Having failed so spectacularly to foresee and forestall the subprime mortgages collapse in the US, to which so much of the current global economic malaise is tied, how is it that credit rating agencies remain in business? The simplistic answer to that question is that as matters stand now, the credit raters are too deeply entrenched in the market to be casually kicked to the kerb.

That situation has been clearly recognised on both sides of the Atlantic and regulatory proposals are now being discussed both in the US congress and the European Union to impose some degree of oversight on how credit rating agencies go about their business.

The subprime crisis, which triggered some of the biggest corporate defaults (Lehman Brothers) and government bailouts (AIG) in history, highlighted the systemic flaws and systematic errors in the credit raters’ business model, where the entire revenue was generated from the very institutions being rated, creating inherent conflicts of interest.

But with so much money in the system, enough to retain an army of lobbyists, and the financial industry’s resistance to radical change, will the proposed regulations achieve anything of note?


How we got here
Credit ratings first gained prominence in the late 19th century, when several firms began offering their own assessments of the creditworthiness of particular financial instruments: corporate bonds, mortgage backed securities or collateralised debt obligations (CDOs). In essence, credit ratings predict the likelihood that a debt will be repaid.

Credit ratings use a scale of letter grades, from AAA (the safest investment possible) to C (highly vulnerable, possibly in default or in arrears). The rating decision itself is based on credit rating models that evaluate risk and the legal framework, rather than in-depth analysis of the collateral.

The AAA is highly coveted not only for prestige purposes, but also because, by law, in some countries mutual and pension funds are only allowed to invest in securities rated AAA. Other financial institutions are limited in the amount they can invest in higher-risk debt. In Central and Eastern Europe, the plank after the fall of communism was set much lower – at BBB- (as rated by Standard&Poor’s or Fitch) or Baa3 (as rated by Moody’s), which designated debt instruments as investment grade and a safe bet to meet their payment schedule.

Bonds and other financial instruments below that threshold would net investors higher yields, but carried higher risk of default and were deemed speculative grade. More derisively, such debt is often referred to as junk.

The rise of the credit rating agencies was traced back by The Wall Street Journal to the Great Depression, when US regulators suggested that banks should rely on "recognized ratings manuals" to evaluate asset quality, which meant the opinions issued by rating agencies.

"What began as a kind of offhand suggestion had in 40 years become an entrenched, government-sanctioned system for outsourcing credit work," WSJ’s Dennis Berman wrote in May. "By the 2000s, any issuer wanting to sell a mortgage bond to an insurance company or a CDO to a bank still had to pass the ratings roadblock. And it had to pay for the privilege, to boot."

Regulatory pitfalls
Although US regulators list 10 nationally recognised statistical rating organisations, and others exist in Europe, the ratings market is dominated by the US-based triumvirate of Standard&Poor’s, Moody’s Investors Service and Fitch Ratings, whose networks now spread to cover the entire globe.

None of them are subject to regulation with regard to the methodology they use to assign ratings and, over the years, the rating agencies have stoutly defended their independence to do so.

But a US senate subcommittee on investigations found in April that credit raters used inaccurate rating models, failed to re-evaluate existing ratings and did not incorporate factors such as fraud, lax underwriting standards or the housing bubble in their credit rating models.

Partially, that was due to "competitive pressures, including the drive for market share and need to accommodate investment bankers bringing in business," the subcommittee said in its findings. The investigation only targeted Standard&Poor’s and Moody’s, the leading two credit rating providers in the US and globally.

The email exchanges subpoenaed by the subcommittee showed that rating agencies skewed their assessments to please their clients, which, in turn, helped the financial system take on far more risk than it could safely handle.

"It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption," Nobel Prize-winning economist Paul Krugman wrote in an op-ed piece for the New York Times in April.

Europe moving forward
One of the focus areas of the EU regulatory reform proposal targets precisely the area of credit raters’ models, requiring a higher degree of regulatory disclosure by credit raters starting from December, when the new rules would come into effect.

Under the proposed changes, a new European supervisory authority, the European Securities and Markets Authority, would be entrusted with exclusive supervision powers over credit rating agencies registered in the EU, including European subsidiaries of credit raters based outside the bloc.

ESMA would have powers to request information, to launch investigations, and to perform on-site inspections. Issuers of structured finance instruments such as credit institutions, banks and investment firms will have to provide all other interested credit raters with access to the information they give to their own rating agency, in order to enable them to issue unsolicited ratings.

The proposals seek to minimise conflicts of interest, banning credit raters from offering consultancy services, among other measures, the European Commission said in a statement on June 2.

In terms of transparency, credit raters would be required to disclose the methodology and internal models and key rating assumptions they use to make their ratings, although the proposals did not stipulate what ESMA’s powers would be to influence the methodology.

The proposals still fell short of answering some fundamental questions, namely the viability of the "issuer-pays" model, whether markets and legislation relied too heavily on credit raters’ opinions and how to spur competition and diversity in the sector. "All these issues are important, and the Commission is looking at them closely – with all relevant stakeholders – and will come forward with further proposals in due course," the EC said.

Any regulatory changes need to be supported by EU governments and the European Parliament to become law.

The US approach
By comparison, the proposed US regulatory changes did not reach as far when the senate passed a reform bill in May. The exact direction to be taken by the US reform effort also remains unclear, because congress will next have to choose between two conflicting amendments passed by the senate.

One proposal would require the securities and exchange commission to create an industry board that would assign credit raters to customers and have the power to regulate rating agency fees and evaluate the accuracy of credit ratings. The other proposal would require a massive rewrite of US laws, removing references to credit raters from all laws governing securities and banking.

The house of representatives adopted its own bill in December 2009 and now the two will have to be reconciled in committee meetings to draft the final bill. Whichever way US lawmakers leaned, the financial reform bill was too tame, critics said.

"Credit derivatives? Banks will still be able to trade them, and peddle the most dangerous ones without using an open exchange. Credit rating agencies? Their wings are barely clipped," New York Times columnist Joe Nocera wrote on June 4.

They told you so
The failure of the credit rating agencies to foresee the subprime crisis was not surprising, in hindsight, given that the credit raters were effectively hired by the people selling debt to give that debt a seal of approval. The more debt was being rated, the higher the credit raters’ revenues soared.

But the concerns that credit raters had become "some of the most important gatekeepers in capitalism without the commensurate oversight or accountability" were not triggered post-subprime crisis, as evidenced by a series of articles published by the Washington Post in November 2004.

In a three-part series published on successive days, the Washington Post’s Alec Klein looked at how the "big three" credit raters had come to dominate global finance without formal oversight; how they came to influence the ability of entire countries to borrow capital; and their business practices, which have sparked repeated allegations of abuse.

"From their Manhattan offices, they can, with the stroke of a pen, effectively add or subtract millions from a company’s bottom line, rattle a city budget, shock the stock and bond markets and reroute international investment," Klein wrote at the time.

"Without their ratings, in many cases, factories can’t expand, schools can’t get built, highways can’t be paved. Yet there is no formal structure for overseeing the credit raters, no one designated to take complaints about them, and no regulations about employee qualifications."

In the US, credit raters were given access to confidential information but had next to no responsibility. "The rating companies say they need such inside data. But when they miss financial meltdowns such as Enron Corp., WorldCom Inc. and the Italian dairy company Parmalat Finanziaria SpA, the raters argue that despite having had insider access in many cases, they can’t be blamed for investor losses because they can’t detect fraud," Klein wrote.

Raking in billions of dollars in revenue every year from fees on every debt issue, credit raters were in reality only rating the corporate health. As one Deutsche Bank ratings advisory official and former Wall Street banker told Klein: "It’s a great business if you can get it."