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Why did Credit Rating Agencies play such a major role in the Financial Crisis of 2007-2008?

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Why did Credit Rating Agencies play such a major role in the Financial Crisis of 2007-2008?
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   Jan BellenghiIPM020 – International Financial Institutions130024150 Why did Credit Rating Agencies play such a major role in the FinancialCrisis of 2007-2008?2!"2!20"#$tudent %ame& 'an (ellenghi$tudent %um)er& "#002*"+0,rofessor& r! $tefano ,agliari 1   Jan BellenghiIPM020 – International Financial Institutions130024150  Introduction $ince the onset of the financial crisis 2007-2008. the (ig /hree credit rating agenciesCRAs1  3oody4s. $tandard 5 ,oor4s and Fitch  ha6e )een caught in the crossfireof critics! /hey o6errated the 6ast num)ers of securities. orth )illions. if not trillions.of dollars at the hu) of the fiasco! Collateralied de)t o)ligations C9s1 andresidential mortgage )ac:ed securities R3($1 accorded the highest possi)lein6estment grade. lured financial institutions and pri6ate in6estors unaare of the realris:s in6ol6ed in in6esting in them! /he 6ie on CRAs ta:en in this essay corresponds to that of the mainstream 6ie.seeing them as ;agents that can deal ith information asymmetry issues4 <oannou.20"#& "01 and hence as financial intermediaries that ease the mo6ement of capital andinformation! While CRAs are surely not the only players ho contri)uted to thefinancial crisis. they did ha6e a dominant role and this essay see:s to anser the=uestion of hat ent rong ith the CRAs4 rating of the nefangled securities!/he first section of the essay ill pro6ide a historical o6er6ie of CRAs. ho theyor: and ho ma:es use of their ser6ices! $ection 2 pro6ides a short description of hat triggered the financial crisis of 2007-2008 and hat influence research hasattri)uted to CRAs in causing it! /he third section consists of a discussion of the issueand the $ecurity and >change Commission4s $>C1 significant influence on theCRAs4 role! /he conclusion restates the main arguments!  Section 1.  An overview of Credit Rating Agencies (efore addressing hat a CRA is. it is crucial to re6ie hat e mean )y creditrating! According to @hanada 20""1 the ser6ice offered )y CRAs is ;an opinion of the creditorthiness of either a company or its security o)ligations at a specific pointin time4 @hanada. 20""& ++81! /heir ser6ice is )eing offered to )oth the issuers of securities as ell as to those potentially interested in ac=uiring them! ence. as Alessiet al! 20"#1 put it. the aim of CRAs is to gi6e   orldide in6estors a cogniantanalysis of any ris: they may face hen purchasing de)t securities e!g! go6ernment )onds. collateralied de)t o)ligations or corporate )onds1 from eligi)le issuers such asgo6ernments. companies and non-profit organiations @hanada. 20""1! <t should )e )orne in mind though that such ratings are ultimately only opinions. hence not pro6iding definiti6e facts and figures of profita)ility or 6alue of either the de)tor or financial instrument (ahena. 20"01!/he demand for industrial reports of the creditorthiness of selected firms asalready present in the "B th  Century and supplied )y 6arious institutions! Credit ratings.as e :no them today. hoe6er. ere esta)lished in the early 20 th  century  April"B0B. to )e eact  and the person credited ith pro6iding the earliest )ond ratings.centering solely on railroad )onds at the time. as 'ohn 3oody! <t too: merely oneand a half centuries for three further rating agencies to esta)lish themsel6es  ;,oor4s,u)lishing Company in "B". the $tandard $tatistics Company in "B22. and the Fitch,u)lishing Company in "B2*4 White. 20"0a& 2""1  and according to $ylla 200"1this rapid epansion as due to the )ond mar:et starting to offer )onds issued )yso6ereign go6ernments and manufacturers! e argues that. ith the groing mar:et. 2   Jan BellenghiIPM020 – International Financial Institutions130024150 in6estors needed =uic: ays to assess 6arious )ond issues and CRA. ha6ing goodreputations. ere the right ones to offer this information ser6ice see (runer 5A)delal. 200+ @hanada. 20"" White. 20"0a White. 20"0)1!$ecurity issuers re=uest a rating from CRAs )ecause it allos them to o)tain a gradehich reflects the ;=uality of assets underlying their security4 @hanada. 20""& +"1!With ratings ha6ing )ecome etensi6ely recognied as a Dstandardied scale of creditorthiness across industries. financial instruments. countries. and e6en timeE(ahena. 20"0& "1 in6estors use them. amongst other factors li:e financial statements.as a tool for )asically assessing the ris: of their in6estment! oe6er. lenders alsoma:e use of these ratings to get an o6er6ie of an issuer4s creditorthiness! /he most common and ell-:non security rating scale is the one used )y 3oody4sand $tandard 5 ,oor4s! (oth use letters to reflect their judgment of securities. ithAAA characteriing the safest option and C and . respecti6ely. denoting the leastoptimal in6estment see Figure "1! >6en though these agencies operate independently.the o6erall rating process is similar across all of them! A mi of =uantitati6e and=ualitati6e 6alues is used to determine a security4s in6estment grade! An eample of the former ould )e legal ad6ice relating to an issuance hereas the latter might loo: at data from the issuer a)out accounting practices (ahena. 20"01!Figure "! Credit Ratings ong. 20""1 %oadays. CRAs are considered gate:eepers )ecause they issue ratings that helpdetermine hether a companyGgo6ernment is orth lending to and at hat cost H @hanada 20""1 stresses the impro6ed mar:eta)ility an in6estor eperiences once his products ha6e )een gi6en a rating! Iltimately though. it can )e summaried thatratings ser6e to ;pro6ide a solution to the information asymmetries )eteen in6estorsand financial firms that issue financial products4 >:ins 5 Cala)ria. 20"2& *1 )y usingan ordinal and cardinal scale to assess in6estment 6ehicles from lo to high ris: in an 3   Jan BellenghiIPM020 – International Financial Institutions130024150 easily understanda)le manner for in6estors ,artnoy. "BBB1!  Section 2. Why Credit Rating Agencies played a role in the Financial Crisis of 2007-2008 While the crisis of 2007-2008 escalated due to a num)er of reasons. there seems to )elittle dou)t that it )egan in the Inited $tates! <t as touched off )y the )urst of thehousing )u))le and the su)se=uent ;groth of mortgage defaults. particularly thosein6ol6ing su)prime mortgages that had )een etended in groing num)ers at theheight of the )u))le to less creditorthy )orroers4 elleiner. 20""& B1! Jariousfinancial institutions. hether directly in6ol6ed in the mortgage )usiness or ones ithlarge in6estments in financial products interlin:ed ith these mortgages. facedfinancial insta)ility!/he main financial instruments referred to in the a)o6e paragraph ere ne types of securities produced and mar:eted in the financial sector! 9f main concern eremortgage-)ac:ed securities 3($s1! /hese pri6ately issued securities srcinating inthe Inited $tates during the 70s increased greatly in 6olume in the B0s! /his as dueto an increased num)er of pri6ate firms entering the mar:et and offering e6ermorecomplely structured securities! 9nce pac:ages of mortgages. including su)primemortgages. ere rapped together. these ne companies created 3($s ith specificris: characteristics and started selling and trading them on a glo)al le6el see )elo  Reason 1. he co!ple"ity of these new financial instr#!ents 1!>6entually. 6arious in6estment 6ehicles started to fail in mid-2007. triggering a a6eof se6ere distresses in money mar:ets due to the etent to hich leading financialinstitutions. )oth in >urope and the Inited $tates. had in6ested in these unregulatedfinancial inno6ations! <t too: only until the )eginning of autumn for this crisis. hichhad its roots in the Inited $tates housing mar:et. to spread its impairments into>urope and from there on glo)ally see elleiner. 20"" Crotty. 200B Alam et al!20"01!@eeping in mind that these 6ery am)iguous financial instruments ere thefundamental factor )ehind the glo)al financial crisis of 2007-2008. the remainder of this section ill try to pro6ide an insight into ho CRAs ere in6ol6ed and hatmade them so dangerous!  Reason   1. he co!ple"ity of these new financial instr#!ents As mentioned a)o6e. the capa)ility of the ;iards of Wall $treet4 @hanada. 20""&+#1 to ma:e phony su)prime mortgages resem)le triple-A securities caused the onsetof the crisis! With the use of collateralied de)t o)ligations C9s1 and residential-3($ R3($1 they managed to join multiple residential su)prime mortgages intosingle products and sell them! oe6er. in order to successfully )ring these products onto the mar:et and createdemand for them. they had to ma:e sure that CRAs ould gi6e them the )est possi)lein6estment grade AAA1! According to @hanada 20""1 and (ahena 20"01 this asno hurdle at all. since a mi of persuasi6e suggestions along ith the ser6ice offered )y CRAs specifically on ho to o)tain AAA rated C9s did the tric:! /hese tomethods made life easy for the ;iards4 since initially unsatisfactory ratings ere 4   Jan BellenghiIPM020 – International Financial Institutions130024150 easily adjusted! As soon as these C9s and R3($ ere gi6en the highest possi)lein6estment grade. )an:s and insurance companies seied the in6estment opportunityand started in6esting hea6ily in these products! /he fate of ehman (rothers.Washington 3utual and A<K. etc! sho ho speculati6e if not fraudulent the highreturns of these products ere!/he incorrect ratings distri)uted )y CRAs on the to most influential ;crisis-spar:ing4financial instruments ha6e not gone unnoticed )y academics! A num)er of them. suchas unt 20081 and @hanada 20""1. concluded that the rating agencies ereo6erhelmed and ineperienced in rating these products! Itig 20"01. for eample.dras upon three reports. from the Financial $ta)ility Forum. the de arosiLre Kroupand the Inited @ingdom Financial $er6ices Authority. to argue that mathematics andstatistics centered approaches coupled ith unsatisfactory historical data ere one of the main reasons for faulty in6estment ratings! /he first. amongst other findings.criticied methodological shortcomings. outdated models of analysis and the lac: of sufficient =uality monitoring of the securitied products! /he second4s principalconclusion as that the flas in the CRAs methodological process. leading to theunderestimation of the collateralied securities. as also due to meager historical dataon the su)prime mar:et of the Inited $tates and ;an ina)ility to ta:e into account these6ere ea:ening of underriting standards )y certain srcinators4 Itig. 20"0& #1!/he third shared the 6ie of the pre6ious to. highlighting outdated models as thedri6ing force for inaccurate ratings! Furthermore. a study )y Alam et al! 20"01 suggests that CRAs should )e )lamed for the outdated =uantitati6e ris: models they used in determining security ratings! %otingthat the agencies had done a reasona)ly positi6e jo) on corporate )onds in the past.the crucial error as the assumption that future performance of any other type of securities ould not differ from that historical eperience! <n order for this to )e true.the frameor: of the economy ould ha6e to remain static. hich in fact it isn4t!Regarding securitied )onds. a lac: of historical data on hich the assessment modelsere )ased. is seen as reason for concern! /he issued ratings did not ;incorporatesystemic ris: attached to the fluctuation of 6alue of the underlying assets of the 3($4Alam et al! 20"0& "21 and once the housing )u))le )urst. this inaccuracy lled to thedefaults on the )onds to far outstrip hat the ratings had implied!  Reason 2. he $%ss#er &ays' (#siness !odel ) Conflict of %nterest  When 3oody4s first issued their railroad )onds at the )eginning of the 20 th  century. )usiness as )ased on the ;in6estor pays4 model! (asically. in6estors ere the primary clients and once a financial instrument as rated. it as made a6aila)le 6iasu)scriptions to hoe6er paid the fees (runer 5 A)delal. 200+ >:ins 5 Cala)ria.20"21! A significant change too: place in the "B70s hen the largest CRAs decided toadopt an ;issuer pays4 )usiness model. here)y the issuer of securities as no paying the agency in order to get his indi6idual securities rated White. 20"0a1! /hisautomatically made the issuer the primary consumer of the rating ser6ice. since heould sell the rated product to in6estors using the ;certificate4 as a selling point>:ins 5 Cala)ria. 20"21! >6en though there is no clear consensus on hat triggered CRAs to mo6e from the;in6estor pays4 to the ;issuer pays4 )usiness model White. 20"0a1. there seems to )e 5
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