Did the Credit Rating Agencies cause the Financial Crisis?

Cleary Wealth Management have some firm views on that question:

It is not a stretch at all to say the entire financial crisis could have been avoided had the credit rating agencies performed their role properly, let alone ethically. For the group as a whole to emerge unscathed and without any change in the regulations governing them is astonishing.

Credit Rating Agencies have been around since the start of the twentieth century. In essence, their role is to express an opinion with respect to the creditworthiness of a borrower seeking to raise money from the market. As there are literally millions of debt issuing entities around the world (sovereign governments, municipals, corporate, NGOs etc), it is impossible for any individual investor to simultaneously appraise all the market issuers.

Credit rating agencies thus provide simple ranking systems so that an investor can easily understand and compare the credit worthiness of an issuer of a debt security and make an assessment as to whether they are receiving a fair reward for the assessed risk. There are a number of rating agencies around the world, but the three that matter are Moody's, Standard & Poors and Fitch Ratings. They all use a similar scale to rank the various debt instruments available to investors running from AAA down to D. We have attached a table of the ratings at the end of the quarterly to assist readers in understanding what the ratings mean.

Essentially, the credit rating represents an opinion on the likelihood of the debt issuer being unable to meet interest or principal repayments. Around 1970, two separate trends established the dynamics of the business which led to the problems in 2008. Firstly, rating agencies started to charge fees to the issuers rather than investors. Prior to this, the rating agencies had sourced revenues from the users of the information as they charged investors a fee to gain access to the information.

However the change to charging the issuer represented a fundamental shift for the industry. No longer were the interests of the data users aligned with the data providers. A rating agency became more akin to an auditor in that they were paid by the people they were reporting on, not by the users relying on the information. The potential conflict of interest is obvious and is exacerbated by the nature of the industry where a few clients provide the bulk of ratings work. With ordinary bonds, no issuer represented more than 1% of a rating agencies business. But under the securitisation model, 7-8 of the worlds large banks represented a huge share of the business and rating agencies were almost forced to relax credit standards in order to retain and grow market share. If you don‟t play, you don‟t get paid.

Secondly, in 1975, a number of SEC regulated banking entities sought to loosen their capital requirements by investing their regulatory capital in rated debt instruments. This was an extremely important point as previously most banks had all of their capital in US Government bonds. Now, provided the securities were rated a certain level by a “Nationally Recognised Statistical Rating Organisation”, they could be held on the entity‟s balance sheet. This made the credit rating critically important in determining whether debt would count as regulatory capital.

Aligned with the second of these changes was the increasing role of trustees of pension funds and the rise of the professional money management industry. An important „prudent person‟ rule – the Putnam Doctrine - that the funds under their purview could only be invested in what were termed “Investment Grade” securities. This was any security ranked BBB- and above by one of the rating agencies. This provided a stark cut-off with securities falling below that level having significantly less demand for their debt and commensurately higher costs. The seeds of the GFC lay in the attempt by the rating agencies to increase revenues through the rating of structured products. Investment Banks starting generating what became known as “Collaterised Debt Obligations” (or CDOs) in the 1990s which they wanted to sell to investors and therefore needed a credit rating. CDO‟s are a blatant attempt to arbitrage the rating system.

As many investors are prohibited by law or mandate from investing into non-investment grade assets, investment banks pooled a range of non-investment grade assets into a CDO and then sliced this pool into a variety of tranches; some of which would be investment grade. Each tranche would be given a separate rating based on its particular credit qualities. Because of the price difference between investment and non-investment grade, banks could pool assets together and make the sum worth more than the parts (less fees of course). Per this system, the process of financial alchemy was underway aided and abetted by the rating agencies.

An investment bank would take a 1,000 sub-prime loans, each of which on its own would be non-investment grade, and parcel them all together so that some of this dross could be sold as AAA rated debt and be held by banks as their regulatory capital. What was previously a small sideline to the main business of rating bonds rapidly became the growth engine for rating agencies. Moody‟s and S&P were rating around 10,000 mortgage securities per annum and charging anywhere from $50,000 to $1 million per issue leading to surging earnings from the big three rating agencies.

The rating agencies were critical to the sale of these products as no security could be sold without a credit rating. In fact, they not only rated the vast volume of securities being issued, but actually sold their methodology and offered consulting services on how to build investment grade CDO‟s. But they did little actual credit analysis themselves, the job for which they were supposedly being paid. The agencies relied heavily on the projections and data provided by the banks themselves including their own optimistic assumptions on the future values of critical variables such as house prices and default rates.

Millions of sub-prime mortgages were being fed into the system and based on historical data, it seemed inconceivable that they would all default at the same time. In fact, rumour has it that the model they used to determine likely defaults of the various tranches did not allow for a negative number for house price appreciation!
By the end of 2008, the huge demand around the world for income yielding products was being met by gigantic volumes of CDO‟s and other synthetic securities.

At the beginning of the credit crisis, there were only 16 AAA rated listed corporate entities around in the world, but 64,000 AAA rated CDO tranches! What the rating agencies clearly missed was that the finance industry‟s underwriting standards were now deplorable, if not outright criminal, and that the US was in the midst of a massive housing bubble. When this bubble started to pop in 2007, people who couldn‟t afford their mortgages started defaulting in record numbers. As rating agencies belatedly realised the drama unfolding, they began rapidly downgrading all mortgage related securities.

This was ground zero of the financial crisis as banks had a lot of these now illiquid securities on their balance sheets with the value rapidly marked down from utopian perfection to cataclysmic reality. As we all now know, reality is an ugly beast and it all went downhill from there. But from crisis emerges opportunity and the rating agencies gross dereliction of duty coupled with lack of due diligence on the part of lazy/passive investors has meant there is a sizeable opportunity currently in the markets for investors who have capital, expertise, diligence and patience.