By Tim Dulaney, PhD and Olivia Wang, PhD
A recent wall street journal article reports that U.S. lawmakers plan to introduce a bill that would require top credit-rating firms to review their credit ratings on a quarterly basis, hoping that more frequent reviews would increase the accuracy of their ratings and help identify potential problems.
According to Wall Street Journal, the bill would “amend the Securities Exchange Act of 1934 to require the chief executive officer of each [credit-rating firm] to attest, quarterly, to the accuracy of the credit ratings issued by the organization.”
This is certainly not the first time Standard & Poor's Ratings Services, Moody's Investors Service and other rating firms have come under scrutiny for the accuracy of their ratings. Credit rating agencies played a central role in the initiation and the deepening of the 2008 financial crisis. The recent collapse of MF Global Holdings Ltd and the revelation that MF Global was still receiving investment-grade ratings days before it filed for bankruptcy drew renewed attention to the role played by rating agencies in warning investors.
Capital Hill is not the only direction from which such pressures are being exerted. Last year the SEC warned S&P that they were investigating S&P’s practice of giving AAA ratings to mortgage backed securities made up of sub-prime home loans and other collateralized debt obligations right before the 2008 financial crisis. For a detailed report, please see here.
Although such an investigation is long over-due, one cannot be too optimistic about the effectiveness of such regulatory actions. As long as credit rating agencies are paid to rate securities by firms who issue securities, instead of investors who rely upon their ratings to make investment decisions, one cannot expect credit ratings to be an objective description of a security’s credit quality.
True enough, when John Moody invented bond ratings back in 1909, he offered himself as a protector of investors’ interest against irresponsible corporate default. His business prospered in the 1930s together with Moody’s rival S&P when a new set of laws was introduced prohibiting banks, insurance companies, and pension funds to hold bonds unless the debt was investment grade.
A turning point occurred in the 1970’s, when Moody’s started to charge issuer fees. This switch from charging investors to charging issuers made the ratings business increasingly lucrative. According to “The Ratings Charade”, a famous article by Richard Tomlinson and David Evans at Bloomberg Markets which warned the public against the imminent danger of subprime mortgage debt in July 2007, fees collected from structured finance issuances accounted for 44 percent of Moody’s reported revenue of $1.52 billion in 2006. However, this imposes a fundamental challenge to the credibility of the rating firms: how can ratings agencies remain objective if the agencies are paid by issuers to rate their securities?
There is no doubt that both the bill proposed by the U.S. Congress and the investigation conducted by SEC are well-intentioned and would be beneficial to the health of the financial industry; however, as long as the deep-rooted conflict of interest remains, rating firms still have every incentive to deviate from the role they were formed to play: guardians of investors’ interests.
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