Problems of the Credit Rating Agencies

Problems of the deferred payment Rating Agencies accessOn July 18th, 2007, while referring to adjustable commit mortgages (ARM) ( overly cognize as subprime mortgages) bandages, an executive of the fitchs residential mortgage group said We continue to be confident(p) that AAA rates reflect the high character reference quality of those bonds. Since then, amongst 2008 and 2009, cxl US banks declargond bankruptcy while the International M cardinaltary breed now estimates world banks global losses due to loans and reference point derivatives to dear $4.1 trillion. If the subprime crisis has been the crisis of reference, it has in like manner been the crisis of credit military paygrade.Credit Rating Agencies (CRAs) (namely the tree study ones Fitch Ratings, Moodys Investors Service and precedent Poors) construct been under a lot of denunciation in the recent credit crisis. Indeed, non all throw away CRAs been charge of making errors of judgment in rate incorporat e debt securities, and as well as of ope valuation a biased course baffle in an oligopolistic merchandise.As a matter of fact, bond impressionrs, political sympathies regulators and investors demand now alienated their blind faith in credit military ranks and on that pointfore slantl the oblige regard to change, reorganize and re expression the CRA certain line of merchandise imitate and manufacture. cleanse though CRAs shag non be considered the sole responsible agent for the credit crisis, they attain encountered great irregularities and capers How displace they be gained? What solutions should be implemented to delay the next credit crisis from happening? How has the credit and CRA crisis affected the leveraged finance industriousness?To tackle this question, we allow for early poll what objurgations credit order agencies call for been undetermined to and what problems construct been identified in the recent old age. By evaluating disparate sol utions and decl atomic number 18 oneselfing prerequisite changes, we exit then examine how the credit valuation backing copy and market structure could be cleansed. Finally, as it directly relates to the credit market and CRAs, we depart study the impact of the crisis on the leveraged finance industry, with a special focus on leverage buyouts, buyout debt financing and integrated finance. part 1 Current problems of the Credit Rating Agencies communication channel illustrationlingthough m any former(a) players, such as lenders, borrowers, regulators, issuers, and macro portions, depose be associated with and blamed for the current credit crunch, Credit Rating Agencies (CRAs) study been incriminate of being the main actors behind the malfunctioning and mispricing of the credit markets. Not completely cod CRAs been blamed for mis evaluation complex incorporate debt products1 and other subprime mortgage associate products, entirely also of operating a biased air mo del in an oligopolistic market.In this first section, we give summarize these three main accusations and analyze in detail the validity of each argument. Solid and clever recommendations can whole be made if the genuine problems accommodate been identified.By analysing Moodys fiscal statements, we can observe that between 2002 and 2006, Moodys net incomes nearly triplight-emitting diode beca call of the ingathering of organize products, accounting for overmuch(prenominal) than 40% of its original revenues in 2006, and the high rims charged for these products. Given the revenues generated, one would expect that CRAs did control the rating of these products. Now, after the neglectfulness rate on adjustable rate mortgages (ARMs) reached its peak during the crisis and collateralized debt obligations (CDOs) became worthless, CRAs defended themselves by explaining how sophisticated these products were and how hard it was to rate them. This channels us to question, did CRAs rate products they did not escort?Before the mortgage market collapse, analysts like John Paulson denotative mental rejection at what appe bed to be a complete mispricing of the structured debt products and began predicting that the market would come downFor me it was so obvious that these securities were completely mispriced and we were living in a casino. I think the other players that were snarled in the business got caught up in the exuberance, in the contention to increase their underwriting volumes, to increase their fees. They were in truth focuse on annual earnings, quarterly earnings and annual bonus pools and with the amount of the liquidity, everyone got caught up in what became a massive credit bubble. (Distressed Volatility 2009)Mark Zandi, an economist at Moodys, coursed in a report on U.S. macro instruction Outlook published in May 2006, that household debt was at a record and a fifth of such debt was classified as subprime. Unfortunately, the sparing fore casting division is separate from the ratings division of the corporation. But how could CRAs not anticipate the crisis and the flaws of their valuation models?The model used to rate structured products has been criticized for two reasons. First, Moodys rating model for assessing CDOs is a statistical model reliant on historical patterns of default. The main assumption behind this model is that past info would bear on relevant, even during a period in which the mortgage industry (and its think products) was undergoing drastic change. Second, the use of this model revealed a hulky failure of vulgar sense (Lowenstein, Triple-A failure 2008)by rating agencies as very complex securities shouldnt stir been rated as plain vanilla bonds, for which the model was designed. CRAs were checking their statistical model, but not the underlying assets.As a consequence, Moodys noted in April 2007 that the model was first introduced in 2002. Since then, the mortgage market has evolved consi derably with the introduction of many invigorated products and an expansion of risks associated with them (Mason 2007) and and so revised the model it used to evaluate subprime mortgages.Similarly, in a response letter to Roger Lowensteins Triple-A failure denomination, Vickie Tillman, Executive Vice death chair of SPs Rating operate claims that her companionships rating model includes two historical entropy and informed assumptions to assess credit quality. This adjusted model doesnt seem to light up the accuracy problem. Deven Sharma, president of SP, admits historical data we used and the assumptions we made importantly underestimated the severity of what has actually occurred (Sharma 2008)Even though one can eviscerate it on the greater complexity of CDOs and the difficulty of accurately assessing the risk write of these products, the CRAs defensive measure doesnt seem justifiable thrown the source of wealth these structure products re bes to them. mavin would ex pect that CRAs would only provide a service they understood. at that place is lull plenty of room for improvement in their models. Research led by Skreta and Veldkamp (Skreta and Veldkamp 2009) suggests that the complexity of any given over asset hasnt increased but sort of that the more complex types of assets became more prevalent. Indeed, when combined with the phenomenon of rating shopping, where issuers shop from one CRA to other to pick the best rating assertable, asset complexity can lead to rating inflation and biased judgment. As a consequence, failure to address po tennertial sources of bias inherent in the business model of the ratings industry could generate future problems. This discussion leads us to the battle of divert inherent in the issuer-pay model, the second main accusation in our analysis.The divergence of entertain between CRAs and bond issuers has been identified as the main problem because it drives the entire CRA business model. This conflict of interest between rating agencies and the bond issuers from whom they receive fees undermines the CRAs ability to give an unbiased assessment of credit risk.There are two types of potential conflicts of interest inherent in the issuer-pay model that may arise from the activities of the CRAs. The first is that rating agencies may be enticed to give better ratings in order to continue receiving service fees. Since CRAs revenues come from issuers, this conflict can lead to an agency problem. The second potential conflict relates to the consulting go CRAs provide to help the issuer to better design products to meet their models different thresholds. In both cases, CRAs run the risk of the issuer going to a different rating agency, which leads to the phenomenon of ratings shopping. Up until the 1970s, the investor-pay business model of credit rating agencies was straightforward investors bought a subscription to receive ratings. It was during the 1970s that the business model evolved i nto an issuer-initiated ratings system where the issuers of securities began paying to be rated. Free riding by investors, leading to a reduction in profits for credit rating securelys, was the main reason for this transition. As gabardine (White 2002)observes, this shift also coincided with the rise in popularity of the photocopying machine. Although the issuer-pay business model has been roughly for more than forty grades now, c at one timern over ratings bias only belatedly emerged. Indeed, the conflict of interest, amplified by the rise of complex structured financial products, calls into question the objectivity of ratings that are critical to the efficiency of the market. (Levitt, Conflicts and the Credit moil 2007)In response to these accusations, CRA executives have nurtureed that the issuer pay model is not contradictory to the efficiency of their business model. It seems that a firm cannot support both issuers and investors simultaneously. In fact, the Report of th e Staff to the Senate Committee on Governmental affairs during the Enron case2 cited empirical evidenceThe conflict appears to be particularly acute for whacking important issues such as Enron . In these cases investors desperately need way from credit rating firms, but often do not get it because of pressure from issuers, and in some cases, atomic number 16 officials. (Egan and Jones 2010)However, CRA executives have also maintain that CRAs have nothing to benefit from adjusting their ratings to their customers needs because they have a theme to uphold. In June 2007, SP claimed that reputation is more important than revenues (Becker and Milbourn 2009) thus asserting that maintaining a good reputation had been a sufficiently strong motive factor for CRAs to keep their high levels of efficiency and objectivity. In reference to this assertion we can ask ourselves is reputation a sufficient motivating factor to maintain discipline among rating agencies?As a matter of fact, res earch led by Mathis, McAndrews and Rochet (Mathis, McAndrews and Rochet, Rating the Raters Are Reputation Concerns Powerful Enough to even out Rating Agencies? 2009)has suggested that this argument is only valid when a large division of the CRA revenues comes from other sources than the rating of complex products. When the reputation of a CRA is good enough, and rating complex products run a large source of revenues (more than 40% of Moodys revenues), the CRA will become too lax and billow its ratings. This mechanism builds on a three-step reputation cycle, ultimately resulting in crises of impudence where a single default provokes a complete loss of reputation by the CRA. First, the CRA tries to build and improve its reputation and gain investors trust by being very strict. Then, once a positive reputation has been gained, the CRA issues more ratings and takes advantage of its reputation. This is when CRAs become more lax and the risk of default increases. Ultimately, when de fault occurs, there is a crisis of confidence the opportunistic CRA is detected and its reputation is very negatively affected. This reputation cycle, which is also a confidence cycle, explains why opportunistic CRA are hard to discolouration and why ratings biases only recently emerged as a concern in response to inquiries from Vailiki Sketra (Sketra and Veldkamp 2009).3 To exemplify this concept of reputation cycle, scholars find that CRAs are more likely to understate credit risk in booms than in recessions (Bolton, Freixa and Shapiro, The Credit Ratings Game 2009).Moreover, reputation seems greatly affected by competition, as it will reduce the effectiveness of the reputational mechanism for two main reasons. First, reputation is only valuable if there are future producer rents. As a result, the inducement for maintaining a good reputation is reduced by competition. Second, from a microeconomical approach, if the demand elasticity facing individual sellers is higher in a compe titive market, the temptation to either reduce prices or otherwise draw out business may be stronger which undermines the quality of output. Therefore, the conflict of interest is not solved by reputation concerns.The second aspect of the conflict of interest relates to the collaboration between CRAs and issuers when designing a debt security. Lewis Ranieri, a pioneer in the mortgage bonds market, once said The whole creation of mortgage securities was involved with a rating (Norberg 2009). As a consequence, starting in the 1990s, CRAs started to abide consulting and advisory services to issuers to improve their ratings a process that involves extended consultations between the agency and its client. The collaborative process that ensues is as follows issuers propose a rating structure on a pool of debt. Then, the CRA will usually beseech a cushion of extra capital, known as an enhancement, to meet the necessary conditions for a specific rating. This practice can be dangerous bec ause it is the CRAs certificate of indebtedness to ensure that the cushion is big enough to safeguard the product, but issuers will try to minimize this extra capitalization in order to maximize their profit margin. Inside the CRAs, consultants and raters were meant to be strictly separated by a Chinese wall4. Regardless, CRAs (namely Moodys) began providing unrequested ratings and offering consultancy services to improve them. Mr. Arthur Levitt, a motive chairman of the Securities and Exchange Commission, pointed out in a recent article in the Wall bridle-path journal that the conflicts of interest arising from such activities are the central problems with CRAsCredit rating agencies are playing both coach and justice in the debt game. They rate companies and issuers that pay them for that service. And, in the case of structured financial instruments, which make it possible to securitize all those subprime mortgages, they help issuers construct these products to obtain the high est possible rating. These conflicts are hard to spot because transparency among these agencies is murky at best, and shortly it is difficult to hold these agencies accountable for any wrongdoing (Levitt, Conflicts and the Credit mash 2007)The agencies are aware of the conflicts that are inherent to their business model but they claim that they are doing their best as to avoid them. In a letter to Roger Lowensteins Triple-A failure article, Vickie Tillman, Executive Vice President of SPs Rating Services defends her companys business models and practicesAt banal Poors, we recognize the business model we use may raise potential conflicts of interest. Thats why we have always had severe policies in place to manage conflicts, and why we currently are implementing redundant measures to further strengthen the independence and quality of our ratings opinions. the single-valued function ratings firms play in the market is to provide independent assessments of the creditworthiness of bonds.In order to make up for these practices, the US Securities and Exchange Commission (SEC) issued a release in February 2007 proposing rules which would observe the issue of unsolicited credit ratings (those not issuer-initiated), as unfair, coercive, or abusive, and thus would prohibit Nationally Recognized Statistical Rating Organizations (NRSROs) from releasing unsolicited credit ratings. Even though the SEC intervention seemed necessary, it didnt change the industrys business model by 2007, the mortgage boom had already reached its peak.Regardless of the criticism surrounding the relationship between issuers and rating agencies, the fact of the matter is that they were plainly bringing bonds to market based on market demand, which clearly indicates a crisis of the issuer-based model. CRAs misbehaviour has played a central component in the current subprime mortgage crisis. As such, the governments and regulative bodies should take steps forward to correct the current bus iness model. We shall and so inquire alternatives to this model in persona 2 of this paper.This conflict of interest leads us to ask, who finally owns the ratings? The evidence regarding whether rating agencies bend to the issuers will is mixed.A paper written by contract-theory scholars, Faure-Grimaud, Peyrache and Quesada (Faure-Grimaud, Peyrache and Quesada 2007) asks this issue by looking at collective governance ratings in a market with truthful CRAs and rational investors. They show that at equilibrium, in a monopoly, a CRA will to the full emit information but that issuers may prefer to suppress their ratings if they are too noisy because full manifestation is impossible even when firms have the possibility for ownership (i.e., the right to disclose the rating). Additionally, they find that competition between rating agencies can result in less information disclosure since CRAs make zero profit and fully disclose information on firms that have values higher than the C RAs fringy observation cost.In fact, the current business model seems to favour the banks in their quest to receive better ratings. Dr. Joseph Mason compared default rates for corporate bonds to equally BAA-rated CDOs before the bubble burst and found that the CDOs defaulted more than ten times as often (Mason 2007). While, as we discussed earlier, it may be consecutive that CDOs are much more complex securities than plain-vanilla bonds, another interpretation of the data is that CRAs were much more lax when dealing with a Wall Street securitizer as client. But who can blame them? While it is true that on the traditional side of the business (unsophisticated bond rating) CRAs have a large variety of clients (virtually every corporation and municipality that issues public debt), this is not the case in structured finance. On the contrary, the panel of clients is much smaller and the fees are much bigger. The only issue is that the client pays only if the CRA delivers the want rati ng. If they do not, the client can either adjust the numbers or take another chance with a competitor, a process known as ratings shopping.Brian Clarkson, former president and CEO of Moodys Investors Service acknowledged, There is a lot of rating shopping that goes on. What the market doesnt know is whos seen certain transactions but wasnt employ to rate those deals (Bolton, Freixa and Shapiro, The Credit Ratings Game 2009). In fact, an important feature of the credit ratings market microstructure is the capacity for a security issuer to choose which ratings to purchase. During this process, a structured debt product is issued and the issuer typically proposes a structure to a CRA. The issuer then asks for a shadow rating, which remains private between the CRA and the issuer, unless the issuer pays to make the rating official. much(prenominal) choices can reflect both explicit and implicit shopping for desired credit reviews and induce a selection effect in the rating process. Sel ection highlights the relation between the decision close whether to rely on unsolicited ratings and the potential for ratings shopping, illustrating how different types of potential conflicts of interest in the credit rating process could interact. Indeed, shopping for ratings is a practice at the bosom of the different conflicts of interest we mentioned above, as it partly invalidates the reputation argument because there seems to be a trade-off between reputation concerns and the risk for ratings shopping. It also encourages CRAs to strengthen their ties and relationship with issuers, most notably by offering a wider range of services. In an interesting paper, Skreta and Veldkamp (Sketra and Veldkamp 2009) examine cherry-picking in ratings, especially for securitization, by issuers who shop for the highest ratings in order to obtain the highest price when selling to round-eyed or little-informed investors. They highlight the influence of risk aversion in motivating the purchas e of multiple ratings. Indeed, because investors are risk-averse, they will try to invest in the best-rated securities for an expected yield without having to asses the risk of every security they may be interested in, and thus rely heavily on ratings. The more ratings they have for a security, the more likely they will be to invest in it. Skreta and Veldkamp (Sketra and Veldkamp 2009) conclude that when combined with asset complexity, rating shopping can lead to rating inflation and thus biased judgment. To support that evidence, Kurt Schacht, managing director of the CFA initiate Centre explained that CRA executives were concerned more or less the hype and insinuation that CRAs easily inflate their ratings in response to pressure from issuers and issuers, implicating the integrity of their process and ratings. In exploring that topic, we were very surprised by the results of our member poll where some 211 of the 1,956 respondents said they have indeed witnessed a CRA change rati ngs in response to external pressures (CFA found 2008).As a consequence, not only does ratings shopping enhance ratings distortion, but it also corrupts the entire rating process by giving issuers an incentive to trick their clients into buying overrated securities.A third and final issue to investigate is the lack of competition in the credit-rating industry. According to The Economist (The Economist 2007), Moodys and Standard Poors dominated the industry by controlling about 80% of the total market in 2007. The third-place competitor, Fitch, had only about 15% of the total dowry that same year. The current form of these institutions received legal status when the SEC introduced the notion-barrier of the NRSROs in 1975. The rest of the market is divided among only a a couple of(prenominal) other institutions that have received legal status. While alluding to the dominance of Moodys and Standard Poors in the credit market, the U.S. Department of Justice has referred to the cred it-rating industry as a partner duopoly (Laing 2007). As noted by Jonathan R. Laing, a partner duopoly differs from an oligopoly because the partners in the duopoly do no face fierce competition against each other because ones good fortune in winning a piece of business is typically followed by the others receiving the same deal at the same downpour fee level (Laing 2007).This duopoly has proved quite profitable, as Moodys operating margin is typically around 50% (if not more) better than Microsoft, Accenture, Intel, Nike or Coca-Cola. In fact, according to Congressman Henry Waxmans statement during the Congressional hearings in October 2008, Moodys had the highest profit margin of any company of the SP 500 index for five years in a row. An important complaint arising from this situation is that the lack of competition permits the main players to shirk, engaging in less effort and research that if they were true active competition (Coffee 2006). It may therefore seem that a scant y market would ensure competition among its CRAs guaranteeing a higher quality and depress price of the ratings. For that reason, competition from new agencies superpower create a vigorous diversity of opinion, leading to more accurate assessments of debt issuers default probabilitiesMany scholars have analyzed whether this industry structure contributes to the efficiency of the global credit market. We shall investigate in further detail what seems to be the optimal market structure in the next section by examining the solutions and changes necessary to combating the sundry(a) issues we have so far considered.Other scholars recognize that the existing duopoly may present risks to the market, especially since the two-rating norm is still in full force. Furthermore, since the CRA business model is reputational-driven business, new competitors may face very high barriers to entry. The CRA industry could therefore not allow for more participants. On the other hand, some scholars su ggest that the SECs role in both creating and perpetuating this duopoly by which establishing the status and necessary requirements to become a NRSROs, and an official registry. Since competition can both be seen as a problem and as a solution to the CRA industry and business model, we shall now examine the different initiatives that can be undertaken to improve the general model and functioning of the credit rating market.Section 2 Solutions to fix the identified problemsThe subprime crisis has brought to light the poor performance of CRAs in rating structured financial products and reminded investors of CRAs past poor performance in predicting the East Asian crisis and the collapse of Enron5. Either directly by regulations, or by market force, there are strong signals that the credit rating business is about to change. The main accusations we previously addressed and the perception that CRAs contributed to the financial crisis led to various investigations and calls for reform. I n this section, after briefly presenting CRAs reaction to criticism, we will first analyze the different alternatives suggested by scholars and experts to the current business model and the boilers suit industry structure. We will then study the different reforms and regulatory recommendation that have been suggested to the current business model that would improve CRAs effectiveness and enhance the overall market efficiency. Finally, once these changes examined, from a regulatory standpoint, we will observe the measures recently adopted by both the European Union and the US government (and regulating agencies), determine how the approaches differ and how necessary regulation is.CRAs reaction to accusationsCRAs have responded to the allegations with cries of innocence. If some rating firms claimed that they did nothing wrong and have indicated that they will encourage openly in any investigation that comes their way, others did acknowledge some mistakes and have announced the inte ntion to reform their practices. For example, spokespersons for Moodys, Standard Poors and Fitch have claimed that their organizations will demand more data and more verification and will subject their analysts to more outside checks (Lowenstein, Triple-A failure 2008) However, some may say that CRAs might have implemented these changes simply to avoid further criticism and regulatory intervention. Indeed, as Lowenstein claims, none of this will remove the conflict of interest in the issuer-pays model . We shall further analyze the case for self regulation in our analysis.In their effort to defend themselves, the CRAs have sought to minimize their role and influence within the financial industry. According to a spokesperson for MoodysWe perform a very significant but extremely limited role in the credit markets. We issue reasoned, forward-looking opinions about credit risk. Our opinions are objective and not tied to any recommendations to buy and sell (Benner and Lashinsky 2007)T he consensus of these critics is that the agencies dropped the freak by issuing investment-grade ratings on securities backed by subprime mortgages they should have known were shaky (Benner and Lashinsky 2007)Rather than accept responsibility for their own lack of diligence, the major CRAs have sought to lay the blame on the mortgage holders who morose out to be deadbeats, many of whom lied to obtain their loans (Lowenstein 2008). Of course, it must be noted that other groups and individuals share the responsibility for the global financial downturn. As Laing says in regard to CRAs, they were just one link in a subprime production line that stretched from sleazy storefront mortgage brokers, corrupt appraisers and close originators to fee-crazed securitizers and, yes, mendacious borrowers (Laing 2007). Nonetheless, as Laing further notes, CRAs must be seen as tell enablers in the problems development.i) New agency industry structure and business modelProposals have been made to i mprove the credit-rating system and thereby reduce the problems we identified. First, it seems that CRA need more independence. As Laing suggests it, many of the changes implemented in the auditing industry with the Sarbanes-Oxley flirt could be in addition carried out. (Even though one may discuss whether this meet has improved capital markets transparency or not, one must note it has enforced the implementation of internal control, due diligence and transparency procedures in firms)For instance ratings agency employees should be prohibited from accepting any favors (whether it is specie of gifts) from their clients and the leading analyst should rotate from a client to another with a certain frequency and should wait at least one year before joining their clients firm (an issuer or investment bank in this case) Laing also suggests that the 2003 SEC proposal, which prohibits the linkage of analyst compensation with new business development, could be reenacted.First, CRAs should be more transparent in two typical ways. The global credit market needs greater transparency about CRAs overall rating model rating assumptions, methodologies, but also the fee structures, and past performance. To be more transparent CRAs should follow stricter disclosure requirements (as mentioned in the Rating Agency Act in 2006). Professor Charles W. Calomiris (Calomiris 2009) suggests that, more disclosure could also be required for publicly traded companies with rated debt when filling in debt-offering documents Particularly, in order to prompt CRAs to reduce or eliminate their conflicts of interest, they should disclose any structuring service or consulting-related activity (and the fees related to such practices) provided to a company in connection with the rating of fixed-income securitiesSecond, there is a strong need, expressed by both scholars and analysts, for a clear distinction between the rating of structured products and traditional debt products and thus different rating symbols could be used so as to avoid confusion. The issue is, not all AAA-rated securities are created equally. As demonstrated in the current credit crisis and as proven by Drexel University finance professor Joseph Mason, CDOs receiving a Baa rating from Moodys were more than ten times as likely to default as similarly rated corporate bonds (Mason 2007). As a matter of fact, despite the identical symbols, structured products typically do not have the same risk profile as traditional corporate bonds. By nature, whereas corporate default can be estimated by very few factors (namely the level of leverage of the firm and its capacity to generate stable cash flows from operations), default on structured debt is dependent on hundreds or thousands of individual defaults e.g., an underlying mortgage pool that are estimated given some distribution. They are not the same analysis so they should not be the same ratings. (CFA Institute 2008) A different rating scale according to the r isk profile of the products could be used as to not mislead investors into buying misrated securities. As an alternative, Professor Coffee at Columbia University suggests the SEC could define a maximum default rate for different class of ratings, so that if a CRAs ratings were to exceed SEC parameters, it would large-minded their NRSRO status. (Coffee 2006) Building on this, the entire rating nomenclature could be changed and ratings could be expressed quantitatively as to avoid grade inflation in CRAs opinions. Indeed, in contrast to numerical estimates (of the probability of default (PD) and loss given default (LGD)),which do have objective and quantifiable meanings, letter grades see more room for sub