Credit Rating Agencies Essay

Today, credit rating agencies such as Moody’s, S&P and the Fitch Group wield global influence by assigning credit ratings to bonds and even countries that have an enormous impact on investor confidence. Following the 2008 subprime mortgage meltdown and the Great Recession of 2009 that resulted, there were growing calls for reform of the rating processes used by credit reporting agencies. To determine the facts with credit rating agencies, this paper reviews the literature to provide an overview of these for-profit organizations and a description of the purposes they serve. An examination of the regulatory environment in which credit rating agencies operate is followed by an analysis of current issues with credit rating agencies in the United States and abroad. Finally, a summary of the research and important findings concerning credit ratings agencies and ways to improve them are provided in the conclusion.

What are credit agencies? Today, there are ten statistical rating organizations that enjoy national recognition and whose ratings are used in certain regulations, including the so-called “Big Three”:  Standard and Poor’s (S&P), Fitch and Moody's Investors Service (Regulators OK overhaul of credit rating agencies, 2014). Living up to their designation, the Big Three continue to dominate the credit ratings market today (New rules will fail to reform ratings agencies, 2014). In addition, in recent years, credit agencies have been criticized for their focus on profit-making (Klein, 2009). Notwithstanding these constraints, CRAs play a valuable role in modern society as discussed below.

What purposes do they serve? Credit rating agencies, also known as credit bureaus or credit ratings agencies (CRAs) are organizations that aggregate and disseminate credit information for use by public and private sector organizations in evaluating creditworthiness (Mierzwinski & Chester, 2007). Besides identifying the creditworthiness, CRAs also provide valuable information to public and private sector organizations to facilitate and fine-tune marketing initiatives (Klein, 2009).

Current CRA regulation in the United States. At present, the Credit Rating Reform Act of 2006 and the Dodd–Frank Wall Street Reform and Consumer Protection Act (discussed further below) are the primary controlling laws that regulate CRAs in the United States. Likewise, the all-but-in-name United States of Europe has regulatory guidance in place for their CRA sector as described below.

Current CRA regulation in the EU.  In an effort to harmonize regulatory oversight of CRAs in Europe, these organizations must now follow more stringent guidelines that make them increasingly accountable to EU stakeholders (Hughes, & Augier, 2014). The new rules took effect June 20, 2014 and are also targeted at reducing over-reliance on credit ratings and improving the quality of the rating process as well as requiring credit rating agencies to be more transparent in their rating of sovereign states (Hughes & Augier, 2014). According to the EU’s press release, “The new rules will also contribute to increased competition in the ratings industry currently dominated by a few market players and will reduce the over-reliance on ratings by financial market participants” (Hughes & Augier, 2014, para. 2). These reforms are intended as reassurances to nervous European consumers and investors to prevent future financial crises (Hughes & Augier, 2014).

Recent changes to CRA regulations. In the United States, number of issues that may affect investors may be unregulated to some extent absent further regulatory or legislative action including the unregulated nature of the methodology used by CRAs (Mierzwinski & Chester, 2007). In the European Union, though, revised rules adopted in May 2013 included mandatory rotation of CRAs and approval of the methodology they use in assigning credit ratings (Update on regulation of credit rating agencies, 2013).

Credit Rating Agency Reform Act of 2006. In 2006, Congress passed the Credit Rating Agency Reform Act that required the U.S. Securities and Exchange Commission (SEC) to promulgate clear guidelines to identify credit rating agencies that would qualify as Nationally Recognized Statistical Rating Organizations (NRSROs) (Credit reporting agencies, 2014). The Credit Rating Agency Reform Act also authorized the SEC to regulate NRSRO internal processes concerning record-keeping practices, guidelines for preventing conflicts of interest, and established the protocol whereby NRSRO determinations were subject to review (Credit reporting agencies, 2014). It is important to note, though, that the Credit Rating Agency Reform Act specifically prohibits the SEC from regulating the rating methodologies used by NRSROs (Credit reporting agencies, 2014).

After the 2008 housing bubble. Credit rating agencies use a business model that is characterized by a fundamental conflict of interests (New rules will fail to reform ratings agencies, 2014). In a painful reminder that greed can infect an entire industry, the 2008 housing bubble focused attention squarely on the CRA sector. According to Baker (2008), prior to the 2008 housing bubble burst, “Banks paid for the rating of their bonds by credit agencies,” a practice that “should have prompted more concern from regulators” (2008, p. 73). These lax practices resulted in enormous profiteering at the expense of the American taxpayer. In this regard, Baker notes that, “This situation was a recipe for abuse” (2008, p. 73). Indeed, a representative from Standard and Poor’s emphasized that, “Securities backed by faulty mortgages were an ‘epicenter’ of the crisis, leading investors astray by ‘wrapping serious financial risks in a thin veneer of creditworthiness (cited in Regulators OK overhaul of credit rating agencies, 2014, p. 3). Prior to the 2008 housing bubble burst, investment bankers and securities issuers practiced what is known as “ratings shopping” and hired the CRA that would provide them with the most advantageous ratings (New rules will fail to reform ratings agencies, 2014). Although regulators have encouraged CRAs to offer unsolicited ratings on issuances they have not been hired to rate, ratings shopping has been revived (New rules will fail to reform ratings agencies, 2014).

Most industry analysts agree that the CRAs were responsible for causing the financial crisis, with the overarching motivation being greed (New rules will fail to reform ratings agencies, 2014). For instance, one analyst suggests that, “Financial institutions that created residential mortgage-backed securities (RMBS) needed strong CRA ratings in order to sell their financial products, since many investors are only allowed to invest in financial instruments that carry investment-grade rating” (2014, p. 2). During the period from 2004 to mid-2007, the S&P and Moody's each collateralized debt obligation (CDO) securities issued in the United States and assigned AAA ratings to most of the RMBS; in addition, these two CRAs also assigned AAA ratings potentially as much as 95% of a securitization (New rules will fail to reform ratings agencies, 2014).

Following the housing bubble burst, there were growing calls for reform of the rating processes used by CRAs, especially on the part of investors that had lost confidence in the entire financial system (Baker, 2008). Although numerous investors sued their CRAs following the 2008 housing bubble collapse for violations of the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) for breach of fiduciary duty, fraud, negligent misrepresentation, and abuse of control (Baker, 2008). According to Harper (2011), though, “For the most part, CRAs have been successful in avoiding liability because of various exemptions and defenses” (2011, p. 1928).

Dodd–Frank Wall Street Reform and Consumer Protection Act. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in an attempt to restore confidence in the U.S. financial system following the 2008 housing bubble and the Great Recession of 2009 (Harper, 2011). In fact, 18 full pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Act”) are devoted specifically to CRA accountability and scrutiny of the various defenses that have enabled CRAs to avoid civil liability in the past (Harper, 2011). The provisions of the Act require the SEC to establish new rules for the following:

Annual reports on internal controls

Conflicts of interest with respect to sales and marketing practices

“Look-backs” when credit analysts leave the NRSRO

Fines and penalties

Disclosure of performance statistics

Application and disclosure of credit rating methodologies

Form disclosure of data and assumptions underlying credit ratings, among other things

Disclosure about third-party due diligence

Analyst training and testing

Consistent application of rating symbols and definitions

Specific and additional disclosure for ratings related to asset-based securities (Credit rating agencies, 2014).

Beyond the foregoing, the Act also requires all federal agencies to:

Review current regulations requiring the use of an assessment of the creditworthiness of a money market instrument or security or any references to credit ratings in such regulations;

Modify such regulations identified in the review to remove any reference to, or requirement of reliance on credit ratings; and.

Substitute with a standard of creditworthiness as the agency shall determine as appropriate for such regulations (Credit reporting agencies, 2014).

In addition, on May 18, 2011, the SEC introduced new rules intended to address the additional requirements set forth in the Act (Credit reporting agencies, 2014). In this regard, in August 2014, the SEC approved two new rules intended to prevent fraudulent or weak loans from being bundled into securities for sale to investors, as well as changes in the manner in which CRAs operate (Regulators OK overhaul of credit rating agencies, 2014). The chairman of the SEC, Mary Jo White, characterized the new rules as being a “very strong package of reforms [that] will improve the quality of credit ratings for the benefit of investors and the capital markets" (cited in Regulators OK overhaul of credit rating agencies, 2014, p. 1). As mandated by the Dodd-Frank financial reform law, the SEC will implement the new rules for all U.S. credit rating agencies, including the Big Three (Regulators OK overhaul of credit rating agencies, 2014).

Credit reporting reform in the U.S. and abroad has succeeded in focusing increasing attention of the management of credit programs in ways that have restored investor confidence (Stanton, 2007). Moreover, the horsewhipping taken by the global economy following the 2008 housing bubble burst resulted in a number of initiatives that are intended to improve regulatory oversight and transparency in CRA operations (Stanton, 2007). Regulators in the EU have taken careful note of the 2008 housing bubble experience and have taken steps to prevent a recurrence there (Update on regulation of credit rating agencies, 2013).