Control of Rating Agencies

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain type of debt obligations as well as the debt instruments themselves. Sometimes, the servicers of the underlying debt are also given ratings.

Most of the time, the issuers of securities are companies, special purpose entities, non-profit organizations, or governments (local, state or national) issuing bonds or other debt-like securities that can be traded on a secondary market.

A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.

There are more than 150 rating agencies existent (with local or industry focus) but the big 3 agencies are dominating the market:
• Moody's
• Standard&Poors (S&P)
• Fitch
In the beginning of the agencies (around 1909) the investors had to pay for the ratings. This changed in the 1970s, when the issuer payed the bill of the agencies. Nowadays it is a mixture of both but most of the time issuers have to pay the rating agencies.

This is causing problems.
First of all, the 3 big agencies can influence the market quite significantly due to their market position and reputation. Their ratings can become a "self-fullfilling prophecy".
Secondly, the rating agencies receive their money from their clients. Therefore they are dependent on the goodwill of their clients. An objective rating can therefore not always be expected.
As a consequence, especially due to the current financial crisis, the request for more (independent) control of the rating agencies becomes more important.

A perfect example is the rating of mortgage-backed securities (CMBS).

It is obvious that the real estate bubble / sub-prime crisis was one of the main triggers of the current economic downfall. Thousands of real estate loans with high risk of default were packaged into very complicated collaterilized debt obligations (CDO), e.g. CMBS, and sold all over the world.
When the real estate market plummeted and the credit default rate increased dramatically, the financial institutions who invested heavily in the CDOs had to write down their values in their balance sheets dramatically.

The governments around the globe fought against the crisis but also demanded a higher control of the agencies as they had given these risky financial products always top ratings.

The rating agencies reacted in July. S&P downgraded the CMBS to a very low "BBB-". However, the main issuers of the CMBS were Goldmann Sachs, JP Morgan Chase, Morgan Stanley, Credit Suisse, and Wachovia.
Without a top rating they cannot deposit their CMBS - within the framework of the existing programme of the Federal Reserve - as security in return for credits. Hence they were up in arms about the rating of S&P.

S&P who had just downgraded these complex financial products withdrew their ratings one week later due to the enormous pressure of the issuers, their clients, and awarded the CMBS again with the top rating of "AAA"!

Of course there are justifications for this move and yes, in general (e.g. in the years before the crisis) the CMBS may be a save store of value, but they are so complex that even the bank clerks have difficulties to understand the underlying risk. Some of these financial products require the reading of up to 90,000 pages to fully understand their structure. Therefore a rating of AAA is more than questionable.

So what is the bottom line?
In my mind, the dependency of rating agencies on their clients has gone too far. They are not objective. An independent control board (from the governments and/or the federal banks) should be put in place. In addition, the payment of rating agencies need some review. I think we should go back to the concept that investors are paying for the ratings not the issuers.
As Ben Bernanke, the chairmen of the Federal Reserve Bank, has said, the insolvency risk of this market carries a huge risk for the whole economy. Therefore he demanded that the problematic loans have to be restructured in a way that the probability of default drops significantly. He is right!