US credit rating agency Standard & Poor’s has accepted a $1.38 billion penalty for its role in fueling the subprime mortgage meltdown writes Professor John Ryan. S&P’s settlement announced 3 February 2015 with the U.S. government, 19 states and the District of Columbia marks a reprimand of S&P which stood accused of having facilitated the overrating of toxic mortgages that was one of the causes of the global financial crisis.This settlement again brings to the forefront the question whether CRAs can be trusted, whether there is sufficient oversight to monitor and of their accountability.
A credit rating evaluates the creditworthiness of the borrower. It provides a measure of the likelihood that the borrower will repay its debt, which describes the risk of default, and therefore the risk of the borrower and the loan. This risk determines the required return on the loan – the interest rate. Because most investors are not adequately funded and resourced enough to adequately determine the credit rating of a borrower, they rely on the ratings provided by CRAs. In principle good ratings are supposed to allow for proper allocation of capital; while poor ratings result in overlending, misallocation of capital, and investor losses.
Thus, proper credit ratings are supposed to make capital markets efficient and underpin strong economic growth. The weaknesses of the credit rating system are well-known and well-understood. It is not surprising that the ratings agencies have been heavily criticized for their failures. The top grade AAA ratings were assigned to large volumes of “toxic” mortgage-backed securities and collateralized debt obligations before the financial crisis that ultimately lost value. A classic example of a corporate rating failure is that of Enron in 2001, where the ratings agencies did not downgrade the company until a few days before its bankruptcy.
Finally, the spectacle surrounding the very late downgrade of the US sovereign debt during the debt-ceiling crisis in 2011 made it all too clear that CRAs are politicized and incapable of prompt, decisive action. Notably, as part of the agreed settlement, S&P also agreed to retract its earlier allegation that the US government had brought the action in retaliation for its downgrade of the United States’ credit rating in 2011.
The modern credit rating system is fraught with problems that have already resulted in trillion-dollar losses and untold suffering by many nations. These problems extend to municipal, corporate, and structured-finance ratings. The system has proven to be a massive failure and needs to be entirely overhauled. The reform must necessarily provide for more transparency, more competition, and more flexibility. Experience during the financial crisis has also heightened concerns that rating agencies’ decisions may be subject to conflicts of interest. Since their revenues are predominantly driven by rating fees earned from issuers, there is a concern that CRAs devote disproportionate resources to chasing new business and rating new products, rather than improving their analysis of existing instruments. Furthermore, the revenue incentives of a CRA are such that ratings may be biased upwards (inflated) so as to meet an issuer’s expectations and thereby gain or keep its business.
The fact that the issuer pays for the rating provides a strong bias for a higher rating. Because the borrower pays, not the lender, the built-in incentive is to serve the interest of the borrower and to assign a better/higher credit rating. This clearly provides a conflict of interest, as the interest of the lender is not really protected and the lender has no recourse for a bad rating. CRAs have also been the subject of controversy during the Eurozone sovereign debt crisis. They have been accused both of failing to predict the crisis in the first place, and then of precipitating it by downgrading the ratings of Eurozone sovereigns too far and too fast. There were other points of severe criticism such as with S&P’s erroneous downgrade of France causing controversy. S&P sent out an email on 10 November 2011 just before 4pm Paris time when the European markets were still open. The yield for France’s 10-year bond jumped 25 basis points to 3.48% and the spread between 10-year French and German bonds hit 1.7%, a Eurozone record. S&P’s waited two hours to issue a correction, after the European markets had closed. It then issued a terse, 65-word ‘clarification’, blaming the mail out on a technical error, in a non-apology to a furious French government.
Even though CRAs publish their methodologies, these procedures lack rigorous validation and peer review. Also, CRAs do not publish the minutes of their rating committees. One common source of inconsistency is the intentional use of too many factors, which allows raters to emphasize some credit drivers, while conveniently ignoring others. Thus, the CRAs do not consistently follow their own methodologies. Naturally, inconsistent methodologies can lead to inconsistent ratings. There is a need to strengthen the accuracy of credit ratings and reduce systemic risk.
First there is a need to rank the CRAs in terms of performance, in particular the accuracy of their ratings. Second, there is a need to facilitate the ability of investors to hold CRAs accountable in civil lawsuits for inflated credit ratings, when a CRAs knowingly or recklessly fails to conduct a reasonable investigation of the rated security. Third, there is a need to ensure CRAs institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy. Fourth, regulators should use their inspection, examination, and regulatory authority to ensure CRAs assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity.
There is still an oligopoly of CRAs which have strong market power but are deeply flawed. An increase in competition could increase the quality of ratings. However, the proposed regulation concerning registration and compliance for new raters creates more, instead of ewer, barriers to entry. Issuing fines after CRAs have failed, for what could be a multiplicity of reasons as we have outlined here, may bring some political satisfaction and public support, but in reality it is too little, too late. Governments and regulators need to take decisive action now and introduce clear regulations and accountability in order to avoid a repetition of a financial market crisis fuelled by inflated credit ratings.
Professor John Ryan is Research Associate at the Von Hügel Institute of St Edmund’s College, University of Cambridge
