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Role of Credit Rating Agencies as Risk Information Brokers, Prepared for the Anthony T. Cluff Fund and the Financial Services Roundtable, Presented to the US SEC and US Congress

Abstract

The recent financial crisis that shook the world caused many to question how such a large and looming financial risk could be underestimated or missed by so many. Regulators charged banks and lenders with fraud and various lending-related infractions. Investors charged investment bankers and credit rating agencies with offering inappropriate risk data and ratings and specifically inaccurate ratings based on nebulous risk data. In fact, as details of the conditions that led to the crisis became clearer in its aftermath, we have come to learn that many of the risky mortgages and loans that were part of the U.S. subprime market were securitized into products that received very favorable ratings by credit rating agencies (CRAs), and that key risk information from the issuers and CRAs did not make it to investors. Investors and regulators relied on ratings of credit-backed securities for the purposes of assessing risk and making investments. CRAs relied on data provided to them by the issuer of the security. Often this data was incomplete, poor, or even purposefully obfuscated by the issuer, in order to secure a higher rating that might be available otherwise. Regulators and investors contend that CRAs likely were operating with less due diligence than needed and were providing ratings based on a market outlook that was not realistic. CRAs charged that ratings were not about considering all outcomes in the future, but about point in time estimates, and that ratings on bonds and securities may be inherently different. The debate continues, and the need for clear, consistent, and reliable risk information is still largely unmet. Clearly, something was missed. Investors and regulators did not have access to the risk information that was desperately needed. Credit rating agencies have come under great scrutiny since the financial crisis. Even the meaning and value of a rating, especially on a credit-backed security, is now questioned by investors and regulators. Recent testimony to the Securities and Exchange Commission (SEC) and the U.S. Congress suggest that regulators and lawmakers view CRAs with disfavor, if not distrust. Investors have echoed this distrust. The role of credit rating agencies, especially in the creditbacked securities market, is highly questioned by many, but the reality is that a risk broker is needed to make capital markets efficient. In the recent Dodd-Frank legislation, there is a direct call to impose new regulation on CRAs, and to require attestation that CRAs conform to new rules of doing business, limiting conflicts of interest and strengthening the science behind the ratings process. In the coming years, the SEC is tasked, under the Dodd-Frank Act, with studying the overall business model for CRAs, and making recommendations to Congress on alternative business models, especially in the credit-backed security market. With this in mind, and the great attention that CRAs have received, it is clear that the financial services industry should also consider the role and future of CRAs and offer direction on how CRAs can serve market participants going forward. There are some government officials and regulators that believe that the credit rating agencies should be highly regulated or even revert to not-for-profit cooperatives. However, the importance of risk information in markets suggests that the role of an independent, third-party, risk information intermediary is needed in the investment and banking communities to facilitate the buy-sell process. An operating model for CRAs that is less dependent on regulation, and more driven by market needs, is superior and should be identified if possible. This study is focused on identifying such a business model.

Type

Article

Author(s)

Russell Walker

Date Published

2010

Citations

Walker, Russell. 2010. Role of Credit Rating Agencies as Risk Information Brokers. Prepared for the Anthony T. Cluff Fund and the Financial Services Roundtable, Presented to the US SEC and US Congress.

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