Rating Agencies
Featured Piece
“Credit Rating Agencies & Regulation: Why Less is More,” by Professor Lawrence White, in Make Markets Be Markets, Roosevelt Institute, (2010).ABSTRACT
The three large U.S.-based credit rating agencies – Moody’s, Standard & Poor’s, and Fitch provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) – is understandable, given this context and history. The hope, of course, is to forestall future such debacles.
In the Media
Stop Mandating Reliance on Ratings, by Lawrence White,The New York Times, February 19, 2013.
Papers
ABSTRACT (Click Here for Paper)
The central role that the three large U.S.-based rating agencies played in the subprime mortgage lending debacle and the subsequent financial crisis has led to expanded regulation of the rating agencies and political calls for considerably more regulation. The advocates of this policy route, however, ignore the history of how the rating agencies came to occupy a central place in the provision of bond creditworthiness information; and they ignore the dangers that more regulation will raise the barriers to entry into and decrease innovation in the provision of bond creditworthiness information. A better policy route would be to reduce the regulation of the rating agencies while reforming the prudential regulation of financial institutions' bond portfolios, by eliminating regulatory reliance on ratings. This would allow financial institutions to obtain their bond creditworthiness information from a wider range of sources, which would encourage new methodologies, new technologies, new procedures, and possibly even new business models. Since the transactors in bond markets are predominantly institutional bond managers, less regulation of the information providers would be appropriate.
The central role that the three large U.S.-based rating agencies played in the subprime mortgage lending debacle and the subsequent financial crisis has led to expanded regulation of the rating agencies and political calls for considerably more regulation. The advocates of this policy route, however, ignore the history of how the rating agencies came to occupy a central place in the provision of bond creditworthiness information; and they ignore the dangers that more regulation will raise the barriers to entry into and decrease innovation in the provision of bond creditworthiness information. A better policy route would be to reduce the regulation of the rating agencies while reforming the prudential regulation of financial institutions' bond portfolios, by eliminating regulatory reliance on ratings. This would allow financial institutions to obtain their bond creditworthiness information from a wider range of sources, which would encourage new methodologies, new technologies, new procedures, and possibly even new business models. Since the transactors in bond markets are predominantly institutional bond managers, less regulation of the information providers would be appropriate.
ABSTRACT (Click Here for Paper)
The three large U.S.-based credit rating agencies - Moody's, Standard & Poor's, and Fitch provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) - is understandable, given this context and history. The hope, of course, is to forestall future such debacles.
The three large U.S.-based credit rating agencies - Moody's, Standard & Poor's, and Fitch provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade actions that played a central role in the financial debacle of the past two years. The strong political sentiment for heightened regulation of the rating agencies as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) - is understandable, given this context and history. The hope, of course, is to forestall future such debacles.
ABSTRACT
By means of the high ratings that they awarded to subprime mortgage‐backed bonds, the three major rating agencies Moody's, Standard & Poor's, and Fitch played a central role in the current financial crisis. Without these ratings, it is doubtful that subprime mortgages would have been issued in such huge amounts, since a major reason for the subprime lending boom was investor demand for high‐rated bonds much of it generated by regulations that made such bonds mandatory for large institutional investors. And it is even less likely that such bonds would have become concentrated on the balance sheets of the banks, for which they were rewarded by capital regulations that tilted toward high‐rated securities. Why, then, were the agencies excessively optimistic in their ratings of subprime mortgage‐backed securities? A combination of their fee structure, the complexity of the bonds that they were rating, insufficient historical data, some carelessness, and market pressures proved to be a potent brew. This combination was enabled, however, by seven decades of financial regulation that, beginning in the 1930s, had conferred the force of law upon these agencies' judgments about the creditworthiness of bonds and that, since 1975, had protected the three agencies from competition.
By means of the high ratings that they awarded to subprime mortgage‐backed bonds, the three major rating agencies Moody's, Standard & Poor's, and Fitch played a central role in the current financial crisis. Without these ratings, it is doubtful that subprime mortgages would have been issued in such huge amounts, since a major reason for the subprime lending boom was investor demand for high‐rated bonds much of it generated by regulations that made such bonds mandatory for large institutional investors. And it is even less likely that such bonds would have become concentrated on the balance sheets of the banks, for which they were rewarded by capital regulations that tilted toward high‐rated securities. Why, then, were the agencies excessively optimistic in their ratings of subprime mortgage‐backed securities? A combination of their fee structure, the complexity of the bonds that they were rating, insufficient historical data, some carelessness, and market pressures proved to be a potent brew. This combination was enabled, however, by seven decades of financial regulation that, beginning in the 1930s, had conferred the force of law upon these agencies' judgments about the creditworthiness of bonds and that, since 1975, had protected the three agencies from competition.
ABSTRACT (Click Here for Paper)
In the run-up to the financial crisis of 2007-2008, market participants relied heavily on the ratings that credit rating agencies assigned to financial instruments, including mortgage-backed securities, to determine creditworthy investment options. As mortgage holders began to default on their loans and many highly rated securities lost value, the poor quality of these ratings became apparent. Policy makers pondering financial regulatory changes to avoid future catastrophes should understand how regulatory actions facilitated a noncompetitive credit rating industry and propelled its members into the center of the bond information process, which in turn contributed to the financial crisis of 2007-2008.
In the run-up to the financial crisis of 2007-2008, market participants relied heavily on the ratings that credit rating agencies assigned to financial instruments, including mortgage-backed securities, to determine creditworthy investment options. As mortgage holders began to default on their loans and many highly rated securities lost value, the poor quality of these ratings became apparent. Policy makers pondering financial regulatory changes to avoid future catastrophes should understand how regulatory actions facilitated a noncompetitive credit rating industry and propelled its members into the center of the bond information process, which in turn contributed to the financial crisis of 2007-2008.
ABSTRACT (Click Here for Paper)
Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings - observe multiple ratings and disclose only the most favorable - before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.
Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings - observe multiple ratings and disclose only the most favorable - before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.
ABSTRACT (Click Here for Paper)
The Securities and Exchange Commission continues to struggle with mutual fund and corporate governance issues and with disputes as to whether the Sarbanes-Oxley Act went too far or not far enough. There is another important domain of the sec, however its regulation of the bond rating industry where recent legislation has significantly changed the landscape and offers the possibility of a more open regulatory regime and a more competitive industry. Unfortunately, progress is not a foregone conclusion. With little fanfare last September, President Bush signed the Credit Rating Agency Reform Act of 2006. The act could well be as important for the development of U.S. capital markets as any likely reform of Sarbanes-Oxley. Consider the fact that, at the end of September 2006, there was over $8 trillion of corporate, state and local government, and asset-backed structured finance bonds outstanding much of it rated by only a (literal) handful of bond rating companies. A full understanding of the significance of the new law requires a brief recounting of the bond rating industry's history and the sec's haphazard regulation of this industry over the past 31 years.
The Securities and Exchange Commission continues to struggle with mutual fund and corporate governance issues and with disputes as to whether the Sarbanes-Oxley Act went too far or not far enough. There is another important domain of the sec, however its regulation of the bond rating industry where recent legislation has significantly changed the landscape and offers the possibility of a more open regulatory regime and a more competitive industry. Unfortunately, progress is not a foregone conclusion. With little fanfare last September, President Bush signed the Credit Rating Agency Reform Act of 2006. The act could well be as important for the development of U.S. capital markets as any likely reform of Sarbanes-Oxley. Consider the fact that, at the end of September 2006, there was over $8 trillion of corporate, state and local government, and asset-backed structured finance bonds outstanding much of it rated by only a (literal) handful of bond rating companies. A full understanding of the significance of the new law requires a brief recounting of the bond rating industry's history and the sec's haphazard regulation of this industry over the past 31 years.
ABSTRACT (Click Here for Paper)
This paper discusses the SEC's regulation of the bond rating industry. Until a few years ago this specific branch of SEC regulation was largely unknown outside the agency and the bond rating industry itself, even among knowledgeable Washington insiders. But the SEC has actually regulated the industry since 1975: by limiting entry, in an indirect but powerful way. As a consequence, incumbent bond rating firms are protected; potential entrants are impeded; and new ideas and technologies for assessing the riskiness of debt, and thereby the allocation of capital, may well be stifled. This entry regulation is an excellent example of good intentions having gone awry, via the "law" of unintended consequences. The good intentions were to improve the safety-and-soundness regulation of financial institutions, and even to use "market" information to do so. But the unfortunate result has been a distortionary entry restriction regime with respect to bond rating firms. Fortunately, there are better ways to achieve the desired goals - ways that would permit the SEC to cease these entry restrictions and nevertheless allow safety-and-soundness regulation of financial institutions to proceed in desirable directions. If the SEC were to exit from its role as the entry regulator of the bond rating industry, financial markets' participants could then make their own decisions as to which firms and methods offer the best information as to the default probabilities and other relevant parameters with respect to debt issuances. This paper expands on these themes.
This paper discusses the SEC's regulation of the bond rating industry. Until a few years ago this specific branch of SEC regulation was largely unknown outside the agency and the bond rating industry itself, even among knowledgeable Washington insiders. But the SEC has actually regulated the industry since 1975: by limiting entry, in an indirect but powerful way. As a consequence, incumbent bond rating firms are protected; potential entrants are impeded; and new ideas and technologies for assessing the riskiness of debt, and thereby the allocation of capital, may well be stifled. This entry regulation is an excellent example of good intentions having gone awry, via the "law" of unintended consequences. The good intentions were to improve the safety-and-soundness regulation of financial institutions, and even to use "market" information to do so. But the unfortunate result has been a distortionary entry restriction regime with respect to bond rating firms. Fortunately, there are better ways to achieve the desired goals - ways that would permit the SEC to cease these entry restrictions and nevertheless allow safety-and-soundness regulation of financial institutions to proceed in desirable directions. If the SEC were to exit from its role as the entry regulator of the bond rating industry, financial markets' participants could then make their own decisions as to which firms and methods offer the best information as to the default probabilities and other relevant parameters with respect to debt issuances. This paper expands on these themes.
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