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Are Rating Agencies to Blame for the Credit Market Crunch?

By Heide B. Malhotra
Epoch Times Washington, D.C. Staff
Oct 21, 2007

A foreclosed home is seen in Miami, Fla. last month. (Joe Raedle/Getty Images)
A foreclosed home is seen in Miami, Fla. last month. (Joe Raedle/Getty Images)

WASHINGTON—Despite holding a monopoly in the U.S. credit rating market and generally good reputation, the major credit agencies—Moody's Investor Services Inc., Standard & Poor's (S&P) and Fitch Ratings Ltd.—failed to warn the public of imminent bankruptcies such as Enron and WorldCom, as well as the recent subprime loan crisis.

Moody's and S&P, a division of The McGraw-Hill Cos., are highly profitable companies operating as what analysts call a "partner monopoly," according to a recent press release of a speech by Sen. Richard C. Shelby (R-Ala) at a U.S. Senate Committee on Banking, Housing and Urban Affairs committee meeting.

Shelby charged that these two firms hold reign over about 40 percent of industry earnings and issue almost 100 percent of all corporate bond ratings.

Credit rating agencies assign credit ratings to the bonds and other debt obligations issued by businesses, governments, and not-for-profit organizations. To the investor, these ratings grade the quality of bonds and the likelihood of its repayment or default. Ratings range from AAA (highest quality and lowest risk) to CCC (certainty of insolvency).

Committee members called the agencies to the table for not informing the public about the credit market crunch in a timely manner. The credit agency market is "an extremely concentrated and anti-competitive industry," suggested an in-depth investigation of the credit agency industry by the Banking Committee.

The "virtual absence of competition was repeatedly cited as a major factor leading to ratings of inferior quality and practices deemed to be abusive and anti-competitive," said Shelby.

Shelby objected especially to buyers of funds paying high prices for being granted a rating. He suggested that this type of arrangement inevitably raised questions of conflicts of interest.

Credit agencies alleged that the Banking Committee findings were faulty and did not take into account agency explanations. They alleged that fraud and substandard loan underwriting standards is the culprit, not reliance on ratings from the rating agencies.

Oversight of Rating Agencies

In response to findings of abusive practices, including charging a company for unsolicited ratings and demanding that the rated firm agree to purchase other services offered by credit agencies, the Banking Committee enacted the "Agency Reform Act of 2006." The White House signed the act into law on September 29, 2006.

The act changed the way credit agencies conduct their business. Rating agencies must register now and be more transparent. Rating agencies no longer may charge a firm for a rating, if the net income in the latest fiscal year exceeds 10 percent of the rating agency' total net income.

The Security and Exchange Commission (SEC) was granted power to inspect rating agency activities as a tool to address any conflicts of interest. However, the act does not allow the SEC to meddle with the methodologies used in the credit analysis by credit agencies.

The effect of the act on credit rating agencies cannot be ascertained yet, as it has not been in effect long enough, and SEC regulations were put in place only recently.

SEC Goes on Record

The U.S. Securities and Exchange Commission (SEC) named America's first seven registered credit agencies, called Nationally Recognized Statistical Rating Organizations (NRSRO), in a recent press release.

Under SEC oversight, these firms must now be transparent and provide their rating methodology to the agency. The firms must also disclose how they evaluate and measure historical downgrades and default rates.

"The Commission's newly-granted oversight of credit rating agencies will protect investors and enhance the reliability of credit ratings by fostering accountability, transparency, and competition in the credit rating industry," said SEC Chairman Christopher Cox in the press release.

The SEC has begun its own investigation into allegations about undue influence on credit underwriters and rating issuers, resulting in deviation from established methodologies, culminating into higher ratings.

Cox had in mind the subprime market crisis when testifying before the Banking Committee recently.

On the Defense

Credit agencies went on the defense. They told the Banking Committee that they look at credits from a historical point of view and evaluate the probability that the borrower may fail to pay its obligations. Models were developed from historical information of firms with similar default histories.

"Ratings speak to one topic and one topic only—credit risk," testified Vickie A. Tillman, VP at S&P during recent Banking Committee hearings, available on the Committees Website.

Tillman contented that the public has a misconception about the present crisis and the role that rating agencies play in the market. "Ratings are just about he probability of default. Nothing more. Now we have liquidity crisis and not a solvency crisis," said Tillman.

Moody's echoes S&P's Tillman's charges that "misrepresentations by mortgage brokers, appraisers and borrowers" are the culprit for the subprime crisis. This dilemma should not be placed at the doorstep of rating agencies.

Academia Enters the Discussion

Academia views credit agencies as gatekeepers, but when they fail to protect the public from loss, their reputation is impaired.

Rating agencies are slow to tell the public when a company is in trouble. Case in point: Enron Corp. was given a lower rating only four days before bankruptcy filings, although the problems was known to the public for quite some time.

History repeates itself, with rating agencies taking their time to downgrade mortgage backed securities during the subprime loan crisis.

"Ratings downgrades are often less prophesies of the future than slightly premature obituaries for terminally ill bonds," told John C. Coffee, Jr., professor at Columbia University Law School.