these demands were confined to a more binding form of self-regulation. But as the crisis progressed, the calls for state regulation grew ever louder. It became apparent after the November 2008 G-20 summit in Washington that state regulation could no longer be avoided. In Europe, the course had been set in this direction even before then. Since European policymakers saw the crisis as evidence that the Anglo-Saxon approach to the financial markets had failed, they believed they were now strongly placed to have a decisive influence on shaping a new international financial order. It is remarkable to note the shift in European policy from a self-regulatory approach, which was comparatively liberal in international terms, to quite rigorous state regulation of CRAs. Both the European Commission and the European Parliament drew up far-reaching plans. Although European policymakers knew that only globally consistent regulation would be appropriate for a new world financial order, their initial draft legislation was geared more toward stand-alone European regulation. While the final version of the European Union Regulation on Credit Rating Agencies focuses firmly on the European arena, the key point for all market participants is that this is unlikely to have an adverse effect on the global ratings market. It must nevertheless be recognized that the scope of the selected regulatory approach is extremely narrow. Certainly, it has the potential to improve the corporate governance of CRAs and prevent conflicts of interests. But it can do nothing to address the repeated calls for greater competition or for CRAs to be made liable for their ratings.
White, Lawrence J. (2010): The Credit Rating Agencies, Journal of Economic PerspectivesFrom the introduction: In 1909, John Moody published the first publicly available bond ratings, focused entirely on railroad bonds. Moody’s firm was followed by Poor’s Publishing Company in 1916, the Standard Statistics Company in 1922, and the Fitch Publishing Company in 1924. … Favorable ratings from these three credit agencies were crucial for the successful sale of the securities based on subprime residential mortgages and other debt obligations. The sales of these bonds, in turn, were an important underpinning for the financing of the self-reinforcing price-rise bubble in the U.S. housing market. When house prices ceased rising in mid 2006 and then began to decline, the default rates on the mortgages underlying these securities rose sharply, and those initial ratings proved to be excessively optimistic. The price declines and uncertainty surrounding these widely-held securities then helped to turn a drop in housing prices into a widespread crisis in the U.S. and global financial systems. This paper will explore how the financial regulatory structure propelled these three credit rating agencies to the center of the U.S. bond markets—and thereby virtually guaranteed that when these rating agencies did make mistakes, those mistakes would have serious consequences for the financial sector. …
Wolverson, Roya (2010): The Road to Financial Regulatory Reform, Council on Foreign Relations BackgrounderContents Introduction Regulating Derivatives Consumer Financial Protection Systemic Risk Regulation Federal Reserve Oversight Credit Rating Agencies Bank Bonuses and TARP Repayment The Volcker Rule
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