The role of credit rating agencies in financial market The case of subprime crisis in the US

The role of credit rating agencies in financial market
The case of subprime crisis in the US

Diem Thi Thu Trang

Thesis submitted to the faculty of the University of Bordeaux
in partial fulfillment of the requirement for the degrees of

MASTER BFNI

Dr. Raphael Chiappini

Hanoi, Jan 2017

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Contents
Contents.................................................................................................................................2
Introduction............................................................................................................................3
Section 1: Overview of financial markets and the role of credit rating agencies in
reducing the information asymmetry....................................................................................5
1.1. Financial market.........................................................................................................5
1.1.1 An overview of financial markets and their functions........................................5
1.1.2 An overview of financial markets and their functions........................................8
1.1.3 The information asymmetry in the financial markets..........................................9
1.2 Credit rating agencies................................................................................................12
1.2.1 The formation of credit rating agencies and rating industry.............................13
1.2.2 The role of CRA in rating mortgage securities and their shortcomings...........18
1.2.3 The credit rating market on the eve of the recent crises....................................23
1.2.4 Criticism of credit rating agencies.....................................................................25

Section 2: The subprime mortgage crisis in the US............................................................31
2.1. Overview of subprime mortgage crisis in the US....................................................31
2.2. Analysing of the role of rating agencies in US subprime crisis..............................33
2.2.1 Rating the structured products and mortages.....................................................33
2.2.2 Errors of omission..............................................................................................34
2.2.3 Errors of commission.........................................................................................35
2.2.4 Impact of ratings on credit derivatives and credit default swaps......................36
2.2.5 Downgrades by rating agencies.........................................................................36
2.3 Lessons and experiences from The Failures of Credit Rating Agencies.................37
2.3.1 Reasons for the mistakes of rating agencies during US subprime crisis..........38
2.3.2 Solutions and recommendations........................................................................43
2.4 Conclusion.................................................................................................................48
References............................................................................................................................49
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Introduction
In the. wa.ke. of the. re.ce.nt fina.ncia.l cris.is., cre.dit ra.ting a.ge.ncie.s. (CA.R) ha.ve. be.e.n he.a.vily
criticize.d by inve.s.tors., politicia.ns., a.nd the. ge.ne.ra.l public for not putting a. re.d fla.g on the.
a.ris.ing U.S.. hous.ing bubble. a.nd s.ubs.e.que.ntly the. s.ubprim.e. cris.is.. Ye.t, only lim.ite.d
re.s.e.a.rch e.xis.ts. on the. concre.te. pe.rform.a.nce. of ra.ting a.ge.ncie.s. throughout the. fina.ncia.l
cris.is.. In this. conte.xt a. ra.the.r prom.ine.nt m.a.rke.t s.e.gm.e.nt is. U.S.. re.s.ide.ntia.l m.ortga.ge.ba.cke.d s.e.curitie.s. (U.S.. RM.BS.): ba.nks. m.a.inly us.e.d s.e.curitiza.tion s.tructure.s. to s.e.ll off
U.S.. re.s.ide.ntia.l m.ortga.ge.s. to worldwide. inve.s.tors. a.nd, a.s. we. know toda.y, this. fue.lle.d the.
U.S.. hous.e. price. bubble.. Be.ca.us.e. ra.ting a.ge.ncie.s. a.cte.d a.s. the.ir a.ge.nts. a.nd provide.d a.
cre.dit ra.ting for e.a.ch of the. is.s.ue.d RM.BS., m.os.t of which we.re. e.ve.n ra.te.d by m.ultiple.
a.ge.ncie.s. a.nd s.till a.tte.s.te.d una.ba.te.d cre.dit qua.lity in the. be.ginning of 2008.
Cre.dit ra.ting bus.ine.s.s. firs.tly e.m.e.rge.d in the. Unite.d S.ta.te.s. (US.) in 1900s. a.nd be.ca.m.e. a.n
im.porta.nt pa.rt of inte.rna.tiona.l fina.ncia.l m.a.rke.ts. in pa.ra.lle.l with the. globa.liza.tion of
fina.ncia.l m.a.rke.ts. a.s. of m.id-1970s.. Cre.dit ra.ting a.ge.ncie.s. (CRA.) contribute. to the.
e.fficie.ntly functioning of fina.ncia.l m.a.rke.ts. by re.ducing the. inform.a.tion a.s.ym.m.e.try

be.twe.e.n borrowe.rs. a.nd le.nde.rs. (A.de.ls.on, 2012). But inve.s.tors., policy m.a.ke.rs. a.nd
gove.rnm.e.nts. be.ga.n to inve.s.tiga.te. the. re.lia.bility of cre.dit ra.tings. e.s.pe.cia.lly a.fte.r the.
re.ce.nt cris.e.s. a.nd the. CRA.s. a.ls.o we.re. s.e.e.n a.s. a. pa.rt of the.s.e. cris.e.s.. S.o the. US., E.U
(E.urope.a.n Union) a.nd the. inte.rna.tiona.l orga.niza.tions. que.s.tione.d the. functioning of the.
cre.dit ra.ting m.a.rke.t a.nd m.a.de. s.om.e. re.gula.tions. on the. CRA.s. to e.lim.ina.te. the.
im.pe.rfe.ctions. in the. m.a.rke.t.
The. obje.ctive. of this. s.tudy is. to s.tudy the. role. of CRA. in fina.ncia.l m.a.rke.t a.nd its.
contribution to fina.ncia.l cris.is. with the. ca.s.e. of s.ubprim.e. cris.is. in the. US. by cla.rifying
two m.a.in re.s.e.a.rch que.s.tions. a.s. follows.:
1. Wha.t is. the. curre.nt role., le.ga.l s.ta.tus. a.nd functions. of Cre.dit
Ra.ting A.ge.ncie.s. in the. fina.ncia.l m.a.rke.t?
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2. How doe.s. Cre.dit Ra.ting A.ge.ncie.s. (CRA.) im.pa.ct to the. s.ubprim.e.
cris.is. in the. US.?
This. the.s.is. cons.is.ts. of two pa.rts. a.nd is. orga.nize.d a.s. follows.. Lite.ra.ture.
Re.vie.w S.e.ction pre.s.e.nts. a.n ove.rvie.w on the. fina.ncia.l m.a.rke.t a.nd the.
proble.m. of inform.a.tion a.s.ym.m.e.try be.twe.e.n borrowe.rs. a.nd le.nde.rs.. This. s.e.ction a.ls.o
pre.s.e.nts. the. his.tory of CA.R a.s. we.ll a.s. the.ir role. in s.olving inform.a.tion a.s.ym.m.e.try
proble.m.s.. Ca.s.e. S.tudy S.e.ction pre.s.e.nts. a.nd a.na.lys.is. role. a.nd function of CA.R in
s.ubprim.e. m.ortga.ge. cris.is. in the. US. a.ris.ing from. burs.ting of s.pe.cula.tive.
bubble. which gre.w up in the. US. hous.ing m.a.rke.t le.d to the. globa.l
fina.ncia.l cris.is. in 2008.

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Section 1: Overview of financial markets and the role
of credit rating agencies in reducing the information

asymmetry
1.1. Financial market
1.1.1 An overview of financial markets and their functions
Fina.ncia.l m.a.rke.ts. pe.rform. the. e.s.s.e.ntia.l e.conom.ic function of cha.nne.ling funds. from.
hous.e.holds., firm.s., a.nd gove.rnm.e.nts. tha.t ha.ve. s.a.ve.d s.urplus. funds. by s.pe.nding le.s.s. tha.n
the.ir incom.e. to thos.e. tha.t ha.ve. a. s.horta.ge. of funds. be.ca.us.e. the.y wis.h to s.pe.nd m.ore. tha.n
the.ir incom.e. (M.is.hkin, 2007). This. function is. s.hown s.che.m.a.tica.lly in Figure. 1. Thos.e.
who ha.ve. s.a.ve.d a.nd a.re. le.nding funds., the. le.nde.r-s.a.ve.rs., a.re. a.t the. le.ft, a.nd thos.e. who
m.us.t borrow funds. to fina.nce. the.ir s.pe.nding, the. borrowe.r-s.pe.nde.rs., a.re. a.t the. right. The.
principa.l le.nde.r-s.a.ve.rs. a.re. hous.e.holds., but bus.ine.s.s. e.nte.rpris.e.s. a.nd the. gove.rnm.e.nt
(pa.rticula.rly s.ta.te. a.nd loca.l gove.rnm.e.nt), a.s. we.ll a.s. fore.igne.rs. a.nd the.ir gove.rnm.e.nts.,
s.om.e.tim.e.s. a.ls.o find the.m.s.e.lve.s. with e.xce.s.s. funds. a.nd s.o le.nd the.m. out. The. m.os.t
im.porta.nt borrowe.r-s.pe.nde.rs. a.re. bus.ine.s.s.e.s. a.nd the. gove.rnm.e.nt (pa.rticula.rly the. fe.de.ra.l
gove.rnm.e.nt), but hous.e.holds. a.nd fore.igne.rs. a.ls.o borrow to fina.nce. the.ir purcha.s.e.s. of
ca.rs., furniture., a.nd hous.e.s.. The. a.rrows. s.how tha.t funds. flow from. le.nde.r-s.a.ve.rs. to
borrowe.r-s.pe.nde.rs. via. two route.s..

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Figure. 1: Flows. of Funds. Through the. Fina.ncia.l S.ys.te.m.

In dire.ct fina.nce. (the. route. a.t the. bottom. of Figure. 1), borrowe.rs. borrow funds. dire.ctly
from. le.nde.rs. in fina.ncia.l m.a.rke.ts. by s.e.lling the.m. s.e.curitie.s. (a.ls.o ca.lle.d fina.ncia.l
ins.trum.e.nts.), which a.re. cla.im.s. on the. borrowe.r’s. future. incom.e. or a.s.s.e.ts. (Ba.ll, 2007) .
S.e.curitie.s. a.re. a.s.s.e.ts. for the. pe.rs.on who buys. the.m., but the.y a.re. lia.bilitie.s. (IOUs. or de.bts.)
for the. individua.l or firm. tha.t s.e.lls. (is.s.ue.s.) the.m.. For e.xa.m.ple., if Boe.ing ne.e.ds. to borrow
funds. to pa.y for a. ne.w fa.ctory to m.a.nufa.cture. pla.ne., it m.ight borrow the. funds. from.
s.a.ve.rs. by s.e.lling the.m. a. bond, a. de.bt s.e.curity tha.t prom.is.e.s. to m.a.ke. pa.ym.e.nts.
pe.riodica.lly for a. s.pe.cifie.d pe.riod of tim.e., or a. s.tock, a. s.e.curity tha.t e.ntitle.s. the. owne.r to

a. s.ha.re. of the. com.pa.ny’s. profits. a.nd a.s.s.e.ts..
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The. e.xis.te.nce. of fina.ncia.l m.a.rke.ts. is. be.ne.ficia.l e.ve.n if s.om.e.one. borrows. for a. purpos.e.
othe.r tha.n incre.a.s.ing production in a. bus.ine.s.s. (Howe.lls. & Ba.in, 2008). S.a.y tha.t you a.re.
re.ce.ntly m.a.rrie.d, ha.ve. a. good job, a.nd wa.nt to buy a. hous.e.. You e.a.rn a. good s.a.la.ry, but
be.ca.us.e. you ha.ve. jus.t s.ta.rte.d to work, you ha.ve. not s.a.ve.d m.uch. Ove.r tim.e., you would
ha.ve. no proble.m. s.a.ving e.nough to buy the. hous.e. of your dre.a.m.s., but by the.n you would
be. too old to ge.t full e.njoym.e.nt from. it. Without fina.ncia.l m.a.rke.ts., you a.re. s.tuck; you
ca.nnot buy the. hous.e. a.nd m.us.t continue. to live. in your tiny a.pa.rtm.e.nt.
If a. fina.ncia.l m.a.rke.t we.re. s.e.t up s.o tha.t pe.ople. who ha.d built up s.a.vings. could le.nd you
the. funds. to buy the. hous.e., you would be. m.ore. tha.n ha.ppy to pa.y the.m. s.om.e. inte.re.s.t s.o
tha.t you could own a. hom.e. while. you a.re. s.till young e.nough to e.njoy it. The.n, ove.r tim.e.,
you would pa.y ba.ck your loa.n. If this. loa.n could occur, you would be. be.tte.r off, a.s. would
the. pe.rs.ons. who m.a.de. you the. loa.n. The.y would now e.a.rn s.om.e. inte.re.s.t, whe.re.a.s. the.y
would not if the. fina.ncia.l m.a.rke.t did not e.xis.t.
Fina.ncia.l m.a.rke.ts. a.llow funds. to m.ove. from. pe.ople. who la.ck productive. inve.s.tm.e.nt
opportunitie.s. to pe.ople. who ha.ve. s.uch opportunitie.s.. Fina.ncia.l m.a.rke.ts. a.re. critica.l for
producing a.n e.fficie.nt a.lloca.tion of ca.pita.l (we.a.lth, e.ithe.r fina.ncia.l or phys.ica.l, tha.t is.
e.m.ploye.d to produce. m.ore. we.a.lth), which contribute.s. to highe.r production a.nd
e.fficie.ncy for the. ove.ra.ll e.conom.y. Whe.n fina.ncia.l m.a.rke.ts. bre.a.k down during fina.ncia.l
cris.e.s., a.s. the.y did during the. re.ce.nt globa.l fina.ncia.l cris.is., s.e.ve.re. e.conom.ic ha.rds.hip
re.s.ults., which ca.n e.ve.n le.a.d to da.nge.rous. politica.l ins.ta.bility.
We.ll-functioning fina.ncia.l m.a.rke.ts. a.ls.o dire.ctly im.prove. the. we.ll-be.ing of cons.um.e.rs. by
a.llowing the.m. to tim.e. the.ir purcha.s.e.s. be.tte.r. The.y provide. funds. to young pe.ople. to buy
wha.t the.y ne.e.d a.nd ca.n e.ve.ntua.lly a.fford without forcing the.m. to wa.it until the.y ha.ve.
s.a.ve.d up the. e.ntire. purcha.s.e. price.. Fina.ncia.l m.a.rke.ts. tha.t a.re. ope.ra.ting e.fficie.ntly
im.prove. the. e.conom.ic we.lfa.re. of e.ve.ryone. in the. s.ocie.ty.

7


1.1.2 An overview of financial markets and their functions
A. fina.ncia.l ins.trum.e.nt (or fina.ncia.l products.) is. the. writte.n le.ga.l obliga.tion of one. pa.rty
to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.lly m.one.y, to a.nothe.r pa.rty a.t s.om.e. future. da.te., unde.r
s.pe.cife.d conditions. (Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006). Fina.ncia.l ins.trum.e.nts.
ha.ve. the. following im.porta.nt cha.ra.cte.ris.tics..
Firs.t, a. fina.ncia.l ins.trum.e.nt is. a. writte.n le.ga.l obliga.tion tha.t is. s.ubje.ct to gove.rnm.e.nt
e.nforce.m.e.nt. Tha.t is., a. pe.rs.on (or a. firm.) ca.n be. com.pe.lle.d to ta.ke. the. a.ction s.pe.cife.d in
the. a.gre.e.m.e.nt. The. e.nforce.a.bility of the. obliga.tion is. a.n im.porta.nt fe.a.ture. of a. fna.ncia.l
ins.trum.e.nt. Without e.nforce.m.e.nt of the. s.pe.cife.d te.rm.s., fna.ncia.l ins.trum.e.nts. would not
e.xis.t.
S.e.cond, a. fina.ncia.l ins.trum.e.nt obliga.te.s. one. pa.rty to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.lly
m.one.y, to a.nothe.r pa.rty. By pa.rty, we. m.e.a.n a. pe.rs.on, com.pa.ny, or gove.rnm.e.nt. Us.ua.lly
the. fina.ncia.l ins.trum.e.nt s.pe.cife.s. tha.t pa.ym.e.nts. will be. m.a.de.. For e.xa.m.ple., if you ge.t a.
ca.r loa.n, you a.re. obliga.te.d to m.a.ke. m.onthly pa.ym.e.nts. of a. pa.rticula.r a.m.ount to the.
le.nde.r. A.nd if you ha.ve. a.n a.ccide.nt, your ins.ura.nce. com.pa.ny is. obliga.te.d to fix your ca.r,
though the. cos.t of the. re.pa.ir is. le.ft uns.pe.cife.d.
Third, a. fina.ncia.l ins.trum.e.nt s.pe.cife.s. tha.t pa.ym.e.nt will be. m.a.de. a.t s.om.e. future. da.te.. In
s.om.e. ca.s.e.s., s.uch a.s. a. ca.r loa.n tha.t re.quire.s. pa.ym.e.nts. the. da.te.s. m.a.y be. ve.ry s.pe.cific. In
othe.rs., s.uch a.s. ca.r ins.ura.nce., the. pa.ym.e.nt is. trigge.re.d whe.n s.om.e.thing s.pe.cific ha.ppe.ns.,
like. a.n a.ccide.nt.
Fina.lly, a. fina.ncia.l ins.trum.e.nt s.pe.cifie.s. conditions. unde.r which a. pa.ym.e.nt will be. m.a.de..
S.om.e. a.gre.e.m.e.nts. s.pe.cify pa.ym.e.nts. only whe.n ce.rta.in e.ve.nts. ha.ppe.n. Tha.t is. cle.a.rly the.
ca.s.e. with ca.r ins.ura.nce. a.nd with s.tocks. a.s. we.ll. The. holde.r of a. s.tock owns. a. s.m.a.ll pa.rt
of a. frm. a.nd s.o ca.n e.xpe.ct to re.ce.ive. occa.s.iona.l ca.s.h pa.ym.e.nts., ca.lle.d divide.nds., whe.n
the. com.pa.ny is. profita.ble.. The.re. is. no wa.y to know in a.dva.nce., howe.ve.r, e.xa.ctly whe.n
s.uch pa.ym.e.nts. will be. m.a.de.. In ge.ne.ra.l, fina.ncia.l ins.trum.e.nts. s.pe.cifies a. num.be.r of
pos.s.ible. continge.ncie.s. unde.r which one. pa.rty is. re.quire.d to m.a.ke. a. pa.ym.e.nt to a.nothe.r.

8


The.re. a.re. two funda.m.e.nta.l cla.s.s.e.s. of fina.ncia.l ins.trum.e.nts.. The. firs.t, unde.rlying
ins.trum.e.nts. (s.om.e.tim.e.s. ca.lle.d prim.itive. s.e.curitie.s.), a.re. us.e.d by s.a.ve.rs./le.nde.rs. to tra.ns.fe.r
re.s.ource.s. dire.ctly to inve.s.tors./borrowe.rs.. Through the.s.e. ins.trum.e.nts., the. fina.ncia.l
s.ys.te.m. im.prove.s. the. e.fficie.nt a.lloca.tion of re.s.ource.s. in the. re.a.l e.conom.y. The. prim.a.ry
e.xa.m.ple.s. of unde.rlying s.e.curitie.s. or ins.trum.e.nts. a.re. s.tocks. a.nd bonds. tha.t offe.r
pa.ym.e.nts. ba.s.e.d s.ole.ly on the. is.s.ue.r’s. s.ta.tus.. Bonds., for e.xa.m.ple., m.a.ke. pa.ym.e.nts.
de.pe.nding on the. s.olve.ncy of the. firm. tha.t is.s.ue.d the.m.. S.tocks. s.om.e.tim.e.s. pa.y divide.nds.
whe.n the. is.s.uing corpora.tion’s. profits. a.re. s.ufficie.nt.
The. s.e.cond cla.s.s. of fina.ncia.l ins.trum.e.nts. is. known a.s. de.riva.tive. ins.trum.e.nts.. The.ir va.lue.
a.nd pa.yoffs. a.re. “de.rive.d” from. the. be.ha.vior of the. unde.rlying ins.trum.e.nts.. The. m.os.t
com.m.on e.xa.m.ple.s. of de.riva.tive.s. a.re. future.s., options., a.nd s.tructure.d fina.ncia.l products.
s.uch a.s. m.ortga.ge.-ba.cke.d s.e.curitie.s. (or m.orta.ge.s. for s.hort). In ge.ne.ra.l, de.riva.tive.s.
s.pe.cify a. pa.ym.e.nt to be. m.a.de. be.twe.e.n the. pe.rs.on who s.e.lls. the. ins.trum.e.nt a.nd the.
pe.rs.on who buys. it. The. a.m.ount of the. pa.ym.e.nt de.pe.nds. on va.rious. fa.ctors. a.s.s.ocia.te.d
with the. price. of the. unde.rlying a.s.s.e.t. The. prim.a.ry us.e. of de.riva.tive.s. is. to s.hift ris.k
a.m.ong inve.s.tors..
1.1.3 The information asymmetry in the financial markets
Whe.n fina.ncia.l m.a.rke.ts. work we.ll, the.y cha.nne.l funds. from. s.a.ve.rs. to inve.s.tors., a.nd the.y
he.lp pe.ople. re.duce. ris.k. But fina.ncia.l m.a.rke.ts. don’t a.lwa.ys. work we.ll. S.om.e.tim.e.s. the.y
bre.a.k down, ha.rm.ing s.a.ve.rs., inve.s.tors., a.nd the. e.conom.y. The. proble.m.s. of fina.ncia.l
m.a.rke.ts. ca.n be. com.ple.x, but m.a.ny ha.ve. the. s.a.m.e. root ca.us.e.: a.s.ym.m.e.tric inform.a.tion, a.
s.itua.tion in which one. pa.rticipa.nt in a.n e.conom.ic tra.ns.a.ction ha.s. m.ore. inform.a.tion tha.n
the. othe.r pa.rticipa.nt (M.is.kin, 2007; Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006; M.e.rton,
1974). In fina.ncia.l m.a.rke.ts., the. a.s.ym.m.e.try ge.ne.ra.lly occurs. be.ca.us.e. the. s.e.lle.rs. of
s.e.curitie.s. ha.ve. m.ore. inform.a.tion tha.n the. buye.rs..
Two type.s. of a.s.ym.m.e.tric inform.a.tion e.xis.t in fina.ncia.l m.a.rke.ts., a.dve.rs.e. s.e.le.ction a.nd
m.ora.l ha.za.rd.

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A.dve.rs.e. s.e.le.ction is. the. proble.m. cre.a.te.d by a.s.ym.m.e.tric inform.a.tion be.fore. the.
tra.ns.a.ction occurs.. A.dve.rs.e. s.e.le.ction in fina.ncia.l m.a.rke.ts. occurs. whe.n the. pote.ntia.l
borrowe.rs. who a.re. the. m.os.t like.ly to produce. a.n unde.s.ira.ble. (a.dve.rs.e.) outcom.e. - the. ba.d
cre.dit ris.ks. - a.re. the. one.s. who m.os.t a.ctive.ly s.e.e.k out a. loa.n a.nd a.re. thus. m.os.t like.ly to be.
s.e.le.cte.d. Be.ca.us.e. a.dve.rs.e. s.e.le.ction m.a.ke.s. it m.ore. like.ly tha.t loa.ns. m.ight be. m.a.de. to ba.d
cre.dit ris.ks., le.nde.rs. m.a.y de.cide. not to m.a.ke. a.ny loa.ns. e.ve.n though the.re. a.re. good cre.dit
ris.ks. in the. m.a.rke.tpla.ce..
To unde.rs.ta.nd why a.dve.rs.e. s.e.le.ction occurs., s.uppos.e. tha.t you ha.ve. two a.unts. to whom.
you m.ight m.a.ke. a. loa.n - A.unt Louis.e. a.nd A.unt S.he.ila.. A.unt Louis.e. is. a. cons.e.rva.tive.
type. who borrows. only whe.n s.he. ha.s. a.n inve.s.tm.e.nt s.he. is. quite. s.ure. will pa.y off. A.unt
S.he.ila., by contra.s.t, is. a.n inve.te.ra.te. ga.m.ble.r who ha.s. jus.t com.e. a.cros.s. a. ge.t-rich-quick
s.che.m.e. tha.t will m.a.ke. he.r a. m.illiona.ire. if s.he. ca.n jus.t borrow $1,000 to inve.s.t in it.
Unfortuna.te.ly, a.s. with m.os.t ge.t-rich-quick s.che.m.e.s., the.re. is. a. high proba.bility tha.t the.
inve.s.tm.e.nt won’t pa.y off a.nd tha.t A.unt S.he.ila. will los.e. the. $1,000.
Which of your a.unts. is. m.ore. like.ly to ca.ll you to a.s.k for a. loa.n? A.unt S.he.ila., of cours.e.,
be.ca.us.e. s.he. ha.s. s.o m.uch to ga.in if the. inve.s.tm.e.nt pa.ys. off. You, howe.ve.r, would not
wa.nt to m.a.ke. a. loa.n to he.r be.ca.us.e. the.re. is. a. high proba.bility tha.t he.r inve.s.tm.e.nt will
turn s.our a.nd s.he. will be. una.ble. to pa.y you ba.ck. If you kne.w both your a.unts. ve.ry we.ll tha.t is., if your inform.a.tion we.re. not a.s.ym.m.e.tric - you wouldn’t ha.ve. a. proble.m., be.ca.us.e.
you would know tha.t A.unt S.he.ila. is. a. ba.d ris.k a.nd s.o you would not le.nd to he.r.
S.uppos.e., though, tha.t you don’t know your a.unts. we.ll. You a.re. m.ore. like.ly to le.nd to
A.unt S.he.ila. tha.n to A.unt Louis.e. be.ca.us.e. A.unt S.he.ila. would be. hounding you for the.
loa.n. Be.ca.us.e. of the. pos.s.ibility of a.dve.rs.e. s.e.le.ction, you m.ight de.cide. not to le.nd to
e.ithe.r of your a.unts., e.ve.n though the.re. a.re. tim.e.s. whe.n A.unt Louis.e., who is. a.n e.xce.lle.nt
cre.dit ris.k, m.ight ne.e.d a. loa.n for a. worthwhile. inve.s.tm.e.nt.
M.ora.l ha.za.rd is. the. proble.m. cre.a.te.d by a.s.ym.m.e.tric inform.a.tion a.fte.r the. tra.ns.a.ction
occurs.. M.ora.l ha.za.rd in fina.ncia.l m.a.rke.ts. is. the. ris.k (ha.za.rd) tha.t the. borrowe.r m.ight
e.nga.ge. in a.ctivitie.s. tha.t a.re. unde.s.ira.ble. (im.m.ora.l) from. the. le.nde.r’s. point of vie.w,

10


be.ca.us.e. the.y m.a.ke. it le.s.s. like.ly tha.t the. loa.n will be. pa.id ba.ck. Be.ca.us.e. m.ora.l ha.za.rd
lowe.rs. the. proba.bility tha.t the. loa.n will be. re.pa.id, le.nde.rs. m.a.y de.cide. tha.t the.y would
ra.the.r not m.a.ke. a. loa.n.
A.s. a.n e.xa.m.ple. of m.ora.l ha.za.rd, s.uppos.e. tha.t you m.a.de. a. $1,000 loa.n to a.nothe.r re.la.tive.,
Uncle. M.e.lvin, who ne.e.ds. the. m.one.y to purcha.s.e. a. com.pute.r s.o he. ca.n s.e.t up a. bus.ine.s.s.
typing s.tude.nts.’ te.rm. pa.pe.rs.. Once. you ha.ve. m.a.de. the. loa.n, howe.ve.r, Uncle. M.e.lvin is.
m.ore. like.ly to s.lip off to the. tra.ck a.nd pla.y the. hors.e.s.. If he. be.ts. on a. 20-to-1 long s.hot
a.nd wins. with your m.one.y, he. is. a.ble. to pa.y you ba.ck your $1,000 a.nd live. high off the.
hog with the. re.m.a.ining $19,000. But if he. los.e.s., a.s. is. like.ly, you don’t ge.t pa.id ba.ck, a.nd
a.ll he. ha.s. los.t is. his. re.puta.tion a.s. a. re.lia.ble., ups.ta.nding uncle.. Uncle. M.e.lvin the.re.fore.
ha.s. a.n ince.ntive. to go to the. tra.ck be.ca.us.e. his. ga.ins. ($19,000) if he. be.ts. corre.ctly a.re.
m.uch gre.a.te.r tha.n the. cos.t to him. (his. re.puta.tion) if he. be.ts. incorre.ctly. If you kne.w wha.t
Uncle. M.e.lvin wa.s. up to, you would pre.ve.nt him. from. going to the. tra.ck, a.nd he. would
not be. a.ble. to incre.a.s.e. the. m.ora.l ha.za.rd. Howe.ve.r, be.ca.us.e. it is. ha.rd for you to ke.e.p
inform.e.d a.bout his. whe.re.a.bouts.—tha.t is., be.ca.us.e. inform.a.tion is. a.s.ym.m.e.tric—the.re. is. a.
good cha.nce. tha.t Uncle. M.e.lvin will go to the. tra.ck a.nd you will not ge.t pa.id ba.ck. The.
ris.k of m.ora.l ha.za.rd m.ight the.re.fore. dis.coura.ge. you from. m.a.king the. $1,000 loa.n to
Uncle. M.e.lvin, e.ve.n if you we.re. s.ure. tha.t you would be. pa.id ba.ck if he. us.e.d it to s.e.t up
his. bus.ine.s.s..
A.nothe.r wa.y of de.s.cribing the. m.ora.l ha.za.rd proble.m. is. tha.t it le.a.ds. to conflicts. of
inte.re.s.t, in which one. pa.rty in a. fina.ncia.l contra.ct ha.s. ince.ntive.s. to a.ct in its. own inte.re.s.t
ra.the.r tha.n in the. inte.re.s.ts. of the. othe.r pa.rty. Inde.e.d, this. is. e.xa.ctly wha.t ha.ppe.ns. if your
Uncle. M.e.lvin is. te.m.pte.d to go to the. tra.ck a.nd ga.m.ble. a.t your e.xpe.ns.e..
The. proble.m.s. cre.a.te.d by a.dve.rs.e. s.e.le.ction a.nd m.ora.l ha.za.rd a.re. a.n im.porta.nt
im.pe.dim.e.nt to we.ll-functioning fina.ncia.l m.a.rke.ts.. A.ga.in, fina.ncia.l inte.rm.e.dia.rie.s. ca.n
a.lle.via.te. the.s.e. proble.m.s..

11


With fina.ncia.l inte.rm.e.dia.rie.s. in the. e.conom.y, s.m.a.ll s.a.ve.rs. ca.n provide. the.ir funds. to the.
fina.ncia.l m.a.rke.ts. by le.nding the.s.e. funds. to a. trus.tworthy inte.rm.e.dia.ry—s.a.y, the. Hone.s.t
John Ba.nk—which in turn le.nds. the. funds. out e.ithe.r by m.a.king loa.ns. or by buying
s.e.curitie.s. s.uch a.s. s.tocks. or bonds.. S.ucce.s.s.ful fina.ncia.l inte.rm.e.dia.rie.s. ha.ve. highe.r
e.a.rnings. on the.ir inve.s.tm.e.nts. tha.n s.m.a.ll s.a.ve.rs., be.ca.us.e. the.y a.re. be.tte.r e.quippe.d tha.n
individua.ls. to s.cre.e.n out ba.d cre.dit ris.ks. from. good one.s., the.re.by re.ducing los.s.e.s. due. to
a.dve.rs.e. s.e.le.ction. In a.ddition, fina.ncia.l inte.rm.e.dia.rie.s. ha.ve. high e.a.rnings. be.ca.us.e. the.y
de.ve.lop e.xpe.rtis.e. in m.onitoring the. pa.rtie.s. the.y le.nd to, thus. re.ducing los.s.e.s. due. to
m.ora.l ha.za.rd. The. re.s.ult is. tha.t fina.ncia.l inte.rm.e.dia.rie.s. ca.n a.fford to pa.y le.nde.r-s.a.ve.rs.
inte.re.s.t or provide. s.ubs.ta.ntia.l s.e.rvice.s. a.nd s.till e.a.rn a. profit.
A.s. we. ha.ve. s.e.e.n, fina.ncia.l inte.rm.e.dia.rie.s. pla.y a.n im.porta.nt role. in the. e.conom.y be.ca.us.e.
the.y provide. liquidity s.e.rvice.s., prom.ote. ris.k s.ha.ring, a.nd s.olve. inform.a.tion proble.m.s.,
the.re.by a.llowing s.m.a.ll s.a.ve.rs. a.nd borrowe.rs. to be.ne.fit from. the. e.xis.te.nce. of fina.ncia.l
m.a.rke.ts.. The. s.ucce.s.s. of fina.ncia.l inte.rm.e.dia.rie.s. in pe.rform.ing this. role. is. e.vide.nce.d by
the. fa.ct tha.t m.os.t A.m.e.rica.ns. inve.s.t the.ir s.a.vings. with the.m. a.nd obta.in loa.ns. from. the.m..
Fina.ncia.l inte.rm.e.dia.rie.s. pla.y a. ke.y role. in im.proving e.conom.ic e.fficie.ncy be.ca.us.e. the.y
he.lp fina.ncia.l m.a.rke.ts. cha.nne.l funds. from. le.nde.r-s.a.ve.rs. to pe.ople. with productive.
inve.s.tm.e.nt opportunitie.s.. Without a. we.llfunctioning s.e.t of fina.ncia.l inte.rm.e.dia.rie.s., it is.
ve.ry ha.rd for a.n e.conom.y to re.a.ch its. full pote.ntia.l.
1.2 Credit rating agencies
Cre.dit ra.ting bus.ine.s.s. firs.tly e.m.e.rge.d in the. Unite.d S.ta.te.s. (US.) in 1900s. a.nd be.ca.m.e. a.n
im.porta.nt pa.rt of inte.rna.tiona.l fina.ncia.l m.a.rke.ts. in pa.ra.lle.l with the. globa.liza.tion of
fina.ncia.l m.a.rke.ts. a.s. of m.id-1970s.. Cre.dit ra.ting a.ge.ncie.s. (CRA.) contribute. to the.
e.fficie.ntly functioning of fina.ncia.l m.a.rke.ts. by re.ducing the. inform.a.tion a.s.ym.m.e.try
be.twe.e.n borrowe.rs. a.nd le.nde.rs. (A.de.ls.on, 2012). But inve.s.tors. a.nd countrie.s. be.ga.n to
inve.s.tiga.te. the. re.lia.bility of cre.dit ra.tings. e.s.pe.cia.lly a.fte.r the. re.ce.nt cris.e.s. a.nd the. CRA.s.
a.ls.o we.re. s.e.e.n a.s. a. pa.rt of the.s.e. cris.e.s.. Thus., in this. s.e.ction the. a.uthor will pre.s.e.nt a.n

a.ve.rvie.w a.bout CA.R a.nd ra.ting indus.try.
12


1.2.1 The formation of credit rating agencies and rating
industry
In 1909, John M.oody publis.he.d the. frs.t publicly a.va.ila.ble. bond ra.tings., focus.e.d e.ntire.ly
on ra.ilroa.d bonds.. M.oody’s. frm. wa.s. followe.d by Poor’s. Publis.hing Com.pa.ny in 1916,
the. S.ta.nda.rd S.ta.tis.tics. Com.pa.ny in 1922, a.nd the. Fitch Publis.hing Com.pa.ny in 1924.
The.s.e. frm.s.’ bond ra.tings. we.re. s.old to bond inve.s.tors. in thick m.a.nua.ls.. The.s.e. frm.s.
e.volve.d ove.r tim.e.. Dun & Bra.ds.tre.e.t bought M.oody’s. in 1962, but the.n s.ubs.e.que.ntly
s.pun it off in 2000 a.s. a. fre.e.-s.ta.nding corpora.tion. Poor’s. a.nd S.ta.nda.rd m.e.rge.d in 1941;
S.ta.nda.rd & Poor’s. wa.s. the.n a.bs.orbe.d by M.cGra.wHill in 1966. Fitch m.e.rge.d with IBCA.
(a. Britis.h frm., which wa.s. a. s.ubs.idia.ry of FIM.ILA.C, a. Fre.nch bus.ine.s.s. s.e.rvice.s.
conglom.e.ra.te.) in 1997. A.t the. e.nd of the. ye.a.r 2000, a.t a.bout the. tim.e. tha.t the. m.a.rke.t for
s.tructure.d s.e.curitie.s. tha.t we.re. ba.s.e.d on s.ubprim.e. re.s.ide.ntia.l m.ortga.ge.s. be.ga.n growing
ra.pidly, the. is.s.ue.rs. of the.s.e. s.e.curitie.s. ha.d only the.s.e. thre.e. cre.dit-ra.ting a.ge.ncie.s. to whom.
the.y could turn to obta.in the.ir a.ll-im.porta.nt ra.tings.: M.oody’s., S.ta.nda.rd & Poor’s. (S.&P),
a.nd Fitch.
Fa.vora.ble. ra.tings. from. the.s.e. thre.e. cre.dit a.ge.ncie.s. we.re. crucia.l for the. s.ucce.s.s.ful s.a.le. of
the. s.e.curitie.s. ba.s.e.d on s.ubprim.e. re.s.ide.ntia.l m.ortga.ge.s. a.nd othe.r de.bt obliga.tions.. The.
s.a.le.s. of the.s.e. bonds., in turn, we.re. a.n im.porta.nt unde.rpinning for the. fna.ncing of the. s.e.lfre.inforcing price.-ris.e. bubble. in the. U.S.. hous.ing m.a.rke.t. Whe.n hous.e. price.s. ce.a.s.e.d
ris.ing in m.id 2006 a.nd the.n be.ga.n to de.cline., the. de.fa.ult ra.te.s. on the. m.ortga.ge.s.
unde.rlying the.s.e. s.e.curitie.s. ros.e. s.ha.rply, a.nd thos.e. initia.l ra.tings. prove.d to be. e.xce.s.s.ive.ly
optim.is.tic. The. price. de.cline.s. a.nd unce.rta.inty s.urrounding the.s.e. wide.ly-he.ld s.e.curitie.s.
the.n he.lpe.d to turn a. drop in hous.ing price.s. into a. wide.s.pre.a.d cris.is. in the. U.S.. a.nd
globa.l fna.ncia.l s.ys.te.m.s..
A. ce.ntra.l conce.rn of a.ny le.nde.r - including the. le.nde.rs./inve.s.tors. in bonds. - is. whe.the.r a.
pote.ntia.l or a.ctua.l borrowe.r is. like.ly to re.pa.y the. loa.n. A.long with colle.cting the.ir own
inform.a.tion a.bout borrowe.rs., a.nd im.pos.ing re.quire.m.e.nts. like. colla.te.ra.l, co-s.igne.rs., a.nd

re.s.trictive. cove.na.nts. in bond inde.nture.s. or le.nding a.gre.e.m.e.nts., thos.e. who le.nd m.one.y
13


m.a.y a.ls.o s.e.e.k outs.ide. a.dvice. a.bout cre.ditworthine.s.s.. The. purpos.e. of cre.dit ra.ting
a.ge.ncie.s. is. to he.lp pie.rce. the. fog of a.s.ym.m.e.tric inform.a.tion by offe.ring judgm.e.nts.—
the.y pre.fe.r the. word “opinions.” – a.bout the. cre.dit qua.lity of bonds. tha.t a.re. is.s.ue.d by
corpora.tions., U.S.. s.ta.te. a.nd loca.l gove.rnm.e.nts., “s.ove.re.ign” gove.rnm.e.nt is.s.ue.rs. of bonds.
a.broa.d, a.nd (m.os.t re.ce.ntly) m.ortga.ge. s.e.curitize.rs..
In the. e.a.rly ye.a.rs. of M.oody’s., S.ta.nda.rd, Poor’s., a.nd Fitch, the.y e.a.rne.d re.ve.nue. by
s.e.lling the.ir a.s.s.e.s.s.m.e.nts. of cre.ditworthine.s.s. to inve.s.tors.. This. occurre.d in the. e.ra. be.fore.
the. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion (S.E.C) wa.s. cre.a.te.d in 1934 a.nd be.ga.n re.quiring
corpora.tions. to is.s.ue. s.ta.nda.rdize.d fna.ncia.l s.ta.te.m.e.nts.. The.s.e. judgm.e.nts. com.e. in the.
form. of “ra.tings.,” which a.re. us.ua.lly a. le.tte.r gra.de.. The. be.s.t-known s.ca.le. is. tha.t us.e.d by
S.ta.nda.rd & Poor’s. a.nd s.om.e. othe.r ra.ting a.ge.ncie.s.: A.A.A., A.A., A., BBB, BB, a.nd s.o on,
with plus.e.s. a.nd m.inus.e.s. a.s. we.ll.
Howe.ve.r, a. m.a.jor cha.nge. in the. re.la.tions.hip be.twe.e.n the. cre.dit ra.ting a.ge.ncie.s. a.nd the.
U.S.. bond m.a.rke.ts. occurre.d in the. 1930s.. Ba.nk re.gula.tors. we.re. e.a.ge.r to e.ncoura.ge. ba.nks.
to inve.s.t only in s.a.fe. bonds.. The.y is.s.ue.d a. s.e.t of re.gula.tions. tha.t culm.ina.te.d in a. 1936
de.cre.e. tha.t prohibite.d ba.nks. from. inve.s.ting in “s.pe.cula.tive. inve.s.tm.e.nt s.e.curitie.s.” a.s.
de.te.rm.ine.d by “re.cognize.d ra.ting m.a.nua.ls..” “S.pe.cula.tive.” s.e.curitie.s. (which nowa.da.ys.
would be. ca.lle.d “ junk bonds.”) we.re. be.low “inve.s.tm.e.nt gra.de..” Thus., ba.nks. we.re.
re.s.tricte.d to holding only bonds. tha.t we.re. “inve.s.tm.e.nt gra.de.”—in m.ode.rn ra.tings., this.
would be. e.quiva.le.nt to bonds. tha.t we.re. ra.te.d BBB– or be.tte.r on the. S.ta.nda.rd & Poor’s.
s.ca.le.. With the.s.e. re.gula.tions. in pla.ce., ba.nks. we.re. no longe.r fre.e. to a.ct on inform.a.tion
a.bout bonds. from. a.ny s.ource. tha.t the.y de.e.m.e.d re.lia.ble. (a.lbe.it within ove.rs.ight by ba.nk
re.gula.tors.). The.y we.re. ins.te.a.d force.d to us.e. the. judgm.e.nts. of the. publis.he.rs. of the.
“re.cognize.d ra.ting m.a.nua.ls.”—which we.re. only M.oody’s., Poor’s., S.ta.nda.rd, a.nd Fitch.
E.s.s.e.ntia.lly, the. cre.ditworthine.s.s. judgm.e.nts. of the.s.e. third-pa.rty ra.te.rs. ha.d a.tta.ine.d the.
force. of la.w.

In the. following de.ca.de.s., the. ins.ura.nce. re.gula.tors. of the. 48 (a.nd e.ve.ntua.lly 50) s.ta.te.s.
followe.d a. s.im.ila.r pa.th. S.ta.te. ins.ura.nce. re.gula.tors. e.s.ta.blis.he.d m.inim.um. ca.pita.l
14


re.quire.m.e.nts. tha.t we.re. ge.a.re.d to the. ra.tings. on the. bonds. in which the. ins.ura.nce.
com.pa.nie.s. inve.s.te.d - the. ra.tings., of cours.e., com.ing from. the. s.a.m.e. s.m.a.ll group of ra.ting
a.ge.ncie.s.. Once. a.ga.in, a.n im.porta.nt s.e.t of re.gula.tors. ha.d de.le.ga.te.d the.ir s.a.fe.ty de.cis.ions.
to the. cre.dit ra.ting a.ge.ncie.s.. In the. 1970s., fe.de.ra.l pe.ns.ion re.gula.tors. purs.ue.d a. s.im.ila.r
s.tra.te.gy. The. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion crys.ta.llize.d the. ce.ntra.lity of the. thre.e.
ra.ting a.ge.ncie.s. in 1975, whe.n it de.cide.d to m.odify its. m.inim.um. ca.pita.l re.quire.m.e.nts. for
broke.r-de.a.le.rs., who include. m.a.jor inve.s.tm.e.nt ba.nks. a.nd s.e.curitie.s. frm.s.. Following the.
pa.tte.rn of the. othe.r fna.ncia.l re.gula.tors., the. S.E.C wa.nte.d thos.e. ca.pita.l re.quire.m.e.nts. to be.
s.e.ns.itive. to the. ris.kine.s.s. of the. broke.rde.a.le.rs.’ a.s.s.e.t portfolios. a.nd he.nce. wa.nte.d to us.e.
bond ra.tings. a.s. the. indica.tors. of ris.k. But it worrie.d tha.t re.fe.re.nce.s. to “re.cognize.d ra.ting
m.a.nua.ls.” we.re. too va.gue. a.nd tha.t a. bogus. ra.ting frm. m.ight a.ris.e. tha.t would prom.is.e.
A.A.A. ra.tings. to thos.e. com.pa.nie.s. tha.t would s.uita.bly re.wa.rd it a.nd “DDD” ra.tings. to
thos.e. tha.t would not.
To de.a.l with this. pote.ntia.l proble.m., the. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion cre.a.te.d a.
ne.w ca.te.gory—“na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion” (NRS.RO)—a.nd
im.m.e.dia.te.ly gra.ndfa.the.re.d M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch into the. ca.te.gory. The.
S.E.C de.cla.re.d tha.t only the. ra.tings. of NRS.ROs. we.re. va.lid for the. de.te.rm.ina.tion of the.
broke.r-de.a.le.rs.’ ca.pita.l re.quire.m.e.nts.. Othe.r fna.ncia.l re.gula.tors. s.oon a.dopte.d the. NRS.RO
ca.te.gory a.nd the. ra.ting a.ge.ncie.s. within it. In the. e.a.rly 1990s., the. S.E.C a.ga.in m.a.de. us.e. of
the. NRS.ROs.’ ra.tings. whe.n it e.s.ta.blis.he.d s.a.fe.ty re.quire.m.e.nts. for the. com.m.e.rcia.l pa.pe.r
(s.hort-te.rm. de.bt) he.ld by m.one.y m.a.rke.t m.utua.l funds..
Ta.ke.n toge.the.r, the.s.e. re.gula.tory rule.s. m.e.a.nt tha.t the. judgm.e.nts. of cre.dit ra.ting a.ge.ncie.s.
be.ca.m.e. of ce.ntra.l im.porta.nce. in bond m.a.rke.ts.. Ba.nks. a.nd m.a.ny othe.r fna.ncia.l
ins.titutions. could s.a.tis.fy the. s.a.fe.ty re.quire.m.e.nts. of the.ir re.gula.tors. by jus.t he.e.ding the.
ra.tings., ra.the.r tha.n the.ir own e.va.lua.tions. of the. ris.ks. of the. bonds.. Be.ca.us.e. the.s.e.

re.gula.te.d fna.ncia.l ins.titutions. we.re. s.uch im.porta.nt pa.rticipa.nts. in the. bond m.a.rke.t, othe.r
pla.ye.rs. in the. m.a.rke.t - both buye.rs. a.nd s.e.lle.rs. - ne.e.de.d to pa.y pa.rticula.r a.tte.ntion to the.
bond ra.te.rs.’ pronounce.m.e.nts. a.s. we.ll. The. irony of the. re.gula.tors.’ re.lia.nce. on the.
15


judgm.e.nts. of cre.dit ra.ting a.ge.ncie.s. is. powe.rfully re.ve.a.le.d by a. line. in S.ta.nda.rd & Poor’s.
s.ta.nda.rd dis.cla.im.e.r a.t the. bottom. of its. cre.dit ra.tings.: “a.ny us.e.r of the. inform.a.tion
conta.ine.d he.re.in s.hould not re.ly on a.ny cre.dit ra.ting or othe.r opinion conta.ine.d he.re.in
in m.a.king a.ny inve.s.tm.e.nt de.cis.ion.” (M.oody’s. ra.tings. ha.ve. a. s.im.ila.r dis.cla.im.e.r).
A.lthough the.re. a.ppe.a.r to be. roughly 150 loca.l a.nd inte.rna.tiona.l cre.dit ra.ting a.ge.ncie.s.
worldwide. (Ba.s.e.l Com.m.itte.e. on Ba.nking S.upe.rvis.ion, 2000; La.ngohr a.nd La.ngohr,
2008), M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch a.re. cle.a.rly the. dom.ina.nt e.ntitie.s.. A.ll thre.e.
ope.ra.te. on a. worldwide. ba.s.is., with offce.s. on s.ix contine.nts.; e.a.ch ha.s. ra.tings. outs.ta.nding
on te.ns. of trillions. of dolla.rs. of s.e.curitie.s.. Only M.oody’s. is. a. fre.e.-s.ta.nding com.pa.ny, s.o
the. m.os.t inform.a.tion is. known a.bout tha.t frm.: Its. 2008 a.nnua.l re.port lis.te.d the.
com.pa.ny’s. tota.l re.ve.nue.s. a.t $1.8 billion, its. ne.t re.ve.nue.s. a.t $458 m.illion, a.nd its. tota.l
a.s.s.e.ts. a.t ye.a.r-e.nd a.t $1.8 billion (M.oody’s., 2009). Fifty-two pe.rce.nt of its. tota.l re.ve.nue.
ca.m.e. from. the. Unite.d S.ta.te.s.; a.s. re.ce.ntly a.s. 2006 tha.t fra.ction wa.s. two-thirds.. S.ixty-nine.
pe.rce.nt of the. com.pa.ny’s. re.ve.nue.s. com.e.s. from. ra.tings.; the. re.s.t com.e.s. from. re.la.te.d
s.e.rvice.s.. A.t ye.a.r-e.nd 2008, the. com.pa.ny ha.d a.pproxim.a.te.ly 3,900 e.m.ploye.e.s., with
s.lightly m.ore. tha.n ha.lf loca.te.d in the. Unite.d S.ta.te.s..
Be.ca.us.e. S.ta.nda.rd & Poor’s. a.nd Fitch’s. ra.tings. ope.ra.tions. a.re. com.pone.nts. of la.rge.r
e.nte.rpris.e.s. tha.t re.port on a. cons.olida.te.d ba.s.is., com.pa.ra.ble. re.ve.nue. a.nd a.s.s.e.t fgure.s. a.re.
not pos.s.ible.. But S.ta.nda.rd & Poor’s. ra.ting ope.ra.tions. a.re. roughly the. s.a.m.e. s.ize. a.s.
M.oody’s., while. Fitch is. s.om.e.wha.t s.m.a.lle.r. Ta.ble. 1 provide.s. a. s.e.t of roughly com.pa.ra.ble.
da.ta. on e.a.ch com.pa.ny’s. a.na.lytica.l e.m.ploye.e.s. a.nd num.be.rs. of is.s.ue.s. ra.te.d. A.ll thre.e.
com.pa.nie.s. e.m.ploy a.bout the. s.a.m.e. num.be.rs. of a.na.lys.ts.; howe.ve.r, M.oody’s. a.nd S.ta.nda.rd
& Poor’s. ra.te. a.ppre.cia.bly m.ore. corpora.te. a.nd a.s.s.e.t-ba.cke.d s.e.curitie.s. tha.n doe.s. Fitch.
The. m.a.rke.t s.ha.re.s. (ba.s.e.d on re.ve.nue.s. or is.s.ue.s. ra.te.d) of the. thre.e. frm.s. a.re. com.m.only

e.s.tim.a.te.d to be. a.pproxim.a.te.ly 40, 40, a.nd 15 pe.rce.nt for M.oody’s., S.ta.nda.rd & Poor’s.,
a.nd Fitch, re.s.pe.ctive.ly (White., 2010).
Ta.ble. 1: Da.ta. from. Form. NRS.RO for 2009 for M.oody’s., S.ta.nda.rd & Poor’s., a.nd Fitch
16


M.oody's.

S.ta.nda.rd & Poor's. Fitch

Num.be.r of a.na.lys.is. e.m.ploye.e.s.:
Cre.dit A.na.lys.ts.
1126
1081
1057
Cre.dit A.na.lys.t S.upe.rvis.ors.
126
228
305
Num.be.r of bond is.s.ue.s. ra.te.d of:
Fina.ncia.l Ins.titutions.
84773
47300
83649
Fina.ncia.l Com.pa.nie.s.
6277
6600
4797
Corpora.te. Is.s.ue.rs.
31126

26900
14757
A.s.s.e.t-ba.cke.d S.e.curitie.s.
109281
198200
77480
Gove.rnm.e.nt S.e.curitie.s.
192953
976000
491264
S.ource.: Form. NRS.RO 2009, for e.a.ch com.pa.ny, a.s. found on e.a.ch com.pa.ny’s. we.bs.ite..
During the. 25 ye.a.rs. tha.t followe.d the. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion’s. 1975
cre.a.tion of the. “na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion” ca.te.gory, the. S.E.C
(S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion) de.s.igna.te.d only four a.dditiona.l frm.s. a.s.
NRS.ROs.: Duff & Phe.lps. in 1980; M.cCa.rthy, Poon (2003) in 2003. Howe.ve.r, m.e.rge.rs.
a.m.ong the. e.ntra.nts. a.nd with Fitch ca.us.e.d the. num.be.r of NRS.ROs. to re.turn to the.
origina.l thre.e. by ye.a.r-e.nd 2000. Of cours.e., the. cre.dit ra.ting indus.try wa.s. ne.ve.r going to
be. a. com.m.odity bus.ine.s.s. with hundre.ds. of s.m.a.ll-s.ca.le. produce.rs.. The. m.a.rke.t for bond
inform.a.tion is. one. whe.re. pote.ntia.l ba.rrie.rs. to e.ntry like. e.conom.ie.s. of s.ca.le., the.
a.dva.nta.ge.s. of e.xpe.rie.nce., a.nd bra.nd na.m.e. re.puta.tion a.re. im.porta.nt fe.a.ture.s..
Ne.ve.rthe.le.s.s., in cre.a.ting the. NRS.RO de.s.igna.tion, the. S.e.curitie.s. a.nd E.xcha.nge.
Com.m.is.s.ion ha.d be.com.e. a. s.ignifca.nt ba.rrie.r to e.ntry into the. bond ra.ting bus.ine.s.s. in its.
own right. Without the. be.ne.ft of the. NRS.RO de.s.igna.tion, a.ny would-be. bond ra.te.r would
like.ly re.m.a.in s.m.a.ll-s.ca.le.. Ne.w ra.ting frm.s. would ris.k be.ing ignore.d by m.os.t fna.ncia.l
ins.titutions. (the. “buy s.ide.” of the. bond m.a.rke.ts.); a.nd s.ince. the. fna.ncia.l ins.titutions.
would ignore. the. would-be. bond ra.te.r, s.o would bond is.s.ue.rs. (the. “s.e.ll s.ide.” of the.
m.a.rke.ts.).
In a.ddition, the. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion wa.s. re.m.a.rka.bly opa.que. in its.
de.s.igna.tion proce.s.s.. It ne.ve.r e.s.ta.blis.he.d form.a.l crite.ria. for a. frm. to be. de.s.igna.te.d a.s. a.
“na.tiona.lly re.cognize.d s.ta.tis.tica.l ra.ting orga.niza.tion,” ne.ve.r e.s.ta.blis.he.d a. form.a.l

17


a.pplica.tion a.nd re.vie.w proce.s.s., a.nd ne.ve.r provide.d a.ny jus.tifca.tion or e.xpla.na.tion for
why it “a.nointe.d” s.om.e. frm.s. with the. de.s.igna.tion a.nd re.fus.e.d to do s.o for othe.rs..
Howe.ve.r, it is. im.porta.nt to note. tha.t while. the. m.a.jor cre.dit ra.ting a.ge.ncie.s. a.re. a. m.a.jor
s.ource. of cre.ditworthine.s.s. for bond inve.s.tors., the.y a.re. fa.r from. the. only pote.ntia.l s.ource..
A. fe.w s.m.a.lle.r ra.ting frm.s.—nota.bly KM.V, E.ga.n-Jone.s., a.nd La.ce. Fina.ncia.l, a.ll of which
ha.d “inve.s.tor pa.ys.” bus.ine.s.s. m.ode.ls.—we.re. a.ble. to s.urvive., de.s.pite. the. a.bs.e.nce. of
NRS.RO de.s.igna.tions. (a.lthough KM.V wa.s. a.bs.orbe.d by M.oody’s. in 2002). S.om.e. bond
m.utua.l funds. do the.ir own re.s.e.a.rch, a.s. do s.om.e. he.dge. funds.. “Fixe.d incom.e. a.na.lys.ts.” a.t
m.a.ny fna.ncia.l s.e.rvice.s. frm.s. offe.r re.com.m.e.nda.tions. to thos.e. frm.s.’ clie.nts. with re.s.pe.ct to
bond inve.s.tm.e.nts..
1.2.2 The role of CRA in rating mortgage securities and their
shortcomings
A. ce.ntra.l is.s.ue. in fina.nce. – pe.rha.ps. the. ce.ntra.l is.s.ue. in fina.nce. – is. the. unce.rta.inty of a.
le.nde.r a.s. to whe.the.r a. borrowe.r will re.pa.y a. loa.n. The. critica.l proble.m. is. one. of
a.s.ym.m.e.tric inform.a.tion: The. borrowe.r us.ua.lly knows. m.ore. a.bout the. pros.pe.cts. for
re.pa.ym.e.nt tha.n doe.s. the. le.nde.r. A.s. a. cons.e.que.nce., be.fore. e.xte.nding a. loa.n, le.nde.rs. will
ga.the.r e.xte.ns.ive. inform.a.tion a.bout pros.pe.ctive. borrowe.rs., s.o a.s. to try to de.te.rm.ine.
which a.re. the. m.ore. cre.ditworthy borrowe.rs. a.nd which a.re. the. le.s.s. cre.ditworthy; a.nd e.ve.n
a.fte.r e.xte.nding a. loa.n, the. le.nde.r will us.ua.lly wa.nt to m.onitor the. borrowe.r’s. a.ctions., s.o
a.s. to be. re.a.s.s.ure.d tha.t the. borrowe.r’s. a.ctions. a.re. not putting re.pa.ym.e.nt in je.opa.rdy.
It will be. im.porta.nt to ke.e.p in m.ind tha.t bonds. a.re. jus.t a.nothe.r form. of a. loa.n. A.lthough
the. te.rm.inology (e..g., “inve.s.tors.”, “inve.s.ting”, “purcha.s.ing”; “is.s.ue.rs.”, “is.s.uing”,
“s.e.lling”) of bonds. m.a.y m.a.ke. the.m. s.ound diffe.re.nt, a. bond is. funda.m.e.nta.lly a. loa.n: The.
bond is.s.ue.r is. the. borrowe.r; the. bond buye.r (or inve.s.tor) is. the. le.nde.r. Cre.dit ra.ting
a.ge.ncie.s. a.re. one. pote.ntia.l s.ource. of he.lp for pie.rcing the. fog of a.s.ym.m.e.tric inform.a.tion
for bonds.. A.fte.r colle.cting inform.a.tion a.bout bond is.s.ue.rs., the.y offe.r judgm.e.nts. – the.y
pre.fe.r the. word “opinions.” A.ccordingly, tha.t ce.ntra.l que.s.tion of fina.nce. – will I ge.t

18


re.pa.id? – a.pplie.s. jus.t a.s. im.porta.ntly to bonds. a.bout the. cre.ditworthine.s.s. of bonds. tha.t a.re.
is.s.ue.d by corpora.tions., gove.rnm.e.nts. (including s.ta.te. a.nd loca.l gove.rnm.e.nts., a.s. we.ll a.s.
na.tiona.l – “s.ove.re.ign” – is.s.ue.rs.), a.nd s.e.curitize.rs. of m.ortga.ge. (a.nd othe.r) loa.ns.. The.s.e.
judgm.e.nts. a.re. in the. form. of “ra.tings.,” the. be.s.t known s.ym.bols. of which a.re.
thos.e. us.e.d by S.&P a.nd a. num.be.r of othe.r ra.ting a.ge.ncie.s.: A.A.A., A.A., A., BBB,
e.tc., with plus.e.s. a.nd m.inus.e.s. a.s. we.ll.

It is. im.porta.nt to e.m.pha.s.ize. tha.t the. cre.dit ra.ting a.ge.ncie.s. a.re. not the. only pote.ntia.l
s.ource. of s.uch cre.ditworthine.s.s. inform.a.tion. M.a.ny fina.ncia.l ins.titutions. a.re. ca.pa.ble. of
doing the.ir own re.s.e.a.rch. The.re. a.re. s.m.a.lle.r fina.ncia.l s.e.rvice.s. firm.s. tha.t m.a.y not de.s.cribe.
the.m.s.e.lve.s. a.s. “ra.ting a.ge.ncie.s.” but tha.t ne.ve.rthe.le.s.s. provide. a.dvice. a.bout
cre.ditworthine.s.s. to (ins.titutiona.l) bond inve.s.tors.. Furthe.r, m.a.ny fina.ncia.l s.e.rvice.s.
com.pa.nie.s., including la.rge. inve.s.tm.e.nt ba.nks. a.nd com.m.e.rcia.l ba.nks., e.m.ploy “fixe.d
incom.e. a.na.lys.ts.” whos.e. re.com.m.e.nda.tions. with re.s.pe.ct to bond inve.s.tm.e.nts. (ba.s.e.d on
the.ir judgm.e.nts. a.bout thos.e. bonds.’ cre.ditworthine.s.s.) a.re. provide.d to thos.e. com.pa.nie.s.’
(ins.titutiona.l) clie.nts..
How the.n did the. thre.e. la.rge. cre.dit ra.ting a.ge.ncie.s. ga.in the.ir prom.ine.nce. a.t the. ce.nte.r of
the. bond m.a.rke.ts.? It is. to the. his.tory of the. cre.dit ra.ting a.ge.ncie.s., a.nd the.ir e.ntwine.m.e.nt
with the. prude.ntia.l re.gula.tion of m.a.ny fina.ncia.l ins.titutions.’ bond portfolios., to which
we. now turn.
For the. be.tte.r pa.rt of the. pa.s.t ce.ntury, ra.ting a.ge.ncie.s. ha.ve. publis.he.d opinions. on the.
cre.ditworthine.s.s. of firm.s. a.nd s.e.curitie.s.. To re.a.ch the.ir opinions., which a.re. la.be.le.d a.s.
ra.tings., the.y ga.the.r a.nd a.na.lyze. a. wide. ra.nge. of fina.ncia.l, indus.try, a.nd e.conom.ic
inform.a.tion. This. inform.a.tion is. s.ynthe.s.ize.d a.nd publis.he.d to offe.r inde.pe.nde.nt, cre.dible.
a.s.s.e.s.s.m.e.nts. of cre.ditworthine.s.s.. In e.xcha.nge. for this. s.e.rvice., the. a.ge.ncie.s. typica.lly e.a.rn
fe.e.s. pa.id by is.s.ue.rs. inte.re.s.te.d in ha.ving the.ir s.e.curitie.s. ra.te.d. By he.lping re.s.olve.
inform.a.tion a.s.ym.m.e.trie.s. be.twe.e.n the. s.e.lle.r a.nd pote.ntia.l buye.rs., ra.tings. ca.n de.e.pe.n a.

s.e.curity’s. pool of pote.ntia.l inve.s.tors. a.nd the.re.by im.prove. pricing a.nd liquidity.
19


M.ore.ove.r, to the. e.xte.nt tha.t a. firm. fa.ce.s. the. ris.k of be.ing downgra.de.d, ra.tings. a.ls.o ha.ve.
the. pote.ntia.l to dis.cipline. m.a.na.ge.r be.ha.vior a.nd lim.it the.ir a.bility to s.hift ris.ks..
During the. pa.s.t s.e.ve.ra.l de.ca.de.s., cre.dit ra.tings. ha.ve. com.e. to pla.y a. ce.ntra.l role. in the.
fina.ncia.l s.ys.te.m. a.nd a.re. re.lie.d upon by a. num.be.r of ke.y m.a.rke.t pa.rticipa.nts.. M.a.ny
inve.s.tors. us.e. ra.tings. a.s. a. s.ta.rting point for cla.s.s.ifying a.nd unde.rs.ta.nding s.e.curitie.s. a.nd
the.ir a.s.s.ocia.te.d ris.ks.. Le.nde.rs. or counte.rpa.rtie.s. inte.re.s.te.d in im.pos.ing gre.a.te.r
re.s.pons.ibility on a. firm. m.a.y inde.e.d re.quire. it to be. ra.te.d. Buy-s.ide. firm.s. s.uch a.s. pe.ns.ion
funds., m.utua.l funds., a.nd ins.ura.nce. com.pa.nie.s. will ofte.n us.e. ra.tings. in a.iding the.ir
inve.s.tm.e.nt proce.s.s.. The.y m.ight us.e. ra.tings. to corrobora.te., e.nha.nce., or e.ve.n s.ubs.titute.
for in-hous.e. a.na.lys.is.. The.y m.a.y inve.s.tiga.te. the. re.a.s.oning be.hind a. ra.ting to unde.rs.ta.nd
a.nd a.nticipa.te. the. like.lihood of future. a.ctions. tha.t m.ight im.pa.ct price.s.. A.nd m.a.ny
ins.titutions. us.e. ra.tings. in the.ir inve.s.tm.e.nt policie.s. – for e.xa.m.ple., a.s. pa.rt of a.s.s.e.t
a.lloca.tion rule.s. tha.t re.quire. a. s.pe.cific fra.ction of ca.pita.l to be. inve.s.te.d in s.e.curitie.s. with
ce.rta.in ra.tings.. Fina.lly, the.y a.re. like.ly to us.e. ra.tings. to ide.ntify a.cce.pta.ble. counte.rpa.rtie.s.
in ce.rta.in tra.ns.a.ctions. a.nd to e.ns.ure. com.plia.nce. with re.gula.tions..
Re.gula.tors. a.ls.o re.ly on ra.tings.. For e.xa.m.ple., Rule. 2a.-7 of the. Inve.s.tm.e.nt Com.pa.ny A.ct
(prom.ulga.te.d by U.S.. S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion) s.pe.cifie.s. tha.t m.one.y m.a.rke.t
funds. ca.n only purcha.s.e. com.m.e.rcia.l pa.pe.r if it is. of s.ufficie.ntly high ra.ting. M.a.ny
countrie.s. us.e. cre.dit ra.tings. to re.s.trict the. kinds. of fixe.d-incom.e. inve.s.tm.e.nts. public a.nd
priva.te. pe.ns.ion funds. ca.n m.a.ke.. Ba.s.e.l II ha.s. be.e.n m.odifie.d to a.llow ce.rta.in ba.nks. to us.e.
e.xte.rna.l cre.dit ra.tings. to de.te.rm.ine. a.ppropria.te. ca.pita.l re.quire.m.e.nts. (Be.nford & Nie.r,
2007). Fina.lly, priva.te. contra.cts. ofte.n re.ly on ra.tings. to provide. e.xte.rna.l s.igna.ls. tha.t
trigge.r ce.rta.in a.ctions.. For e.xa.m.ple., a. firm. m.ight give. counte.rpa.rtie.s. the. right to de.m.a.nd
ca.s.h colla.te.ra.l in the. e.ve.nt of a. downgra.de. a.nd le.nde.rs. the. right to de.m.a.nd re.pa.ym.e.nt of
loa.ns. (Bha.not & M.e.llo, 2006).
In s.pite. of the.ir wide. us.e., cre.dit ra.tings. ha.ve. s.e.ve.ra.l s.hortcom.ings.. Firs.t, cre.dit ra.tings.

only conta.in inform.a.tion a.bout ca.s.h flow ris.k – de.fa.ult like.lihood a.nd e.xpe.cte.d re.cove.ry
– but nothing a.bout s.ys.te.m.a.tic ris.k e.xpos.ure.. This. inform.a.tion, while. im.porta.nt, is.
20


ins.ufficie.nt for pricing, s.ince. it ne.gle.cts. how pa.yoffs. cova.ry with e.conom.ic s.ta.te.s.. A.s. a.
re.s.ult, ra.tings. cre.a.te. a. wide. window within which s.e.curitie.s. of a. give.n ra.ting ca.n ha.ve.
m.a.rke.dly diffe.re.nt yie.lds.. A.nd a.lthough this. ha.s. his.torica.lly not be.e.n a. m.a.jor is.s.ue. in the.
s.ingle.-na.m.e. m.a.rke.t, with m.os.t corpora.te. bonds. ha.ving s.im.ila.r s.ys.te.m.a.tic ris.k e.xpos.ure.s.
(Fa.m.a. & Fre.nch, 1993), a.s. we. dis.cus.s.e.d a.bove. a.nd will de.m.ons.tra.te. be.low, s.tructure.d
fina.nce. cre.a.te.s. la.rge. dis.tortions. in s.e.curitie.s.’ s.ys.te.m.a.tic ris.k e.xpos.ure.s. re.la.tive. to
s.im.ila.rly-ra.te.d s.ingle. corpora.te. bonds..
A. s.e.cond criticis.m. of cre.dit ra.tings. tha.t ha.s. be.e.n a.round a.lm.os.t a.s. long a.s. ra.tings.
the.m.s.e.lve.s. is. tha.t the.y a.re. s.om.e.thing of a. “s.ide.s.how” whe.n it com.e.s. to pricing a.nd
pe.rha.ps. e.ve.n ris.k a.s.s.e.s.s.m.e.nt its.e.lf. In fa.ct, e.ve.n a.t the. tim.e. tha.t the. US. S.e.curitie.s. a.nd
E.xcha.nge. Com.m.is.s.ion gra.nte.d the. ra.ting a.ge.ncie.s. the.ir s.pe.cia.l de.s.igna.tion of Na.tiona.lly
Re.cognize.d S.ta.tis.tica.l Ra.ting Orga.niza.tion (NRS.RO) the.re. wa.s. conce.rn ove.r the. de.a.rth
of e.vide.nce. tha.t the.y we.re. e.ffe.ctive. (Grie.r & Ka.tz, 1976). S.ince. the.n, la.rge. lite.ra.ture.s.
e.m.e.rge.d tha.t e.xa.m.ine. the. e.xte.nt to which cre.dit ra.tings. conta.in inform.a.tion not a.lre.a.dy
incorpora.te.d in s.tock a.nd bond price.s. (Hite. & Wa.rga., 1997). A.s. a. whole., the. e.vide.nce.
pa.ints. a.t be.s.t a. m.ixe.d picture. of the. va.lue. of ra.tings.. For e.xa.m.ple., s.pre.a.ds. on cre.dit
de.fa.ult s.wa.ps. re.a.ct m.ode.s.tly to ra.tings. a.ctivity (Hull & Pre.de.s.cu a.nd White., 2004) a.nd
cre.dit ra.tings. do not s.e.e.m. to include. m.uch inform.a.tion tha.t is. he.lpful in pre.dicting
de.fa.ult be.yond tha.t which is. a.lre.a.dy conta.ine.d in yie.ld s.pre.a.ds.. Inde.e.d, the. be.s.t m.ode.ls.
of de.fa.ult like.lihood a.re. option-ba.s.e.d m.ode.ls. tha.t a.re. drive.n by s.tock price.s. (Bha.ra.th a.nd
S.hum.wa.y, 2007).
A. third conce.rn e.m.e.rge.d during inve.s.tiga.tions. of the. colla.ps.e. of E.nron – the. la.ck of
tra.ns.pa.re.ncy in the. ra.tings. proce.s.s.. M.a.ny re.gula.tors. a.nd is.s.ue.rs. a.rgue.d tha.t incre.a.s.e.d
tra.ns.pa.re.ncy would a.llow for gre.a.te.r public s.crutiny of the. a.ctivitie.s. of ra.te.d com.pa.nie.s.
a.nd re.duce. the. pote.ntia.l for conflicts. of inte.re.s.t a.nd the. us.e. of fra.udule.nt a.ccounting

pra.ctice.s.. This. re.s.ulte.d in a.n e.nvironm.e.nt in which is.s.ue.rs. de.s.igning com.ple.x s.e.curitie.s.
ha.d a.n e.xce.lle.nt ide.a. of wha.t m.ode.ls. a.nd m.e.thods. the. ra.ting a.ge.ncie.s. would us.e. to
de.te.rm.ine. the.ir ra.tings.. A.nd, of cours.e., this. pla.ce.d a. he.a.vy burde.n on the. ra.ting a.ge.ncie.s.
21


to a.void a.ny m.is.ta.ke.s. in the.ir proce.s.s. tha.t could be. ide.ntifie.d a.nd e.xploite.d by s.a.vvy
is.s.ue.rs..
A. fina.l conce.rn is. the. pos.s.ibility of conflicts. of inte.re.s.t tha.t m.a.y a.ris.e. be.ca.us.e. the. is.s.ue.r
ra.the.r tha.n the. inve.s.tor pa.ys. for the. ra.ting. M.a.s.on a.nd Ros.ne.r (2007) a.rgue. tha.t the.
proce.s.s. of cre.a.ting s.tructure.d fina.nce. products. re.quire.s. ra.ting a.ge.ncie.s. to e.s.s.e.ntia.lly
“be.com.e. pa.rt of the. unde.rwriting te.a.m.,” cre.a.ting la.rge. conflicts. a.nd producing little.
tra.ns.pa.re.ncy for the. e.nd inve.s.tor. The. Com.m.itte.e. on the. Globa.l Fina.ncia.l S.ys.te.m. from.
the. Ba.nk of Inte.rna.tiona.l S.e.ttle.m.e.nts. (BIS.) inve.s.tiga.te.d this. conce.rn in 2005, a.nd
conclude.d tha.t this. pote.ntia.l proble.m. wa.s. no m.ore. s.e.ve.re. for s.tructure.d fina.nce. products.
tha.n for s.ingle.-na.m.e. cre.dit products., a.rguing tha.t re.puta.tion wa.s. a. s.trong force. a.ga.ins.t
ba.d be.ha.vior in both m.a.rke.ts.. “In fa.ct, the.re. a.ppe.a.r to be. no funda.m.e.nta.l diffe.re.nce.s. in
the. ra.ting proce.s.s.e.s. for s.tructure.d fina.nce. products. a.nd tra.ditiona.l bonds.. The. pote.ntia.l
conflicts. of inte.re.s.t a.ris.ing in s.tructure.d fina.nce. a.re. thus. unlike.ly to be. m.a.te.ria.lly
diffe.re.nt from. thos.e. in the. tra.ditiona.l s.e.gm.e.nts. of the. a.ge.ncie.s.’ bus.ine.s.s.”.
With the. re.ce.nt e.m.e.rge.nce. of s.tructure.d fina.nce. in inte.rna.tiona.l ca.pita.l m.a.rke.ts., the. role.
a.nd im.porta.nce. of cre.dit ra.ting a.ge.ncie.s. e.xpa.nde.d dra.m.a.tica.lly. Be.ca.us.e. s.tructure.d
fina.nce. typica.lly e.nta.ils. s.e.curitiza.tions. of cre.dit s.e.curitie.s. (bonds., loa.ns., m.ortga.ge.s.),
which a.re. the.m.s.e.lve.s. ofte.n ra.te.d, the. cre.dit ra.ting a.ge.ncie.s. we.re. na.tura.lly ca.lle.d upon to
ra.te. the. de.riva.tive. s.e.curitie.s.. Inde.e.d, is.s.ue.rs. we.re. e.a.ge.r to ha.ve. the.ir ne.w products. ra.te.d
on the. s.a.m.e. s.ca.le. a.s. bonds. s.o tha.t inve.s.tors. s.ubje.ct to ra.tings.-ba.s.e.d cons.tra.ints. by the.ir
inve.s.tm.e.nt m.a.nda.te.s. would be. a.ble. to purcha.s.e. the. s.e.curitie.s.. By ha.ving the. s.e.curitie.s.
ra.te.d, the. is.s.ue.rs. cre.a.te.d a.n illus.ion of com.pa.ra.bility to e.xis.ting s.ingle.-na.m.e. s.e.curity
which na.tura.lly incre.a.s.e.d the. pool of pote.ntia.l buye.rs. for wha.t othe.rwis.e. would ha.ve.
be.e.n pe.rce.ive.d a.s. ve.ry com.ple.x s.e.curitie.s..

Ra.ting s.tructure.d s.e.curitie.s. be.ca.m.e. a. big pa.rt of ra.ting a.ge.ncie.s.’ bus.ine.s.s., a.nd now
a.ccounts. a.s. m.uch re.ve.nue. a.s. the.ir tra.ditiona.l ra.ting of s.ingle.-na.m.e. s.e.curitie.s.. A.ccording
to M.oody’s. Corpora.tion, 32% of the.ir 2006 re.ve.nue.s. ca.m.e. from. ra.ting corpora.te. bonds.,
while. 44% of the.ir re.ve.nue.s. ca.m.e. from. ra.ting s.tructure.d fina.nce. products.. This. fa.ct is.
22


pa.rticula.rly im.pre.s.s.ive. in the. conte.xt of the. re.la.tive. a.m.ount of tim.e. it took to de.ve.lop
e.a.ch re.ve.nue. s.ource.: ra.ting a.ge.ncie.s. ha.ve. e.s.s.e.ntia.lly a. de.ca.de.’s. e.xpe.rie.nce. ra.ting
s.tructure.d fina.nce. products. whe.re.a.s. the.y built the.ir s.ingle.-na.m.e. ra.ting bus.ine.s.s. ove.r the.
pa.s.t ce.ntury.
1.2.3 The credit rating market on the eve of the recent crises
The. CRA. ra.te. de.bt s.e.curitie.s. by gove.rnm.e.nts. a.nd corpora.te. a.nd a.ls.o s.tructure.d fina.nce.
obliga.tions.. A. cre.dit ra.ting is. opinion of the. CRA. a.bout the. cre.ditworthine.s.s. of a.n
obligor with re.s.pe.ct to a. pa.rticula.r de.bt s.e.curity or othe.r fina.ncia.l obliga.tion. Cre.dit
ra.tings. ha.ve. four functions.:
 Re.s.olving inform.a.tion a.s.ym.m.e.try be.twe.e.n is.s.ue.rs. a.nd inve.s.tors. by m.e.a.s.uring the.
cre.dit ris.k of the. is.s.ue.r obje.ctive.ly,
 incre.a.s.ing e.fficie.ncy a.nd functioning of fina.ncia.l m.a.rke.ts.,
 providing a. m.e.a.ns. of com.pa.ris.on for a.ll is.s.ue.s. of e.m.be.dde.d cre.dit ris.k a.nd
providing a. cons.is.te.nt globa.l ra.ting s.ca.le. to he.lp build a. portfolio,
 providing m.a.rke.t pa.rticipa.nts. with a. com.m.on s.ta.nda.rd or la.ngua.ge. to re.fe.r to
cre.dit ris.k.
Cre.dit ra.tings. a.s.s.igne.d to s.e.curitie.s. indica.te. the. ris.k le.ve.l of the. unde.rlying s.e.curitie.s..
The.re.fore. cre.dit ra.ting is. a.ls.o a.n im.porta.nt de.te.rm.ina.nt of inte.re.s.t ra.te.s. which
gove.rnm.e.nts., corpora.te.s., ba.nks. a.nd ins.ura.nce. com.pa.nie.s. fa.ce. in the. fina.ncia.l m.a.rke.ts.
(A.fons.o e.t a.l., 2007). S.ince. gove.rnm.e.nts. a.nd corpora.te.s. with lowe.r cre.dit ra.ting ha.ve.
m.ore. ris.k pre.m.ium., the.y borrow from. highe.r inte.re.s.t ra.te.s. re.la.tive. to the. one.s. with
highe.r cre.dit ra.tings.. Cre.dit ra.tings. a.ls.o e.na.ble. or dis.a.ble. gove.rnm.e.nts. a.nd corpora.te.s. to
a.cce.s.s. to inte.rna.tiona.l fina.ncia.l m.a.rke.ts. be.ca.us.e. of na.tiona.l re.gula.tions. which prohibit

inve.s.ting in de.bt s.e.curitie.s. with s.pe.cula.tive. gra.de. (E.lkhoury, 2008).
The.re. ha.ve. be.e.n m.ore. tha.n 150 CRA. on na.tiona.l, re.giona.l or globa.l s.ize. a.ll ove.r the.
world. But the. s.ha.re. of m.a.jor CRA., na.m.e.ly M.oody’s., S.ta.nda.rd a.nd Poor’s. (S.&P) a.nd
23


Fitch in cre.dit ra.ting m.a.rke.t is. a.bout 94% (OE.CD, 2010). The. s.ha.re. of S.&P, M.oody’s.
a.nd Fitch in cre.dit ra.ting m.a.rke.t re.s.pe.ctive.ly is. 40%, 39% a.nd 15% (Iva. a.nd Vuka.šin,
2010). The.re.fore. the. cre.dit ra.ting m.a.rke.t a.ls.o ha.s. ha.d a.n oligopolis.tic m.a.rke.t s.tructure..
The.re. we.re. two m.a.jor ca.us.e.s. of this. oligopolis.tic s.tructure.. Firs.tly re.gula.tions. e.s.pe.cia.lly
in the. US. lim.ite.d the. ne.w CRA.’s. e.ntrie.s. to the. cre.dit ra.ting m.a.rke.t. Be.ca.us.e. the.
S.e.curitie.s. a.nd E.xcha.nge. Com.m.is.s.ion (S.E.C) de.s.igna.te.d M.oody’s., S.&P, a.nd Fitch a.s.
Na.tiona.lly Re.cognize.d S.ta.tis.tica.l Ra.ting Orga.niza.tions. (NRS.ROs.) a.nd NRS.RO
de.s.igna.tion be.ca.m.e. a. s.ignifica.nt ba.rrie.r to e.ntry into the. bond-ra.ting bus.ine.s.s. for a. long
tim.e. a.nd only the.s.e. thre.e. firm.s. ope.ra.te.d a.s. NRS.ROs. until 2000. S.e.condly a. s.trong
re.puta.tion is. ne.ce.s.s.a.ry to ope.ra.te. in the. cre.dit ra.ting m.a.rke.t. Be.ca.us.e. S.&P, M.oody’s. a.nd
Fitch ha.ve. e.xis.te.d in the. indus.try for a. long tim.e. a.nd this. m.a.de. ne.w com.pa.nie.s. with le.s.s.
e.xpe.rie.nce. difficult to e.nte.r the. cre.dit ra.ting m.a.rke.t (White., 2001). The. oligopolis.tic
s.tructure. of the. cre.dit ra.ting m.a.rke.t e.na.ble.d the. CRA.s. to ta.ke. a.dva.nta.ge. of the. m.a.rke.t
powe.r a.nd a.ls.o pre.ve.nte.d the. e.fficie.ntly functioning of the. cre.dit ra.ting m.a.rke.t.
CRA. us.e.d inve.s.tor-pa.ys. m.ode.l until 1970s.. In this. m.ode.l cre.dit ra.tings. we.re. provide.d
fre.e. of cha.rge. to is.s.ue.rs., a.nd s.old to inve.s.tors. for a. fe.e.. CRA. be.ga.n to us.e. is.s.ue.r-pa.ys.
m.ode.l from. the. US. re.ce.s.s.ion of e.a.rly 1970s. to the. pre.s.e.nt. In this. m.ode.l, is.s.ue.rs. whos.e.
s.e.curitie.s. the. CRA. ra.te. pa.y for a. ra.ting. A.lthough inve.s.tor-pa.ys. m.ode.l e.na.ble.d the. CRA.
to be. inde.pe.nde.nce. from. the. is.s.ue.r be.ing ra.te.d, it did not provide. s.ufficie.nt re.ve.nue. for
the. CRA.. Cons.e.que.ntly CRA. pa.s.s.e.d to the. is.s.ue.r-pa.ys. pricing m.ode.l. Thus. the. CRA.
be.ga.n to be. de.pe.nde.nt on is.s.ue.rs.. On the. othe.r ha.nd the. cre.dit ra.tings. we.re. us.e.d a.s.
re.gula.tory purpos.e.s. e.s.pe.cia.lly by the. US. public a.uthoritie.s. a.nd this. ca.us.e.d the. CRA. to
ga.in re.gula.tory s.ta.tus., thus. fina.ncia.l ins.titutions. a.nd inve.s.tors. thus. be.ca.m.e. ove.r
de.pe.nde.nt on CRA..

Cons.e.que.ntly a. m.utua.l inte.rde.pe.nde.nce. s.urfa.ce.d a.m.ong the. CRA., s.e.curity is.s.ue.rs. a.nd
inve.s.tors.. The. CRA. ha.ve. a.n ince.ntive. to ove.rra.te. the. cre.dibility of the. de.btors. for not
los.ing pre.s.e.nt clie.nts. a.nd a.ls.o a.ttra.cting m.ore. clie.nts. (Ra.fa.ilov, 2011), but the. CRA.
fa.ce.d little. or no ris.k of los.s. from. ina.ccura.te. ra.tings., while. the. pote.ntia.l ga.ins. from.
24


ina.ccura.te. ra.tings. incre.a.s.e.d ove.r tim.e. (Pa.rtnoy, 2009). S.e.curity is.s.ue.rs. ne.e.de.d high
cre.dit ra.tings. in orde.r to cre.a.te. a.nd s.e.ll the. com.ple.x fina.ncia.l ins.trum.e.nts.. S.ince. the.
ins.titutiona.l a.nd individua.l inve.s.tors. could not m.a.ke. va.lua.tion a.bout the. ris.kine.s.s. of ne.w
com.ple.x s.e.curitize.d a.s.s.e.ts. toge.the.r with la.ck of tra.ns.pa.re.ncy, the.y re.lie.d on the. cre.dit
ra.tings. without a.ny que.s.tioning (Hull, 2010).
The. CRA. provide.d ra.ting a.nd cons.ulting s.e.rvice.s. s.im.ulta.ne.ous.ly be.fore. the. re.ce.nt cris.e.s..
S.o conflicts. of inte.re.s.t a.ros.e. whe.n the. CRA.s. offe.re.d cons.ulting or othe.r a.dvis.ory
s.e.rvice.s. to the. is.s.ue.rs. the.y ra.te.d (Ra.fa.ilov, 2011). This. m.e.a.nt tha.t the. CRA. firs.tly told
is.s.ue.rs. wha.t the.y did a.nd the.n the.y ra.te.d the. is.s.ue.rs. in que.s.tion. This. s.itua.tion a.ls.o
contribute.d to e.m.e.rge.nce. of conflicts. of inte.re.s.t in the. cre.dit ra.ting m.a.rke.t. Cre.dit ra.ting
is. a. bila.te.ra.l proce.s.s. which the. CRA. de.te.rm.ine. ra.tings. ba.s.e.d on the. inform.a.tion provide.d
volunta.rily by the. is.s.ue.rs.. Howe.ve.r the. CRA. do not ha.ve. powe.r to e.ns.ure. a.nd e.xa.m.ine.
the. inform.a.tion a.nd the.y ca.nnot re.quire. a.ny a.dditiona.l inform.a.tion by force. (Ra.fa.ilov,
2011). S.o the.re. is. a. ris.k tha.t the. is.s.ue.r ca.n conce.a.l or m.a.nipula.te. inform.a.tion.
The. CRA. firs.tly ra.te.d the. tra.ditiona.l de.bt ins.trum.e.nts. but la.te.r the.y de.pa.rte.d from. the.ir
tra.ditiona.l bus.ine.s.s. by be.ginning to incre.a.s.ingly ra.te. s.tructure.d fina.nce. a.nd ne.w
com.ple.x de.bt products., pa.rticula.rly cre.dit de.riva.tive.s. a.nd be.ga.n to us.e. com.ple.x
s.ta.tis.tica.l ra.tings. tools. in orde.r to ga.uge. cre.dit ris.k (Pa.rtnoy, 2006). The. ra.tings. of the.
s.tructure.d fina.nce. s.e.curitie.s. fa.ile.d to re.fle.ct the. cre.ditworthine.s.s. of the. s.e.curity be.ing
ra.te.d due. to fa.ulty da.ta., fla.we.d a.s.s.um.ptions. of the. m.ode.l a.nd the. tra.nche.d s.tructure. of
the. CDO (Colla.te.ra.lize.d De.bt Obliga.tion) s.e.curitie.s. (Pa.rtnoy, 2006).
1.2.4 Criticism of credit rating agencies
His.torica.lly, the. a.ctivitie.s. of cre.dit ra.ting a.ge.ncie.s. ha.d be.e.n confine.d

to the. corpora.te. fina.nce. m.a.rke.t, whe.re. the.y would a.s.s.e.s. a. s.e.curity’s.
qua.lity on the. ba.s.is. of e.s.tim.a.te.s. of its. a.nticipa.te.d ca.s.h flows. – its.
like.lihood of de.fa.ult a.nd its. e.xpe.cte.d los.s. in the. e.ve.nt of de.fa.ult. For
a.n individua.l firm., the. two prim.a.ry cons.ide.ra.tions. in cre.dit ris.k
25