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A Magazine of Ideas

Agency Problems—and Their Solution

Saturday, January 24, 2009

Credit rating agencies played a major role in the financial crisis. A better future is possible.

The bond rating industry’s 100th anniversary is this year. Rating agencies have lately been in the news and before congressional committees for less salutary reasonsthe role that they played in faulty assessments of the riskiness of mortgage-backed securities. Here’s a quick guide to the whys and wherefores of the rating agency business.

Q. What do rating agencies do?

A. Rating agencies primarily offer judgments“opinions” is the word that they preferabout the creditworthiness of bonds that have been issued by various kinds of entities: corporations, governments, and (most recently in the news) the packagers of mortgages and other debt obligations. Those judgments come in the form of “ratings,” which are usually a letter grade. The best-known scale is that used by Standard & Poor’s and some other rating agencies: AAA, AA, A, BBB, BB, and so on (with pluses and minuses, as well).

Q. Why are they considered so important?

A. The lenders in credit markets are always trying to ascertain who is a creditworthy borrower, and who is not. Bonds, of course, are just another form of a loan, so bond investors seek the same kinds of information about bond issuers’ creditworthiness. The credit rating agencies are among the potential sources of information that lenders and investors can consult.

Starting in the 1930s, however, U.S. bank regulators insisted that banks could invest in bonds only if those securities were “investment grade” (which is BBB- or better on the S&P scale)as determined by the major rating agencies. In the following decades, other financial regulators adopted similar approaches, insisting that the bond investments of their regulated institutions (such as insurance companies, pension funds, money market mutual funds, and broker-dealers) should also be attuned to rating agencies’ ratings. These requirements have greatly increased the rating agencies’ importance in the credit markets, since even unregulated participants want to know which bonds are likely to be held by regulated institutions.

Q. How many rating agencies are there?

A. Worldwide, there are probably over 100. The three largest and most important rating agencies are headquartered in the United States: Moody’s, Standard & Poor’s (which is a subsidiary of McGraw-Hill), and Fitch (which is a subsidiary of FIMILAC, a French business services conglomerate). There are a few smaller U.S. firms as well.

Q. So, which rating agencies must U.S. regulated financial institutions heed?

A. There are a special set of rating agenciesdesignated as “Nationally Recognized Statistical Rating Organizations” (NRSROs) by the U.S. Securities and Exchange Commission (SEC)whose ratings must be followed.

Q. How many NRSROs are there?

A. As recently as 2002 there were only three: Moody’s, S&P, and Fitch. Today there are ten. Two are headquartered in Japan and one is headquartered in Canada; one (A.M. Best) specializes in insurance companies’ obligations. That leaves six: the Big Three and three smaller firms (Egan-Jones, Lace Financial, and Realpoint).

Q. What role have the rating agencies played in the current financial crisis?

A. Recall that the crisis started as a problem of widespread defaults on recently issued mortgage-related securities that had subprime mortgages as their underlying collateral. The three large U.S. rating agencies initially were overly optimistic about the creditworthiness of these mortgages. Like too many other participants in the mortgage markets, they seemed to be “drinking the Kool-Aid” that housing prices could only increasein which case even subprime mortgages wouldn’t be a problem, since the borrower could always refinance the mortgage or sell the house at a profit.

The rating agencies’ overly optimistic ratings allowed the packagers of these securities to sell large “senior” slices as “safe” (low-interest bearing) investments and thus allowed substantial profits to be made on the packaging process, which in turn encouraged more subprime mortgages to be originated, etc.

The rating agencies were also criticized for delays in downgrading these securities after other market participants had already recognized the problems. These criticisms echoed others earlier in the decade, when Moody’s and S&P had maintained “investment grade” ratings on Enron’s debt until only five days before that company’s bankruptcy filing in November 2001.

Although there is plenty of blame to go around with regard to the current debacleand in the end, the investors who bought the bonds were overly optimistic, too reliant on credit ratings, and ignored risk to a shocking degreethe rating agencies clearly played a major role in exacerbating the problem.

Q. How do the rating agencies earn their living? Who pays them?

A. The original business model for the rating agencies, established when John Moody published the first publicly available ratings in 1909, was an “investor pays” model. Moody, and subsequently other rating agencies, sold thick “rating manuals” to bond investors. In the early 1970s the Big Three changed to an “issuer pays” business model, which means that an issuer of bonds pays fees to the rating agency that rates its bonds. This model continues today. The three smaller U.S. agencies, however, maintain an “investor pays” model.

Q. Why the change to the “issuer pays” business model?

A. There is no definitive answer. Here are some leading candidates: First, the early 1970s was the era when high-speed photocopying machines became commonplace, and the rating agencies may well have feared that widespread copying by bond investors of their ratings manuals would reduce their revenues. Next, the rating agencies may have belatedly realized that the issuers needed ratings in order to sell their bonds to regulated financial institutions, for the reasons mentioned above, therefore the issuers should be willing to pay for a rating (and photocopying wouldn’t interfere with fees charged to issuers). Finally, the unexpected bankruptcy of the Penn-Central Railroad rattled the bond markets and may have made bond issuers willing to pay credit rating agencies to vouch for their creditworthiness (although that bankruptcy should also have increased bond investors’ willingness to pay to discover who was more creditworthy).

Q. Doesn’t the “issuer pays” business model create a conflict of interest?

A. It certainly creates the potential for conflict of interest. If the credit rating agency is being paid by the bond issuerand the bond issuer has the ability to “shop around” for another rating by a different rating agencythen the issuers may well have leverage with the rating agencies, and the latter may shade their ratings in favor of issuers in order to keep the engagement.

The rating agencies used to argue that they took special efforts to make sure that this potential didn’t become an actuality. They have now acknowledged that the problem is greater than they had earlier admitted and that additional steps, including greater transparency, are required to deal with the problem.

The rating agencies also argue that even an “investor pays” business model can involve some conflicts, since investors would prefer lower ratings (and thus higher yields) for newly issued bonds, as would anyone who has sold short any other security of the issuing entity. With respect to subsequent downgrades, investors who already own the bonds would disfavor them, while short sellers would welcome them. Nevertheless, the potential conflicts seem substantially less severe than for the “issuer pays” model.

Finally, the rating agencies point out that the “issuer pays” model has the advantage of rapid dissemination of ratings to the market, whereas an “investor pays” model would require some lag in general dissemination. But if the former ratings are less accurate than the latter would be, then the advantages of speedy dissemination are clearly muted.

Q. Was the “issuer pays” model even more of a potential problem in the rating of the mortgage-related securities?

A. Yes it was. Unlike the rating of a corporate bond or a government bond, where the existing structure of the entity that is to be rated is largely a given (although judgments about future prospects can clearly be more subjective), the underlying mortgage (and other) collateral and the payment structures of the mortgage-related securities were largely malleable. Thus the rating agencies worked closely with the packagers/issuers to determine collateral requirements and payment structures, whichat a minimumheightened the appearance problems of the “issuer pays” model.

Q. But aren’t the rating agencies regulated?

A. Well, yesand noand sort of. Remember the “NRSRO” designation that was mentioned above? The SEC devised it in 1975 so as to prevent broker-dealers from using the ratings of potentially “bogus” rating firms. After creating the category, the SEC immediately “grandfathered” Moody’s, S&P, and Fitch into it, and then designated only four more NRSROs over the next 25 years. But mergers among the entrants and between the entrants and Fitch reduced the number of NRSROs back to the original three by 2001.

In essence, the SEC had become a major barrier to entry into the rating agency business. It would not be surprising to discover that a protected oligopoly had become sluggish and carelessand the potential conflicts of the “issuer pays” model surely didn’t help matters.

However, except for the rare designation of a new NRSROand even then, the SEC conducted the designation process in an extremely opaque fashion, never specifying any criteria for designationthe agency didn’t impose any other regulatory controls on the rating agencies.

In 2006, the Congress passed legislation that specifically instructed the SEC to cease being a barrier to entry and to allow all qualified applicants to be designated as NRSROsand to do so in a more transparent process. (As a consequence of this legislation, and of congressional pressures earlier in the decade, there are now the ten NRSROs mentioned above.) The legislation specified the criteria for designation and did give the SEC some limited regulatory powers to ensure that incumbent NRSROs are adhering to those criteria (such as addressing conflict-of-interest problems). The SEC is currently investigating the NRSROs’ behavior during the debacle.

Q. So, is more regulation needed?

A. That’s one possible direction for SEC action. Since the large U.S. rating agencies made a slew of bad judgments in the past few years, new regulations could try to push them to make better judgments in the future. These efforts could include such measures as mandatory training for bond analysts, required disclosures on potential conflicts, mandatory “Chinese walls” between the analysts and the business/marketing personnel at NRSROs, or even a ban on the “issuer pays” business model. The SEC took a few modest steps in these directions in December.

Q. Are there drawbacks to more regulation?

Yes there are. In its efforts to get the NRSROs to “pull up their socks,” the SEC may well reduce or eliminate flexibility in the industry and squelch creativity and innovation with respect to alternative business models and better ways of assessing the default probabilities of bonds. Further, there is always the risk that the SEC “gets it wrong”say, mandating the wrong kind of Chinese wallsbut in that regulatory sphere, there are no alternatives.

Q. Is there a better way?

A. Yes, and it’s one which would rely less on regulation and more on markets.

Let’s start with the basic goal of financial regulation that led to the required reliance on rating agencies and then led to the SEC’s creation of the NRSRO category and its subsequent protective moat around the category’s incumbents. That goal was to insure the safety of the bond portfolios in banks, insurance companies, pension funds, money market mutual funds, broker-dealers, etc. This was a worthy goal. But in deferring to the NRSROs’ judgments as to safety (such as the determination of “investment grade”), the regulators were in essence delegating their safety judgments to this select group of rating agencies, who turn out not to have done their jobs all that well.

The key, then, is for the financial regulators to pull back that delegation. The goal should still be to have safe bond portfolios in regulated financial institutions. But the burden should be on each institution to defend its choices of bonds to its regulator. This defense could reside in original research. Or it could involve reliance on a trusted advisor, which could be a rating agency or some other advisory service. Regardless of the form of defense, the regulator should insist that the financial institution has a reasoned, sound basis for its choices.

Regulated financial institutions would thus be free to take advice from sources that they consider to be most reliablebased on the track record of the advisor, the business model of the advisor (including the possibilities of conflicts of interest), and anything else that the institution considered relevant. Again, the institution would have to justify its choice of advisor to its regulator. But, subject to that constraint, the bond-advisory information market would be opened to new ideas and new entry in a way that it has not been since the 1930s.

With this burden-on-the-institution regulatory model adopted by financial regulators, the SEC could eliminate the NRSRO designation.

Q. Wouldn’t this open market for bond-advisory information mean the demise of the “issuer pays” business model?

A. Not necessarily. Suppose that bond investors, such as banks, are able to ascertain which rating agencies provide reliable bond ratingsi.e., provide reliable advice. (After all, these are supposed to be sophisticated investors, not the “widows and orphans” that require extensive protection from repeatedly making their own mistakes.) Then these investors will be willing to pay higher prices for, and thus accept lower yields on, the bonds that are rated highly by these reliable rating agencies. In turn, even under an “issuer pays” business model, issuers should want to hire the recognized-to-be-reliable rating agencies since the issuers will thereby be able to pay lower interest rates on the bonds that they issue.

Q. Is there anything else that would help?

A. Yes. In the past few decades, when investors or issuers have sued a rating agency, claiming that they were injured by that agency’s rating, the agencies have usually prevailed by claiming that they are “publishers” (remember that word “opinion” that they like?) and thus are protected by the First Amendment of the U.S. Constitution. Although perfect accuracy is an unrealistic expectation, and thus they should be given some range for making errors, nevertheless opening up the possibility that the rating agencies could be held financially accountable for their wider errors might well provide them with stronger incentives for getting it right.

Lawrence J. White is Professor of Economics at the NYU Stern School of Business. From 1986 to 1989 he was a board member of the Federal Home Loan Bank Board and, in that capacity, also a board member of Freddie Mac.

Image by Darren Wamboldt/Bergman Group.