IP2023Final

GregoryKenter
29/04/2015
IP2023
Assessing the Blame of the Credit Rating Agencies in the Financial Crisis
Introduction
In the financial world, progress is largely determined by the quality of information
obtained by a specific party. Plans are formulated around various streams of intuition,
evidence, and other sources of intelligence to take advantage of lucrative investment
opportunities and to fundamentally create low-risk scenarios with the loaning of money.
The information is a vital component in the valuing of an asset, and in finance, investment
opportunities are only as valuable as people are led to believe that they are. However,
investors will not utilize just any report claiming that their money is safe – they need official
appraisals and proven experts to review their prospective moves and give a
recommendation based on their findings. These services are the primary function of credit
rating agencies, private institutions that provide their professional insight and opinions on
various investment situations. Their work assists investors of all levels in helping them
determine what are appropriate and safe ways to allocate wealth in opportunities all over
the world. Essentially, they issue a professional stamp of approval in the investment world.
Through this institutional framework, it would then seem that it would be in the
agencies’ best interest to provide complete and accurate reports as well as untarnished data
to the investing public, who, prior to the financial crisis, took the word of these companies
as the proverbial word of God. The common investor, disadvantaged by his access to
limited information, must, in essence, blindly trust the expertise of the credit rating
agencies when they want to invest. In the financial meltdown, that sense of trust was
grossly abused by the inherent conflicts of interest that drove the credit rating agencies to
conduct business irresponsibly and unfairly. But as investigations have shown, their
shortcomings were not solely highlighted before the crisis. There are plenty of indications
that the credit rating agencies have made it increasingly difficult for the recession to be
corrected after its unravelling. This paper will provide appropriate context in understanding
the motivations for the business of credit rating agencies as well as insight into their faults
during and after the financial crisis.

GregoryKenter
29/04/2015
IP2023
Functionality and Context
Credit rating agencies exist as a way to “assess the creditworthiness of bond issuers
– companies or countries who borrow money by issuing IOUs known as bonds.” (Marston,
2014) When a loan is made from one party to another, a credit agency’s job is to determine
how risky a loan is of not returning to the lender, or what is called ‘defaulting on a loan’. In
determining this riskiness, there are a series of possible rankings that a major agency can
bestow upon a particular investment situation. The highest of the grades, AAA, signifies “an
extremely strong capacity to meet financial commitments…[that exist] within a universe of
credit risk,” meaning essentially that there is no such thing as a zero-percent risk of
defaulting, but the chances of that investment doing so are still considerably low (Wearden,
2011). Typically, there are only a handful of AAA ratings in principle that should be given
out to large-scale entities. For example, there are a select handful of countries that
correspond to AAA-rated sovereign debt consistent with the rating agencies, such as
Denmark, France, Germany, Singapore, and the United States (Wearden, 2011). Each
country exhibits, in theory, stable markets, low-risk financial transactions, and developed
infrastructure. For many investor groups such as retirement funds, insurance companies,
and banks, it was typically “forbidden to purchase securities with a lower rating than BBB as
determined by recognized rating agencies” (Vukovic, 2011). Therefore, in order for
investment banks to purchase and sell more securities as collateralized debt obligations or
bet against using the credit default swap framework, the credit rating agencies were very
quick to issue out significantly high amounts of optimal ratings. From the beginning of the
decade to the start of the crisis in 2007, the amount of these top-rated securities nearly
doubled, representing hundreds of billions of dollars being approved as the safest
investment grade possible (Ferguson, 2010).
One issue that inevitably rises from this framework is the determining of which
institutions are qualified to make these ratings. In 1975, the SEC “gave oligopoly status to
three rating agencies in the United States. Standard and Poor’s, Moody’s, and Fitch became
the only agencies that had the right to give out official ratings to various market securities”
(Vukovic, 2011). This was also the birth of a new business classification, called “Nationally
Recognized Statistical Rating Organizations” – also known as NRSRO’s – which were meant
to eliminate any tampering of the true value of investment opportunities (Marston, 2014).

GregoryKenter
29/04/2015
IP2023
As a consequence, these companies were “able to enjoy special status in the law”, operate
with little-to-no regulation of their work, and conduct business within a monopolistic
market structure (Zhang, Xing, 2012). This would eventually lead these agencies to continue
their surges of high ratings, and, combined with the majority of the private shares of these
businesses being owned by major financial institutions, these businesses seemto have been
operating on an agenda. Other competitors, based on this monopolistic market structure,
were not able to enter into fair competition environments, which gave the Big Three free
reign to set the ratings they each saw fit.
The simplest explanation for this unprecedented rise in AAA ratings seems to lie
within the way these agencies make money themselves. According to hedge fund manager
Bill Ackman, the rating agencies would receive higher compensation based on the overall
amount of ratings reports distributed, particularly ones that garnered favourable reviews of
the assets discussed. This dynamic led to massive increases in the profits of the “Big Three”.
Moody’s recorded a quadrupling of earnings from 2000 to 2007, catapulting from less than
one billion to well over two billion, with the other two agencies following similar trajectories
(Ferguson, 2010). What is even more conflicting than the firms’ method of compensation,
however, is the apparent conflict of interest in each company’s stockholder community.
According to recent shareholder reports, JP Morgan owns “5.2% of shares in Fitch’s parent
company, Fimalac; Morgan Stanley owns 2.27% of Moody’s shares; and State Street owns
both 4.28% of McGraw-Hill Shares (McGraw-Hill is S&P’s parent company) and 3.3% of
Moody’s shares.” (Fraser, 2011). To own such large proportions of stock in companies that
basically rate their own performance is considered to a significant breach in professionalism
and, for lack of a better term, cheating the system.
Collapse and Drastic Revaluation
One would logically assume that in the months leading up to the crisis, the writing
was on the wall for many of the institutions that would soon implode, and the ratings given
by the Big Three would accurately convey this. Sadly this was not the case, and the Big
Three continued to cultivate a charade of just the opposite. In order to portray an attractive
forecast to the investor public as well as keep profits at high levels, there were hardly any
indications from the agencies that the major firms were in serious trouble. In fact, by the

GregoryKenter
29/04/2015
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time the major financial institutions were on the brink of collapse, many of them were still
rated with solid investment grades. Jerome Fons, a former managing director of Moody’s,
claims that many of the largest firms on Wall Street were rated as high as AAA up until the
days leading up to their collapse. “Bear Sterns [and Lehman Brothers were] rated A2 within
days of failing, AIG was AA within days of being bailed out, and Fannie Mae and Freddie Mac
were both AAA-rated when they were rescued by the government” (Ferguson, 2010). But as
the housing bubble burst and the cards began to fall in the mortgage-backed security
market, the credit rating agencies could no longer hide the hollow nature of their reports
and were forced to massively condemn the very investment opportunities that were
considered top-tier, all at the same time. The results of this eventuality were catastrophic,
and it is believed that this After a US Senate investigation, it was determined by
investigation leaders Carl Levin and Tom Coburn that “perhaps more than any other single
event, the sudden mass downgrades of residential mortgage-backed securities and
collateralized debt obligation ratings were the immediate trigger for the financial crisis.”
(Younglai, Lynch, 2011).
Such drastic errors in judgement beg the question of whether these agencies were
deliberately trying to mislead the investor public or they were just simply incompetent in
their jobs. According to the Senate report, it seemed that the answer was both – internal
documents circulated amongst Moody’s and S&P employees showed continued concerns
regarding the dangers of the mortgage market, and “failed to heed their own warnings.”
Ironically, if the agencies had listened to their own professional expertise, they would have
“issued more conservative ratings [connected to] shoddy mortgages” but instead “had no
financial incentive to assign tougher ratings to the very securities that, for a short while,
increased their own revenues, boosted stock prices, and expanded their executive
compensation” (Younglai, Lynch, 2011). This report essentially revealed the sad truth of
these companies – they had an opportunity to stop this kind of shady business and decided
to look the other way for higher profits. They proved to be too incompetent to understand
the ripple effects of their actions in the long term and decided to vie for short-term gains at
the cost of billions of dollars spent on subprime investments.

GregoryKenter
29/04/2015
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Post-Crisis Fallout
Even more infuriating in the eyes of many is the underwhelming aftermath of the
collapse. The credit rating agencies, by definition, provide their expert “opinions” when
they submit their reports and evaluations, and they have maintained this framework during
numerous testimonies and congressional investigations. This defence is an automatic
failsafe, which “protects the credit rating agencies from being sued due to wrong or
misjudged ratings as they are protected under the First Amendment of the US Constitution”
(Vukovic, 2011). Frank Partnoy, a professor of law and finance at the University of California
at San Diego, has testified before the Senate and the House of Representatives on the faults
of the credit rating agency. “Both times [Partnoy testified in front of congress] the agencies
trot out prominent First Amendment lawyers,” he claims, “and they argue that when [the
agencies] say something is rated AAA, it is merely an opinion – [the investor] shouldn’t rely
on it.” The agency representatives continue to use this point to their advantage, and they
state that “their opinions do not speak to the market value of a security, the volatility of its
price, or its suitability as an investment” (Ferguson, 2010). This ‘opinionated dynamic’,
which some consider fundamentally flawed, has also been a driving force behind court
action. In February of 2013, Standard and Poor’s was taken to court by the Department of
Justice on grounds of fraud and financial deception. All too familiarly, the Department of
Justice claimed that Standard and Poor’s caused the “loss of billions of dollars on
collateralized debt obligations and residential mortgage-backed securities [due to] the
inflated ratings that misrepresented the securities’ true credit risks.” The lawsuit
additionally stated that Standard and Poor’s “falsely represented that its ratings were
objective, independent, and uninfluenced by relationships with investment banks”
(Kaufman, 2013).
Despite the defensive maneuvers of the agencies to uphold their claims of
opinionated (and therefore unchecked) assertions, the government’s findings became
increasingly transparent as time progressed. The credit rating industry became a major
scapegoat in the consequent forensic analysis of the crisis, and became a prominent
example of a business that would be primed to face significant changes. The most glaring
issue of the credit rating agency fiasco was the lack of real regulatory procedures, both
internally and externally, that would keep the companies from over-issuing top tier ratings.

GregoryKenter
29/04/2015
IP2023
This realization was one of the main points in the creation of the ‘Dodd-Frank Wall Street
Reform and Consumer Protection Act’, also referred to as the ‘Dodd-Frank Act’, a law
passed in 2008 that was meant to stimulate the regulation protocols of the major financial
institutions (Carbone, 2010). Under this law, the Securities and Exchange Commission, the
government agency primarily in charge of regulating the financial institutions of the country,
was given “stronger enforcement mechanisms, and [added] a number of requirements on
NRSRO’s that [were] immediately effective” (Securities and Exchange Commission, 2014).
The topics addressed in the act concerned annual reports on internal controls, conflicts of
interest in selling and marketing methods, accurate records of third party due diligence, and
the overall submission of generalized data and assumptions of credit ratings (Securities and
Exchange Commission, 2014). Unfortunately, the Dodd-Frank Act has faced little support to
help regulate this industry. The Department of Justice’s lawsuit was met with a request by
Standard and Poor’s to dismiss the suit altogether, and a proposed bill that would “prevent
the securities industry from shopping around among the credit rating agencies to get a
product’s initial rating” was promptly shot down in the proverbial “sausage machine that
makes laws in Washington” (Kaufman, 2013).
Conclusion
In retrospect, the credit rating agency problem needs to be thought of in three
sections – before, during, and after the crisis. In each of these periods, there were severe
and controversial policies implemented by the agencies that helped ignite, further amplify,
and sustain the effects of the financial recession. Before the implosion, credit rating
agencies were too quick to give out top tier ratings to investments that would be otherwise
considered subprime. This, combined with the financial ownership and compensation of
the agencies themselves, laid a foundation for irresponsible, risky loans and investments
being issued at record-breaking rates. The agencies were forced to relinquish their earlier
ratings when the situation became too drastic to ignore and massively downgrade
previously spotless prospects, which is now considered by many prominent government
representatives to be the single most important catalyst during the entire recession. And
after the worst years of the crisis had passed, the credit rating industry was called to answer
for their faulty reports, the major companies hid under the protection of the First
Amendment, giving them no real threat of punishment for shoddy performance.

GregoryKenter
29/04/2015
IP2023
So the question remains – how much blame do the credit rating agencies truly
deserve for the financial crisis? Considering the fact that this issue is merely a cog in a much
larger, more expansive scheme, one could make an argument that the NRSRO’s are
deserving of only a small portion of guilt. They, ultimately, were not the parties that pushed
for deregulation of derivative trades in Congress like Senator Phil Gramm, or guided
individual financial firms to create record numbers of collateralized debt obligations like
Merrill CEO Stan O’Neill, or abused the credit default swap market with insurance funds like
AIG executive Joe Cassano (Time, 2015). Without the credit rating agencies, however, none
of these other pieces would have gone forward with their risky business deals and impulsive
gambling with taxpayer dollars. They were one of the few groups of institutions that could
have stood up - not just with strong moral backing, but with cold, hard, facts – and brought
the mess to a halt before it spiralled out of control. They decided to keep functioning for
high profits and for the benefit of their own investor community. Even if they were simply
giving their ‘opinions’ on different assets, they failed to understand the magnitude of their
work in a long-term sense, and, according to the SEC, “may have encouraged investors to
place undue reliance on the credit ratings issued by those entities” (Kiviat, 2009). The entire
situation is an interesting insight into the notion that certain items are only as valuable as
people think they are, even the items themselves are worthless. The blame of the credit
rating agencies is strongest in this regard – they violated the economic trust of the investor
public in an obscene way and knowingly fooled millions into believing that certain
investment options were not simply solid choices, but the highest rated choices possible.
The bottom line of the credit rating agency issue is that there are very few entities that can
be trusted anymore. The information used to invest responsibly and carefully has been
deemed untrustworthy. This feeling of insecurity is unfortunate legacy that the credit rating
agencies have left in the wake of the recession, and it will no doubt be quite a long time
before this stigma goes away.

GregoryKenter
29/04/2015
IP2023
Works Cited
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Impact-of-the-DoddFrank-Acts-Credit-Rating-A__/Files/View-full-article-The-Impact-of-the-
DoddFrank-Ac__/FileAttachment/CM022211InsightsCarbone.pdf>.
"CreditRatingAgencies - The Dodd-FrankAct."SEC.gov.SecuritiesandExchange Commission,9May
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<http://www.bbc.com/news/10108284>.
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Web.10 Apr. 2015.

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<http%3A%2F%2Fwww.theguardian.com%2Fbusiness%2F2011%2Fjul%2F27%2Ftriple-aaa-
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