What?role?did?credit?rating?agencies?(CRAs)?play?in?the?financial?crisis??
University?of?Iowa?Center?for?International?Finance?and?Development?
Amanda?Bahena?
The?role?of?credit?rating?agencies?
What a credit rating is: A credit rating measures the ability and willingness of a borrower to pay its debt. The more creditworthy a borrower, the higher a CRA will rate it. What a credit rating isnot: A credit rating is not a buy/sell recommendation. It does not predict profitability. Who/What CRAs rate: Within the world of MBSs and CDOs, CRAs rate : 1.?The instrument itself: The rated instruments at the center of the financial crisis include mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). 2.? Institutions holding the instruments: An instrument’s rating affectsthe credit ratings of the investing institution. As of mid-2008, most MBSs were held by foreign investors (20%), Fannie Mae and Freddie Mac (16%), and commercial banks (16%). Key CDO investors include banks, insurance companies, pension funds and hedge funds. 3.?The issuers of the financial instrument Most MBSs are issued by: (1) Fannie Mae and Freddie Mac, which are U.S. government-sponsoredenterprises; and (2) Banks: the top MBS issuers in 2007 were Countrywide, J.P. Morgan, GMAC, Lehman Bros., and Citigroup. CDOs are issued primarily by banks. Top CDO issuers in 2007 were Merrill Lynch, Citibank, and UBS. Credit ratings affect issuers and investors: A borrower with a high credit rating can raise capital at a lower cost than a borrower with a low credit rating, because investors whotake on risk expect to be compensated with higher rates of return/ interest rates on the risky investments. Credit ratings of an instrument may change over time. A downgrade suggests a higher default risk and therefore makes the downgraded instrument less valuable. CRAs downgraded billions of dollars in MBSs and CDOs over the past year. Investors holding those downgraded instruments watched theirinvestments plummet in value.

CRAs?helped?to?develop?the?MBSs? and?CDOs?that?sparked?the?crisis?
CRAs advised issuers on how to structure and prioritize the tranches of an MBS or a CDO. The goal was to help issuers squeeze the maximum profit from a CDO or an MBS by maximizing the size of its highest rated tranches. The purpose of tranching is to create at least one class of assets with a highercredit rating than the average rating of a CDO or an MBS’s underlying asset pool. CRAs rate each tranche based on the creditworthiness of the loans in that tranche and its priority. Tranches get higher credit ratings by “prioritization”: issuers guarantee “senior” tranches will be paid before “junior” or “subordinated” tranches. In the height of the housing boom, almost all senior tranches got thehighest rating possible: AAA.

Rating?mistakes?
As foreclosures are increasing, MBSs and CDOs backed by MBSs are crumbling. The CRAs admitted that they failed to adequately assess the credit risks in MBSs and CDOs. This failure occurred for several reasons:
1.? The CRAs held an over-optimistic view of the housing market. Their rating model assumed that housing prices would continue to increasegenerally. 2.? MBSs and CDOs contain individual mortgages, and at the time of rating, the CRAs knew little about the creditworthiness of individual borrowers behind the mortgages. When rating MBSs and CDOs, the CRAs relied heavily on historical statistical data, not on personal information about each borrower. 3.?CRAs underestimated the complexity of the MBSs and CDOs. 4.? The SEC found that thegrowth in the quantity and complexity of structured finance deals since 2002 proved too much for some CRAs.

S&P,?Moody’s?and?Fitch?dominate? the?credit?rating?field?
Credit rating agencies are private companies. The credit rating industry is dominated by three firms: 1.?Standard and Poor’s (S&P), 2.?Moody’s Corporation, and 3.?Fitch Ratings. Over 100 CRAs exist, but these three share 95% of…