From the hero during the boom, to the villain during the bust (subprime meltdown), life for credit rating agencies have come a full circle. Are they the real villain or a mere scapegoat is still a moot point. In all fairness, the credit rating agencies are not the only ones to be blamed for the subprime fiasco. Issuers, regulators and investors are equally guilty. The statement by no means undermines the lead role played by CRAs in bringing the world financial market to its knees.
Credit Rating Agencies (CRAs) trace their roots way back to early last century when they were midwifed by institutions to respond to the problem of information asymmetry. Since then they have been providing opinions on the creditworthiness of issuers and their financial obligations. With time, the importance of these opinions to investors and other market participants has increased by leaps and bounds mainly due to the increase in the number of issuers, the advent of new and complex financial products and the globalization of the financial markets. Credit ratings affect securities markets in many ways, including an issuer’s access to capital, the structure of transactions, and the ability of fiduciaries and others to make particular investments. CRAs have the gumption of making a security a hot-cake or a damp squib.
Business Model of CRAs
The issuer hires a CRA for the issuance and maintenance of the credit rating of the instruments to be launched. CRAs in turn charge fees from the issuers for the credit rating services. The issuer has an upper hand in the whole transaction as it is his prerogative to approach any CRA under the sun as per his business need and preference. Moreover, the issuer is not obliged to stick to the same CRA and can terminate the contract anytime when things go awry.
It is like a student can choose his/her teacher to get the grades and even can sack the teacher in case teacher dares to give a poor grade. Unsolicited ratings do occur sometimes but it is very few and far in between.
It is like a student can choose his/her teacher to get the grades and even can sack the teacher in case teacher dares to give a poor grade. Unsolicited ratings do occur sometimes but it is very few and far in between.
Market Structure
Monopolistic market seems to be prevalent in this case. Three firms Moody’s investor Services, S&P’s Inc. and Fitch Inc. between them comprise approximately 85% of the rating market. These big-shots, operating in niches have the similar though not identical products and can afford to demand a premium for their products. Reputation seems to be the major entry barrier.There has not been a single new entrant for a very long time who has challenged the apple pie order of these big daddies of credit rating.
Subprime fiasco and CRAs
The first finger to CRAs was raised after Enron saga. CRAs continued to rate Enron a good credit risk until four days before the firm declared bankruptcy. The incident generated a lot of heat and questions were raised about CRAs and their efficacy.
Subprime was the next nail in the coffin. It was not only Enron all over again, but rather more ominous, more scary. During the credit boom (low interest rates), the lenders were falling over each other to extend credit to borrowers. They had found an innovative way to transfer the credit risk from their books to that of other investors. They pooled their loans, securitised it into bonds and sold it off to other investors. Investors were not convinced about the credibility of these bonds initially. Here came the CRAs. They rated the bonds and investors over relied on their ratings.
Issuers manipulated the system to earn the top notch rating for their derivatives, relying on the ratings investors plunged into trading like there was no tomorrow. The derivatives started gaining grounds and no one complained as everyone issuers, CRAs and investors earned a tidy sum. The music stopped at its peak when the interest cycle turned upwards and Housing market crashed. The market value of the derivatives started plummeting due to rising defaults by the original borrowers. It snowballed into a major financial catastrophe and impacts are still being felt all over the world.
On close investigation, it came into light that “Ratings assigned by CRAs were in no way reflective of the fundamental of the underlying and there were connivance between the issuers and the CRAs.” Moreover, the overreliance by investors on the credit rating exaggerated the issue.
Subprime was the next nail in the coffin. It was not only Enron all over again, but rather more ominous, more scary. During the credit boom (low interest rates), the lenders were falling over each other to extend credit to borrowers. They had found an innovative way to transfer the credit risk from their books to that of other investors. They pooled their loans, securitised it into bonds and sold it off to other investors. Investors were not convinced about the credibility of these bonds initially. Here came the CRAs. They rated the bonds and investors over relied on their ratings.
Issuers manipulated the system to earn the top notch rating for their derivatives, relying on the ratings investors plunged into trading like there was no tomorrow. The derivatives started gaining grounds and no one complained as everyone issuers, CRAs and investors earned a tidy sum. The music stopped at its peak when the interest cycle turned upwards and Housing market crashed. The market value of the derivatives started plummeting due to rising defaults by the original borrowers. It snowballed into a major financial catastrophe and impacts are still being felt all over the world.
On close investigation, it came into light that “Ratings assigned by CRAs were in no way reflective of the fundamental of the underlying and there were connivance between the issuers and the CRAs.” Moreover, the overreliance by investors on the credit rating exaggerated the issue.
No one can a turn a blind eye to the fact that CRAs started very well , sped up to a reckless speed under the influence of fear (of issuers’) and greed (moolah) and without the safety belts on. They finally crashed the vehicle (read market) killing all onboard (read investors). They themselves appeared slightly bruised (if not unscathed) from the ruins.
However, they now got the lesson that no one will board their vehicle if they do not show some credibility. Credit rating agencies now are striving real hard to reinvent themselves indeed. Though I strongly feel that there must be a strict regulatory mechanism to instil a sense of responsibility in these brats (read CRAs).
However, they now got the lesson that no one will board their vehicle if they do not show some credibility. Credit rating agencies now are striving real hard to reinvent themselves indeed. Though I strongly feel that there must be a strict regulatory mechanism to instil a sense of responsibility in these brats (read CRAs).
Hope better sense prevails !
:) Ravi .
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