Failures of Risk rating Agencies during the Global Financial Crisis

This is a short excerpt from my independent study research paper title; "Failures of Risk management during the financial crisis and the new trends for the post crisis era". I have a full copy of the paper in PDF available for anyone interested in reading it or for reference. Just leave a comment and I will be in touch. Enjoy!

Credit rating agencies (CRA's) long periods after their establishment have done a great job at maintaining their high authority and determined adequate ratings assessing, with relative perfection, the actual probability of debtor’s insolvency. While there was also some other objective reasons for the wrong decisions by CRA’s in the past crises like the Asian financial crisis, the global financial crisis of 2008 showed that most of the inaccuracies in credit rating can be due solely to the mistakes of the rating agencies. Firms like Lehman Brothers went bankrupt while its investment rating was an investment one (A-). Another big corporation AIG insurance had same investment rating (A-) when it was bailed out by the federal financial aid. No evidence of fraud or submission of false information was found in either case. Both companies were public and operated on the most sophisticated financial market with highest standards of transparency. Thus, the deterioration of the financial condition of this firms was a permanent one, not temporary. Hence, the fault of the rating agencies in these cases is beyond doubt.

What was intriguing about the CRA’s was that studies found that despite the individual cases of  inappropriate (inadequate) ratings, the agencies’ overall rating of corporate bonds do reflect the actual associated credit risk.

(Rafailov 2011) claimed that the most significant failure of CRA is the assessment of the risk of mortgage-backed securities and mostly of collateralised debt obligations (CDO). This argument seems to support the evidence that the global financial crisis resulted from the defaults in sub-prime mortgage backed securities.

 Causes of the Failures

•      The entity issuing the securities pays the main portion of the fees determining the ratings and thus the CRA becomes dependent on this fees and the conflict of interest thereto. The agencies have an incentive to overlook problems with a company’s credibility and issue a higher rating than actual (or deserved) in order to attract more clients by doing so and at the same time will not lose current clients who would go to another agency. This was a fundamental problem due to the conflict of interest issue with investors’ interests requiring an unbiased assessment of the issuer. With regards to structured financial instruments (SFI) the problem with the business model was escalated because most part of the issuance of SFI’s is controlled by a few big investment banks and hence forming a major part of the income of CRA’s.

•         Lack of authority to verify the information. It is interesting to understand that credit ratings are based on voluntary information provided by the issuer. The CRA have no authority to verify the authenticity of the information provided and have no power to request further information by compulsion. Therefore, under such circumstances the issuer can conceal unfavourable information which enables overrating.

•      The problem of “The Big Three” i.e. no competition. The CRA market is basically controlled by the three biggest rating agencies (Standard & Poor’s, Moody’s and Fitch), that control 95% of the market (Langohr 2008 pp. 384-386). This creates an environment in which the opinion the investors receive is not diverse with regards to an issue, and it can lead to the formation of a cartel by the big three agencies to maintain monopolistic high prices for their services and can conduct coordinated policies to segment the market. Moreover under such an environment the risk assessment as well as business models applied are restricted to a certain level of diversity as there are only three firms controlling 95% of the market.

•          The Regulatory Body’s over reliance on Credit ratings. The regulators substantially relied on credit ratings and information produced by CRA’s in regulating the financial market. For instance some financial institutions are allowed to invest in debt instruments only if they have an investment rating provided by some defined CRA’s. Also in its determination of capital requirements of banks and other financial institutions, the regulatory authority uses the credit rating to determine the riskiness and value of various instruments. Furthermore the Central Banks had minimum credit rating requirements when granting refinancing to chartered banks. All these implicitly practically handed regulatory power to CRA’s through change of credit rating as their decisions/actions have enormous impact on the decisions of a lots of investors. This status of regulatory nature creates systematic risk, because it motivates the institutions to invest in overrated securities

•   Conflict of Interest. Normally the CRA firms that determines an issuer’s credit rating also gives professional advice to firms about how their different actions will affect their credit rating. This is a clear conflict of interest as same CRA that advice a firm how to maintain a sound credit rating will have no incentive to criticize its own work by giving a bad credit rating. Obviously the CRA’s will not want to upset the issuers and lost business by giving consulting advice on one hand and giving anything less than satisfactory rating on the other hand. In a nutshell credit rating and consultancy services are practically incompatible for any firm to combine without bias, for example how do you criticize your own advice? This was a really huge and arguably one of the most serious problem with the credit rating.

•        The problem with dependence on mathematical models. This is a common problem in structured instruments where ratings are based on the use of mathematical models, by which the probability of insolvency of different pools of debt obligation is modeled. These mathematical models do not have any component of fundamental analysis or expert assessment of the issuer’s financial condition. Rafailov (2011) argued that “the events during the global financial crisis showed that in most cases the models used are incomplete. They do not account for the presence of asymmetry of the information among borrowers, originator banks, financial institutions securitizing them (arrangers), rating agencies and investors”. He used the originator risk as an example, arguing that Originator banks have an incentive to deceive the arrangers and the rating agencies’ regarding the true creditability of borrowers. “For the information is not examined, there is created a moral risk that the originator banks provide false information as well as reduce the criteria upon lending of loans. The problem further deteriorates due to the fact that after securitization the lending banks do not assume the credit risk any more. Thus, there is no incentive for them to maintain high standards upon lending. As a result of that risk the actual probability of insolvency under individual loans is bigger than the one implied in the model and the credit rating is too optimistic” (Rafailov 2011). Another problem with this mathematical models is lack of complete information. For the determination of the credit rating for these structured instruments depends entirely on the mathematical model, the quality of the final results depends on the quality of the input information. As argued earlier, however, the CRA’s have no authority to request verification of information and if the information given is wrong or incomplete, then this mathematical model will give a misleading result.

•     Lack of efficient Regulation in the credit rating industry. CRA’s play a fundamental role in the sound functioning of the financial system, however, their business wasn’t governed by any strict regulation for long times prior to the crisis in 2008, depending entirely on self-regulation.

The above specified problems explain the reasons for inaccurate ratings determined by the CRA’s. Given the fact these problems were especially serious in the case of SFI’s, the failure in that area is not accidental. This failure hugely contributed to the events that lead to the rise and magnitude of the 2008 financial crisis. Without the work of the CRA’s the issue of overrated risky mortgage backed securities would not have been enormous as it was, investors would not have invested in the volume they did in these securities without the overrated risk because their expected return would not have been high compared to the risk assessment. As a matter of fact the banks would not have the propensity to securitize their loans at the lower realistic rating, because at this rating they would have received lower prices for them. Moreover without the overrating the investment banks facilitating the process would have made less profit because the spread between what they receive under securitized loans and what they pay under Tranches would have been lower if the tranches rating were lower.