Credit rating agencies: The infallible church of the financial world

The role the credit rating agencies played in the financial crisis is significant if not extreme. After all, it was their “blessing” which turned junk into gold. In many respects the rating agencies are like the medieval church; their power stemming from their greatest advantage: belief. When it comes to most things in life, especially where we lack knowledge, such as going to the doctor, we have to put our faith in someone else. But what happens if we place our faith in the wrong hands? A paper by Benmelech and Dlugosz (2009) highlights some of the failings of the credit rating agencies.  In 2007 and 2008, approximately 7% of structured finance securities rated by Moody’s were downgraded each year and the average downgrade was around 5 notches. Structured financed securities that fell 8 or more notches were most likely to be rated AAA (the fallen angels) and almost two thirds of downgrades were attributed to securities backed by home equity loans or first mortgages. Now while 7% may not seem an excessive amount, we have to bear in mind that this is the equivalent of 7% of Rolex watches turning out to be market stall fakes; it’s not good enough.

Backed by belief?
(Picture courtesy of compellingparade.com)

It was the AAA ratings which allowed the securitisation machine to go into overload, eventually leading to massive write downs. The credit rating agencies were trusted and they failed; their stamp of approval was adhered to even when similarly rated corporate bonds were paying much lower interest. Moody’s had the expected default frequency (default probability) of Lehman brothers 3 months before it went bust at 0.6%; what a prediction! So why do investors put their faith in this holy trinity of institutions? Over the years they have obtained the force of law (see White (2009)), with safety judgments outsourced by regulators and significant barriers to entry created by the SEC. They are an opaque ruling elite; incompetent, complacent and corrupt. The issuer pays model is subject to extreme abuse and the money generated by the credit rating agencies in the run up to the crisis was enough to allow corners to be cut and concerns to be overlooked. They have gone from caring about accuracy to caring about profits; the money is just too easy. 

AAA it is then....
(Picture courtesy of healthimaging.com)

I keep thinking of ways to transform the credit rating agencies but then I realise what is needed is not necessarily tonnes of rules and regulations but simply a change in attitude, both by investors and by the state. These credit rating agencies after all are only providing “opinions” (their words!) The reliance on the ratings, such as advocated by Basel iii, needs to be scrapped; the state and the church need to be separated. Investors putting their absolute faith in the opinion of credit rating agencies is like putting all your faith in a slick car garage salesman; you’ve got to be a bit more savvy than that! Yet, despite all their mistakes, the Big Three still hold about 95% of the market share. Issuers need to seek new rating agencies (more reliable ones) and investors need to start recognising these other rating agencies, otherwise more accurate and innovate agencies are simply being overlooked. In general, more scepticism needs to be shown. The Big 3 rating agencies have shown their weakness and while governments may impose tighter regulation and new rules, the spirit of change lies with the investor. The church should be run by its people, not the other way round!