omics Department of Economics University of Michigan 611 Tappan St An - PDF document

1 omics, , Department of Economics, Univer
omics, , Department of Economics, University of Michigan, 611 Tappan St., Ann Arbor, Michigan 48109-1220.University of Michigan, 611 Tappan St., Ann Arbor, Michigan 48109-1220.I cies shifted their business model from Òinvestor paysÓ to Òissuer pays.Órating agencies shifted their business model from Òinvestor paysÓ to Òissuer pays.Ó11 W information by offering judgmentsÑthey prefer the word ÒopinionsÓ22Ñabout Ñabout 1 Overviews of the credit rating industry can be found in, for example, Cantor and Packer (1995), Langohr and Langohr (2008), Partnoy (1999, 2002), Richardson and White (2009), Sinclair (2005), Sylla (2002), and White (2002a, 2002b, 2006, 2007, 2009). credit quality of bonds that are issued by corporations, U.S. state and local the credit quality of bonds that are issued by corporations, U.S. state and local governments, Òsov

2 ere by selling their assessments of cred
ere by selling their assessments of creditworthiness to investors. This occurred in the reated in 1934 and era before the Securities and Exchange Commission (SEC) was created in 1934 and began requiring corporations to issue standardized ! nancial statements. These began requiring corporations to issue standardized ! nancial statements. These j would be equivalent to bonds that were rated BBBÐ or better on the Standard odyÕs, PoorÕs, Standard, and Fitch. MoodyÕs, PoorÕs, Standard, and Fitch. Essentially, the creditworthiness judgments of these third-party raters had attained the force of law..I r safety decisions to the credit rating agencies. In the 1970s, federal pension their safety decisions to the credit rating agencies. In the 1970s, federal pension regulators pursued a similar strategy.regulators pursued a similar strategy.33T t

3 hree rating agencies in 1975, when it de
hree rating agencies in 1975, when it decided to modify its minimum capital requirements for broker-dealers, who include major investment banks and secu-requirements for broker-dealers, who include major investment banks and secu-r too of risk. But it worried that references to Òrecognized rating manualsÓ were too vague and that a bogus rating ! rm might arise that wou participants in the bond market, other players in the marketÑboth buyers and sellersÑneeded to pay particular attention to the bond ratersÕ pronouncements sellersÑneeded to pay particular attention to the bond ratersÕ pronouncements as well. The irony of the regulatorsÕ reliance on the judgments of credit rating as well. The irony of the regulatorsÕ reliance on the judgments of credit rating agencies is powerfully revealed by a line in Standard & PoorÕs standard disclaimer

4 agencies is powerfully revealed by a li
agencies is powerfully revealed by a line in Standard & PoorÕs standard disclaimer ment decision.Ó (MoodyÕs ratings have a similar disclaimer.)any investment decision.Ó (MoodyÕs ratings have a similar disclaimer.)F o made investors more willing to pay to ! nd out which bonds were really safer, also made investors more willing to pay to ! nd out which bonds were really safer, and which were not. e onlyÓ (like The Village Voice, some metropolitan ÒgiveawayÓ daily newspapers, and , some metropolitan ÒgiveawayÓ daily newspapers, and some suburban weekly ÒshoppersÓ). Information markets for the quality of bonds some suburban weekly ÒshoppersÓ). Information markets for the quality of bonds have a similar feature, in that the information can be paid for by issuers of debt, have a similar feature, in that the information can be paid for by issu

5 ers of debt, buyers of debt, or some mix
ers of debt, buyers of debt, or some mix of the twobuyers of debt, or some mix of the two4 the door to potential con correct and the errors are distributed symmetrically (that is, the raters are honest but less than perfect) but the issuers can choose which rating to purchase, the issuers will systematically choose the most optimistic. (This model thus has the same mechanism that underlies the operation of the ÒwinnerÕs ring this era was not Indeed, the major complaint about the rating agencies during this era was not that they were too complian Fifty-two percent of its total revenue came from the United States; as recently 2009). Fifty-two percent of its total revenue came from the United States; as recently a the three ! rms are commonly estimated to be approximately 40, 40, and 15 percent 6 The suit was eventually dismissed. See Jeff

6 erson County School District No. R-1 v.
erson County School District No. R-1 v. MoodyÕs InvestorÕs Services, ommissionÕs During the 25 years that followed the Securities and Exchange CommissionÕs 1 McCarthy, Crisanti & Maffei in 1983; IBCA in 1991; and Thomson BankWatch in 1992. However, mergers among the entrants and with Fitch caused the number of 1992. However, mergers among the entrants and with Fitch caused the number of ever, it is important to note that while the major credit rating agencies However, it is important to note that while the major credit rating agencies are a major source of creditworthiness for bond investors, they are far from only potential source. A few smaller rating ! rmsÑnotably KMV, Egan-Jones, and ial, all of which had Òinvestor paysÓ business modelsÑwere able to Lace Financial, all of which had Òinvestor paysÓ business modelsÑwere able to surv

7 ive, despite the absence of NRSRO design
ive, despite the absence of NRSRO designations (although KMV was absorbed survive, despite the absence of NRSRO designations (although KMV was absorbed b hedge funds. ÒFixed income analystsÓ at many ! nancial services ! rms offer recom-mendations to those ! rmsÕ clients with respect to bond investments.mendations to those e less-well-known features of federal ! nancial regulation until the Enron one of the less-well-known features of federal ! nancial regulation until the Enron bankruptcy of November 2001. In the wake of the Enron bankruptcy, however, the bankruptcy of November 2001. In the wake of the Enron bankruptcy, however, the media and Congress noticed that the three major rating agencies had maintained media and Congress noticed that the three major rating agencies had maintained Òinvestment gradeÓ ratings on EnronÕs bonds until

8 ! ve days before that company Òinvestmen
! ve days before that company Òinvestment gradeÓ ratings on EnronÕs bonds until ! ve days before that company d d how the latter could have been so slow to recognize EnronÕs weakened ! nan-asked how the latter could have been so slow to recognize EnronÕs weakened ! nan-c condition of WorldCom, and were subsequently grilled about that as well. ! nancial condition of WorldCom, and were subsequently grilled about that as well. I it rating agencies, they profess to provide a long-term perspectiveÑto Òrate credit rating agencies, they profess to provide a long-term perspectiveÑto Òrate through the cycleÓÑrather than providing an up-to-the-minute assessment. This through the cycleÓÑrather than providing an up-to-the-minute assessment. This s ings that the market believes to be in" ated, since those bonds will carry higher ratings that the marke

9 t believes to be in"yields relative to t
t believes to be in"yields relative to the rating and the institutionÕs bond manager can thereby obtain s actually provide useful informa-whether the three major credit rating agencies actually provide useful informa-t e is report, for example, states: ÒThe quality of MoodyÕs long-term performance is illustrated by a simple measure: over the past 80 years across a broad range of illustrated by a simple measure: over the past 80 years across a broad range of asset classes, obligations with lower MoodyÕs ratings have consistently defaulted asset classes, obligations with lower MoodyÕs ratings have consistently defaulted a nancial marketsÕ separately determined spreads on the relevant bonds (over ave noted that when a major (1999) and Creighton, Gower, and Richards (2007), have noted that when a major rating agency rating agency changes f

10 arther away from, that regulatory Òcliff
arther away from, that regulatory ÒcliffÓÑmany ! nancial institutions must to, or farther away from, that regulatory ÒcliffÓÑmany ! nancial institutions must then reassess their holdings of that bond, rather than reacting to any truly new then reassess their holdings of that bond, rather than reacting to any truly new information about the default probability of the bond. The question of what true information about the default probability of the bond. The question of what true value the major credit rating agencies bring to the ! nancial markets remains open value the major credit rating agencies bring to the ! nancial markets remains open and dif! cult to resolve.and dif! cult to resolve.88F t the potential con" icts Although the rating agenciesÕ reputational concerns had kept the potential con" icts in check, the possibility that the co

11 n" icts might get out of hand loomed (Sm
n" icts might get out of hand loomed (Smith an securities ended up being owned by many ! nancial ! rms, including banks. backed securities ended up being owned by many ! nancial ! rms, including banks. M ese bonds.tionsÕ abilities and incentives (via capital requirements) to invest in these bonds.1010 S ings on the mortgage-related securities.ratings on the mortgage-related securities.During their earlier history, the credit rating agencies rated the bonds that During their earlier history, the credit rating agencies rated the bonds that were issued by corporations and various government agencies. But in rating of were issued by corporations and various government agencies. But in rating of m uld earn what securities on what kinds of mortgages (and other kinds of debt) would earn what levels of ratings for what sizes of tranches of thes

12 e securities (Mason and Rosner, uer.issu
e securities (Mason and Rosner, uer.issuer.1111 sign of the securities, and where they were under considerable ! nancial in the design of the securities, and where they were under considerable ! The main policy responses to the growing criticism of the three large bond ratersÑover the sluggishness in downgrading Enron and WorldCom debt, on ratersÑover the sluggishness in downgrading Enron and WorldCom debt, on the enhanced role of the three incumbent credit rating agencies.entry and the enhanced role of the three incumbent credit rating agencies.However, the Securities and Exchange Commission did begin to allow more However, the Securities and Exchange Commission did begin to allow more e assumptions, and track records in the construction of ratings (Federal Register, vol. , vol. 74, February 9, 2009, pp. 6456Ð84; and F74, February 9, 2

13 009, pp. 6456Ð84; and Federal Register e
009, pp. 6456Ð84; and Federal Register efforts to ! x problems, by prescribing speci! ed structures and processes, unavoid- Under such rules, the rating agenciesÕ judgments would no longer have the force of law. However, no other ! nancial regulator has similarly withdrawn its delegations.law. However, no other requirement would be geared to the riskiness of the bonds that it holds); but those 12 In October 2009, the Federal Reserve announced that it would be more selective with respect to which ratings it would accept in connection with the collateral provided by borrowers under the FedÕs ÒTerm Asset-Backed Securities Lending FacilityÓ (TALF) and would also conduct its own risk assessments of proposed collateral; and in November 2009, the National Association of Insurance Commissioners (NAIC) announced that it had asked the Paci! c Inve

14 stment Management Company (PIMCO) to pro
stment Management Company (PIMCO) to provide a separate risk assessment of residential mortgage-backed securities that were ments should remain the responsibility of the regulated institutions safety judgments should remain the responsibility of the regulated institutions themselves, with oversight by regulator European Central Bank. 2009. ÒCredit Rating Agencies: Developments and Policy Issues.Ó Monthly Bulletin, May, pp. 107Ð117.Flandreau, Marc, Norbert Gaillard, and Frank Packer. 2009 ÒRatings Performance, Regulation and the Great Depression: Lessons from Foreign Government Securities.Ó CEPR Discussion Paper No. DP7328. (June).Fridson, Martin S. 1999. ÒWhy Do Bond 2005. ÒInformational Effects of Regulation FD: Evidence from Rating Agencies.Ó Journal of Finan-cial Economics, 76(2): 309Ð330.Langohr, Herwig, and Patricia Langohr. 2008.

15 The Rating Agencies and Their Credit Rat
The Rating Agencies and Their Credit Ratings: What They Are, How They Work, and Why They Are Relevant. Chichester: Wiley.Lof Economics, 56(5): 657Ð74.!"#$%&'()%*+,-.)$%&'/"%$0'1$02$&'"03'4)"0$'!5'4)$%67035'!""#$%&'()%*+,)%+-%./01232)%4)53671,$8%Journal of Economic Perspectives!%!9:;=%!&#x 29 ;?@"$MoodyÕs Corporation. 2009. Annual Report 2008. New York: MoodyÕs.Morkotter, Stefan, and Simone Westerfeld. 2009. ÒRating Model Arbitrage in CDO Markets: An Empirical Analysis.Ó International Review of Financial Analysis, 18(5): 21Ð33.Partnoy, Frank. 1999. ÒThe Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies.Ó Washington University Law Quarterly, 77(3): 619Ð712.Partnoy, Frank. 2002. ÒThe Paradox of Credit Ratings.Ó In Ratings, Rating Agencies, and the Global Financial System, ed. Richard M. Levich, Carmen Rein

16 hart, and Giovanni Majnoni, 65Ð84. Bosto
hart, and Giovanni Majnoni, 65Ð84. Boston: Kluwer.Richardson, Matthew C., and Lawrence J. White. 2009. ÒThe Rating Agencies: Is Regula-tion the Answer?Ó In Restoring Financial Stability: How to Repair a Failed System, ed. Viral Acharya and Matthew C. Richardson, 101Ð115. New York: Wiley.Rysman, Marc. 2009. ÒThe Economics of Two-Sided Markets.Ó Journal of Economic Perspectives23(3): 125Ð43.Sinclair, Timothy J. 2005. The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca: Cornell University Press.Skreta, Vasiliki, and Laura Veldkamp. 2009. ÒRatings Shopping and Asset Complexity: A Theory of Ratings In" ation.Ó Journal of Monetary Economics, 56 (5): 678Ð95.Smith, Roy C., and Ingo Walter. 2002. ÒRating 48Ð52.White, Lawrence J. 2009. ÒThe Credit-Rating Agencies and the Subprime Debacle.Ó Critica