WHY DID CREDIT RATING FAIL IN CREDIT CRISIS

When it comes to sub-prime mortgage crisis， we will still take a deep breath to calm down. The crisis destroyed economy， trades and even people’s life. A large number of victims are still scraping their lives. We need to know why？ What are the underlying forces of credit crisis？ Factors come from different dimensions； however， this paper will focus on the credit rating failure.

This term paper aims to find the reason behind credit rating failure in credit crisis focusing on the overreliance of risk estimating model and the factors of functional inefficient market. Reasons come from four aspects， including corporate dishonest， conflicts of interest loose regulation and lack of transparency.

Key Words： Credit rating， CRAs， Conflicts of Interest

1、Overreliance on Credit Rating Models

Usually， CRAs use credit rating models to quantified credit rate of derivative bonds. Hong Liang （2006 ）1 pointed out three models that employed by CRAs：

1）Traditional binomial probability distribution

2）Monte Carol simulation

3）Risk estimation model on MBS

“Financial firm’s overreliance and overconfidence on untested risk models led to an underestimation of risk， which led to excessive positions in the mortgage market and ultimately to the financial crisis” 2.

Through this citation， we will easily figure out that financial firms rely too much on risk models. However， these models may have performed poorly in the 2008 crisis for a number of reasons3.

First， the data encapsulated by risk models is selected from a relatively short history that is limited. Second， those credit rating models are not “structural models”， but the “reduced-form” models. “reduced-form” model isn’t account for underlying changes in supply and demand behavior. Thus， it is hard for it to examine possible changes in adverse selection or moral hazard behavior4.

2. Conflicts of Interest

Conflicts of interest formed in the supply chain of securitization （The Securitization Supply Chain shown as below）， it is the biggest contributor to credit rating failure. Conflicts of interest， significantly involved the way the investment banks would procure ratings on their securitizations5：

1）To maintain potential customers， CRAs are likely to delay or avoid issuing degrade rating reports that will adversely affected their interest.

2）CRAs provide advantageous rating report to companies that could help them with credit risk management.

3）Rating fees vary from the scale of companies， “the more complex the securitization product the more the CRA gets paid” 6. CRAs turn to be snobbish in conflicts of interest.

Graph 1 the securitization supply chain

3.1Lack of Transparency

Information can’t move from CRAs to government smoothly， hence， the information is asymmetrical. Governments rely too much on CRAs without knowing how does rating model work， does the rating model suit the real facts…

To some extent， governments even don’t know whether the rating come from practice or it is just trump up by CRAs. As for investors， although some rating agencies offer their clients rating analytical software， which helps to improve transparency of rating methodologies[ Moody's markets its subprime ABS rating analytics， M3， to paid subscribers， and S&P makes its analytics， Levels， commercially available. However， these and other fee-based rating related services raise the concern of conflict of interests. We will discuss this issue in the next sub-section.]， they didn’t know how to use rating to optimize their profit.

Transparency is determined by information disclosure. Thus， we will have a deep insight into information disclosure.

3.2Information disclosure

Information disclosure has two meanings：

On one hand； it refers to how much information that CRAs tell governments， investors and issuers. On the other hand， the information of the company being rated should give to CRAs. Undoubtedly， both parts will influence the quality of rating. However， there are numerous reasons hinder the information disclosure7.

1）No consensus for information disclosure

Rating models are important to CRAs， thus， they don’t want to share it with governments. In the market， nobody knows to what extent stands for information disclosure. IOSCO instructs CRAs to do information disclosure in four dimensions. However， there is still a long way to specific standard8.

2）No access to “Nonpublic Material Information”

Nonpublic Material Information also refers to companies’ top secret. CRAs have no access to nonpublic material information， so that will adversely influence the quality of rating.

4From Integrity to Profit-Oriented

4.1Dishonest of CRAs

With the advent of competition， CRAs discarded theirs initial value to chase for profits. I would like to take Moody’s as an example to illustrate my stance.

Before 2000s， Moody’s conservative analytical culture has been praised. Like many competitors， Moody’s proclaimed itself with notions of integrity， commitment and expertise9.

“When I left Moody’s in 2007， an analyst’s worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody’s market share， for impairing Moody’s revenue， or for damaging Moody’s relationships with its clients， and lose his job as a result.10”

4.2SEC’s loose regulation

SEC is Securities and Exchange Commission established by American government. Initially， SEC is supposed to regulate CRAs. However， facts astonished everyone. It was not only getting away with CRAs’ dishonest acts but also give loose to regulate CRAs to gain collusive profits.

An email between CRA analysts uncovered by a subsequent SEC investigation noted， “Let’s hopes we are all wealthy and retired by the time this house of cards falters. 11”

4.3Conclusion

No matter is the dishonest of Moody’s or is the loose regulation， it reveals a severe problem that integrity lapses nowadays. There is no denying that Moody’s prioritize profitability over integrity is to be blamed. However， introspections from government to citizens are needed.

BIBLIOGRAPHY

1、Hong Liang， 2006.2.10， “Moody’s rating model of ABS”， the 30th “research of credit rating”

2、A large number of research articles have been written on predicting default risk. See Demyanyk and Hasan （2009）， Kumar and Ravi （2007）， Fethi and Pasiouras （2009）， and Altman and Saunders （1998） for comprehensive reviews of studies on the predictions of default risk models.

3、William W. Lang （2010） “The Mortgage and Financial Crises： The Role of Credit Risk Management and Corporate Governance”， Federal Reserve Bank of Philadelphia

4、Capuano et al. （2009） summarize some of the recent advances in an effort to improve credit risk modeling： modifications of structural models and reduced-form models， reassessment of default correlations using copulas， pricing of credit index options， etc.

5、Kevin Selig， “Credit Rating Agencies and the Financial Crisis”， the Kenan Institute for Ethics at Duke University， http：///licenses/by-nc-nd/3.0/

6、Smith， Elliot B. “‘Race to Bottom’ at Moody’s， S&P Secured Subprime’s Boom， Bust.” Bloomberg， 25 Sept. 2008. Web， 12 Dec. 2010. http：///apps/news pid=newsarchive&sid=ax3vfya_Vtdo

7、F. Phillip Hosp Problems and Reforms in Mortgage-backed Securities： Handicapping the Credit Rating Agencies Electronic copy available at： http：///abstract=1362336

8、Carol Ann Frost， Credit Rating Agencies in Capital Markets： A Review of Research Evidence on Selected Criticisms of the Agencies， State University of New York at Buffalo School of Management

9、Moody’s Corporation. Moody’s Investors Service： About Us. Moody’s Corporation. Moody’s Corporation： About Us. 2010. Web. 10 Dec. 2010. http：///Pages/atc.aspx

10、“Testimony of Mark Froeba.” Testimony before The Financial Crisis Inquiry Commission. 2 June 2010. Report available at http：//www.fcic.law.stanford/edu

11、Ibid. Also see： “Email No. 2： Analytical Manager to Senior Analytical Manager （Dec. 15， 2006， 8：31 PM）” Staff Report. The Securities and Exchange Commission， Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies. Rep. 8 July 2008. Print.

李卓轩（1993-），女，汉族，河北石家庄人，西南财经大学经贸外语学院，本科学历，研究方向：货币金融。