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New Pathways for Credit Rating Agencies: A Critical Study of European and American Approaches

| November 11, 2012 | 0 Comments

INTRODUCTION

The financial crisis of 2007-08 revealed serious lapses in the functioning, regulation, supervision and governance of the financial markets globally. Although, it was the failure of Collateralised Debt Obligations (“CDOs”) especially the ones based on the subprime mortgage, that sparked the crisis, the mere fact that these carried the highest ratings proved the ratings to be worthless and brought the rating agencies under the scanner. The Securities Exchange Commission (“SEC”) eventually discovered that there was a failure on the part of the rating agencies in precisely determining the creditworthiness of CDOs and other structured financial products. In the wake of the crisis Credit Rating Agencies received severe criticism for their role in the crisis. Investigations and reports hinted at better regulations, disclosures and increased accountability for rating agencies. Legislative changes were soon to follow.

Prior to the crisis there existed no regulation in the European Union (“EU”). The International Organisation of Securities Commissions (“IOSCO”) Code which was introduced for the purpose of protecting investors did not bear the expected results. It could not cope up to the drastic changes since it was of the nature of a soft law and lacked sanctions. European Union was quick to assess the situation and come up with a brand new legislation, Credit Rating Agency Regulation (“CRA Regulation”). The CRA Regulation has been very recently amended by the regulation 513/2011, the reasons for which and also the working of the new amended law, would be dealt under Part 2. The regulation came into force on 6 July 2011.

Crisis struck the American market soon after the Credit Rating Agency Reform Act (“CRAR Act”), 2006. The CRAR Act which intended to empower the Securities Exchange Commission to watch over the credit rating industry was, an outcome of the recommendations made in the report submitted by the (“SEC”) as a requirement under the Sarbanes-Oxley Act of 2002. The severity of the crisis led the United States (“US”) Government to act urgently not only to prevent a financial calamity but also to devise methods to try and ensure the non-occurrence of such a crisis. The result was the Dodd Frank Act, 2010, an act which majorly affected credit rating agencies, their organisation, activities and practices.

With the above backdrop this work explores the important developments which have been introduced in the two different jurisdictions and also the impact caused or may be cause. The second part deals with the importance of a CRAs and their role in the financial crisis. Although, the regulatory initiatives initiated by the US and EU after the crisis were propelled by the same factors, they have distinct traits and hence would be critically analysed separately under the third and the fourth parts respectively. The fifth part would make a modest effort at comparing the two new sophisticated regimes which would be followed by the concluding observations.

 

THE IMPORTANCE OF CREDIT RATINGS AND THEIR ROLE IN THE CRISIS

Before proceeding ahead for the sake of understanding one has to be clear about the meaning of credit rating and ratings agencies – what does it imply and what aspects could it possibly engulf within itself. In the near past various regulatory bodies while reviewing the credit rating industry have made an effort to do so. According to the SEC, ‘a credit rating reflects a rating agency’s opinion, as of a specific date, of the creditworthiness of a particular company, security, or obligation’. The CRAR Act which amends the Securities Exchange Act, 1934 defines it as ‘an assessment of the creditworthiness of an obligor as an entity or with respect to specific securities or money market instrument’. The European Union CRA Regulation defines credit rating as:

An opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt or financial obligation, debt security, preferred share or other financial instrument, issued using an established and defined ranking system of rating categories.

The European legislation provides us with a much more lucid explanation. Nevertheless if one is to make some sense out of the three above stated definitions various global sources one would see it as an opinion formed after the process of assessment of the credit worthiness of a particular financial product or the party responsible for the product.

Credit ratings agency in the European Union refers to ‘a legal person whose occupation includes the issuing of credit ratings on a professional basis’. The US however, has a slight distinction between credit ratings and Nationally Recognised Statistical Ratings Organisations (“NRSROs”), a distinction which was materialised by the CRAR Act 2006. The former is a ratings agency in essence but is not permitted to work as a ‘commercial credit reporting company.’ NRSROs were designated the official ratings agency by the Securities Exchange Commission (“SEC”) in 1975 to ascertain the real meaning of ‘investment grade’ and deal with the multitude of ratings agencies. With this the SEC instantly grandfathered Moody’s, S&P, and Fitch – what we know as the big three in the market. NRSRO refers to a credit ratings agency that

(A) issues credit ratings certified by qualified institutional buyers, in accordance with section 15E(a)(1)(B)(ix), with respect to—

(i) financial institutions, brokers, or dealers;

(ii) insurance companies;

(iii) corporate issuers;

(iv) issuers of asset-backed securities (as that term is defined in section 1101(c) of part 229 of title 17, Code of Federal Regulations, as in effect on the date of enactment of this paragraph);

(v) issuers of government securities, municipal securities, or securities issued by a foreign government; or

(vi) a combination of one or more categories of obligors described in any of clauses (i) through (v); and

(B) is registered under section 15E.

NRSROs carry the legal stamp to issue ratings relating to financial companies, insurance companies, corporate issuers and issuers of asset backed securities which other rating agencies are not permitted to.

Importance and purpose of Credit Ratings Agencies

The prime aim of a credit rating agency is to foresee any possibility of an event of a credit default which in simple terms would mean ‘failure to pay.’ This attained by calculating the creditworthiness of the obligor.

Securities markets are like information markets. In modern finance ideas promoting the production of information have been considered to be one of the most powerful and rewarding inventions. It is in these efficient information markets that rating agencies compete in. Information asymmetry is the pinnacle that ratings agency wield in the market. The biggest obstruction to investor right is their lack of information to what goes on in a company. It is the information asymmetry held by the investor and the people sitting inside the company. In any given circumstance an investor will not have more information than a person inside. This is where credit rating agencies come into the picture. Since rating agencies have access to classified information they can look into the company or the obligor’s capacity to repay a debt. It is the unsophisticated investors and small investment firms which derive the maximum benefit due to lack of internal resources to conduct intensive research of the targeted investment plan. With this information they act as an independent third party in between the investor and the company and eventually help to overcome the information asymmetric.

The question which eventually crops up in one’s minds is why information asymmetry exists. Why could there not be complete transparency in information? Investor could gain price sensitive information, more detailed financial statements and they could also make the management responsible for representation in those statements. But the bottom line is that companies are highly complicated species born out of the financial world. They work in an extremely competitive environment and familiarize themselves with the slightest of changes in the shortest possible time span hence, evolving all the time. This gives them the competitive edge which when let out would cease their advancement and growth. Hence as a matter of principle, closing down the gap between the investors and the companies can never be fulfilled.

However, even though the rating agencies might be able to foresee a default, it is never engineered to predict the exact time of the occurrence of a default. Rating agencies do not change their rating until and unless there is an occurrence of something that might alter the elementary creditworthiness of an issuer. Despite a downgrade in the financial capabilities of the issuer the ratings may still remain the same if there a possibility of restoration of the financial condition that existed.

Role of Credit Ratings Agency in the Financial Crisis

The recent crisis has been seen as the worst financial crisis since the Great Depression which started in the year 1929. It has led to numerous investigations and corresponding reports analysing the causes of the financial crisis. Aldo Caliari, discovered a similar pattern to the causes reported in various investigations and summed it up in the following points:

1. The crisis followed a boom period with exceptional growth of credit worldwide. “Benign economic and financial conditions fed the boom for a long period of time.  In this easy credit environment of capital abundance, the amount of risk and leverage that borrowers, investors, and intermediaries were willing to take on increased.

2. Additionally, a wave of financial innovations fed the boom by expanding the system’s capacity to generate assets and leverage. Structured finance instruments became a commonly-traded derivative during this period.

3. Banks and other financial institutions helped in the collapse by establishing off-balance-sheet funding and investment vehicles.  These investment vehicles, in turn, invested in complex, structured products comprised of mortgage-backed securities. This process was encouraged by the risk management practices in financial firms, their regulation, and their supervision

4. The increased competition among lenders encouraged a relaxation of lending standards, most notably in the U.S. subprime mortgage market.

5. Credit rating agencies and investors both overlooked the level of risk of complex instruments.

The above concise summary makes it clear that the crisis had no individual villain. Starting from the lenders entering into subprime mortgage loans (eventually leading to predatory lending) without maintaining the required standards and documentation, to the same mortgages getting securitised by investment banks to form ever complicating derivatives like CDOs, to these derivatives receiving the seal of internationally recognised and trusted ratings agencies, and a couple of others, clubbed together to form a ticking bomb which finally blew in the year 2007.

Soon after the crisis started, not only were the ratings rendered worthless, the rating agencies also brought about hasty and startling credit rating downgrades which led to huge market losses and sucked out the liquidity. For the purpose of examining the role of credit rating agency we shall be examining the Turner Review and US government FCIR. The Turner review presented three inter related reason to describe the elucidate the role of rating agencies. The first one being:

The role of securitised credit increased hugely in total importance with the development of structured credit. As a result so too did the dangers that hard-wired procyclicality would contribute to a self-reinforcing downturn. The growth of the credit derivatives market for instance, created the possibility that the use of credit ratings in counterparty collateral arrangements would produce a strongly procyclical effect: this danger crystallised in the case of AIG in September 2008, where a threatened rating agency downgrade led to severe liquidity strain. And as a greater proportion of securitised credit was held not by end investors intending to hold to maturity (and therefore interested solely in probability of default) but by investing vehicles (e.g. SIVs and mutual funds) performing maturity transformation, some of these investors seem to have assumed, quite wrongly, that a rating carried an inference for liquidity and market price stability, rather than solely for credit risk.

The second reason which the review presented was:

Ratings for structured credit proved far less robust predictors of future developments than ratings for the single name securities which had existed for many decades. Changes in the ratings of structured credit have been far more volatile over the past two years than the historical record for single name credits, and far more weighted towards downgrades. This breakdown in rating effectiveness reflected: (i) the fact that ratings were being extended to a instruments where there was limited historical experience, (ii) the enormous complexity of many structured credit instruments, and (iii) a misplaced confidence inthe ability of mathematical modelling to define the risks. The resulting instability of ratings has not only produced direct procyclical effects, but has undermined confidence in the future stability of credit ratings, in turn reinforcing deflation effects. These ratings also play a role within the Basel II framework: the FSA therefore believes there should be a fundamental review of the use of structured finance ratings in that context.

And the third reason:

Finally, there are concerns about whether the governance of rating agencies has adequately addressed issues relating to conflict of interest and analytical independence. Rating agencies competing for the business of rating innovative new structures may not have ensured that commercial objectives did not influence judgements on whether the instruments were capable of being rated effectively.40 And the practice of making the models by which agencies rated structured credits transparent to the issuing investment banks also created the danger that issuers were ‘structuring to rating’ i.e. designing specific features of the structure so that it would just meet a certain rating hurdle. However, this risk must be set against the need of investors to have access to appropriate data to allow them to make their own assessment of a CRA’s methodologies and ratings.

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