Credit rating agencies and their rôle in the current financial crisis

You can't properly blame the credit rating agencies (CRAs) for causing the current financial crisis, but that is what I am doing here.

The rôle of the CRAs is to evaluate the risk of securities and to issue ratings on types of securities as well as the securities themselves. Here I am mostly talking about the CRAs issuing credit ratings for certain types of debt obligations (eg. mortgage-backed securities) and the specific instruments that are issued (eg. the individual CDOs, CDSs, and so on).

In the USA, the two major CRAs, Moody's and Standard & Poor's, receive a sort of charter from the Federal government (they are two of the Nationally Recognized Statistical Rating Organizations) to issue the above ratings as well as they know how to. All investors have free knowledge of these ratings and are influenced by them in the following ways:

1) The value of every security has priced into it its CRA rating. That is, an artificially high rating has the potential to lead to bubbles of that security.

2) Some institutional funds are required to invest in securities based on their ratings. That is, a pension fund or money market fund may invest in only 'triple A' bonds believing its portfolio to be extremely low-risk; if the ratings are issued wrongly or in error, the above belief is misplaced.

3)The vast majority of investors have not the resources to perform due diligence on the majority of their investments (some of these may be obscure and highly complicated derivative instruments) and thus rely on the major CRAs to do this work for them. Thus the CRAs inspire confidence in the markets and confidence in them leads to higher economic activity and liquidity.

Needless to say, the CRAs failed to do their job. The very high rating of Iceland just prior to its bankruptcy and the crash of the 'triple A' mortgage-backed securities bubble should suffice as examples here. But how do their erroneous ratings implicate them as being responsible for the financial crisis? I give my reasons below:

1) Just after the world discovered there was a crisis in the 'subprime' market, the CRAs downgraded many asset-backed securities, sending prices tumbling. The US government's seal of approval of these CRAs' ratings created a vicious cycle of falling prices.

Many funds investing in these securities based on their high ratings now had to dump them (often for a heavy loss, especially after the recent fall in prices) because of the funds' rules. This forced selling, based on nothing more than a change in official opinion of some securities by the CRAs, compounded the financial crisis.

Of course, the firms whose debt got downgraded suffered the most as their borrowing costs (interest rates) shot up. (Banks and most other creditors have an obligation to follow the CRAs' ratings when buying debt.) This is not to mention that higher interest rates on mortgages mean that more loans are non-performing, which of course amplified the crisis by reducing the value of asset-backed securities.

2) For a world so previously so dependent on the CRAs' opinions, it was a shock for most people to see that these agencies' valuations and opinions were worthless. Suddenly, a 'triple A' rating meant zilch. This only sapped investors' confidence more, and the current impotency of the CRAs to influence and make confident the markets only led to sparse liquidity and credit (hence the term 'credit crunch').

Funds that invested based on the CRAs' ratings decided to hold cash (if they even existed any more), and many smaller companies could not issue debt because nobody trusted the CRAs' opinions (and nobody else did research on small companies).

It is very easy for me to write with the benefit of hindsight that the markets in the earlier part of this decade should not have trusted the CRAs as much as they did; that the funds' rules were putting blind faith in the CRAs; that pensioners and others who need low-risk,stable returns should have been more careful about their money; and that more investors should have evaluated the companies and securities they were investing in themselves instead of relying on the CRAs to make their decisions for them. But the state of the world as it existed prior to summer 2008 relied heavily on the CRAs, and this is why they cannot dodge responsibility for the current recession. Just as Freddie Mac and Fannie Mae had government approval to better facilitate mortgage lending, the major CRAs had Congress's approval to facilitate liquidity and confidence in the more obscure and complicated securities markets. And they failed.

Not only do I blame the CRAs for causing what has happened already so far in the financial crisis, I blame them also for illiquidity and non-confidence that will stay in the markets at least until, in my opinion, late 2010. I assign blame to the CRAs for giving current investors no basis upon which to invest their money, which will be saved and not contribute to economic activity. That is, an average investor who has no means (except at prohibitive cost) to perform risk control and due diligence can no longer trust the CRAs' opinions, and will choose to put his money into a savings account instead of fueling the markets with liquidity.

Below, I will give some reasons why I believe the above state of affairs came into being, and what I believe to be a solution:

1) All employees of a credit rating agency are investment banking rejects. This is of course a generalisation, but there is some truth to it because working for a CRA has none of the glamour (and a fraction of the pay) of working in a similar rôle at another financial organisation such as a bulge-bracket bank.

The agency does not have the talent or resources to properly issue ratings on the wide variety of securities that exist today, and I believe that this is a major reason why they failed to successfully predict the current recession.

The only solution I can think of for this problem is for the CRAs to have an official mandate from the government, and with Federal backing offer high efficiency wages to its employees to attract the best talent available.

2) As the CRAs are mostly paid by bond issuers, there is a major conflict of interest which tends to inflate ratings. I see no way to avert this conflict of interest except by having the CRAs nationalised and having only the government provide it with revenue.

Conclusion

I think that the era of CRAs wielding disproportionate influence in the credit markets has ended, and that we have entered a new low plateau of economic activity because of the loss of confidence. I do not think that the CRAs can gain their prestige and status back, so there will (have to) be some new institutions to take their place. Until then (I'm guessing this will take about two years) low business confidence will be the major player in the markets.