University of Maribor Faculty of Economics and Business, Maribor

Bachelor Seminar Paper

The Role of the Rating Agencies in the Current Financial Crisis

Vloga Bonitetnih Hiš v Aktuelni Finančni Krizi

Author: Petar Filipov Program: University studies Direction: Finance and Banking Mentor: Prof.Dr. Timotej Jagrič Proofreader (English part): Menča Zafirova Proofreader (Slovenian part): Maja Frelih Study year: 2012

Maribor, June, 2012

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Foreword The Subprime crisis that occurred in 2007-2008, was the most disturbing and severe crisis since The Great Depression. The global stock market indexes and housing prices noted a sharp drop. Big corporations, conglomerates, defaulted, were acquired and bailed out, since they could not meet their financing obligations. Substantial number of people lost their jobs worldwide and a lot of sectors in the economy were struggling. Within this Bachelor seminar paper, it is presented how the credit rating agencies influenced the credit crunch. The main issue discussed in this seminar work is the role of the rating agencies in one of the greatest crushes in history. They (the agencies), actually, participated in creating the structured financial products, which during the housing bubble were increasingly trading. These structured financial products were very complex and highly risky and maybe, the most crucial cause of the crisis. First, in the seminar paper it is described how the agencies work and their origins. As in the last century, Standard and Poor’s and Moody’s, emerged to great power in the financial system with assigning ratings to issuers of debt. This position in the financial world that the agencies held, has brought many academicians to doubting the possible moral hazard problems within the credit ratings business. Furthermore, it is explained how the financial turmoil emerged and the trends that preceded the credit crunch. Questions regarding the role of the agencies in the securitization process are discussed. For instance, were the rating agencies biased; were the ratings on the structured financial products inflated and if so, what were the incentives for it? Several theories and empirical evidence has been put forward concerning the importance of the ratings in the securitization process. It is concluded in this paper, that the ratings assigned to the financial derivatives were inflated and the agencies noted increased returns from it, which presents the incentives of the agencies during the housing bubble. These empirical findings also indicate of moral hazard problem within the ratings system.

~ 3 ~ Table of Contents 1. Introduction ................................................................................................................................ 4

2. The Credit Rating Agencies ....................................................................................................... 6

2.1 What really ‘’rating’’ is? .......................................................................................................... 6

2.2 Origins and Historical Development ........................................................................................ 7

2.2.1 Credit-reporting agency ..................................................................................................... 7

2.2.2 The Specialized Business/Financial Press ......................................................................... 8

2.2.3 Investment Bankers ........................................................................................................... 8

2.3 How do the CRA’soperate? ...................................................................................................... 9

2.4 Ownership and payment process ............................................................................................ 13

3. The Financial Crisis in 2007-2008 ........................................................................................... 15

3.1 Trends in the Banking Industry that led to the liquidity squeeze ........................................... 15

3.2 Common Structured Products ................................................................................................. 19

3.3 Beginning and Unfolding of the Crisis ................................................................................... 19

3.4 Several Events from the Crisis ............................................................................................... 22

3.4.1 The Mono-line insurers ................................................................................................... 22

3.4.2 Bear Stearns ..................................................................................................................... 23

3.4.3 Lehman Brothers, Merrill Lynch & AIG ......................................................................... 24

4. The Role of the Agencies in the Crisis ..................................................................................... 26

4.1 The Agencies and their role in the creation of the structured products .................................. 26

4.1.1 Importance of the ratings in the securitization................................................................. 28

4.2 Ratings Oligopoly and Moral Hazard ............................................................................... 30

4.2.1 Criticism and Oligopoly ........................................................................................... 31

4.2.2 Moral Hazard ................................................................................................................... 31

5. How large the impact of the ratings in the crisis was: empirics ............................................... 34

5.1 Credit Analysis ....................................................................................................................... 34

5.2 Rise of structured finance and record downgrades ................................................................. 34

5.3 Credit Rating Agencies Revenues .......................................................................................... 37

5.4 Investment Bank Abuses ........................................................................................................ 39

6. Conclusion & Limitations ........................................................................................................ 40

6.1 Conclusion .............................................................................................................................. 40

6.2 Limitations .............................................................................................................................. 40

7. Abstract ..................................................................................................................................... 41

8. References ................................................................................................................................ 45

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1. Introduction The financial crisis from 2007-2008 was the most severe and disturbing crisis since the Great Depression. There have been enormous losses, having large repercussions on the real economy. Many corporations went down, like one of the largest investment banks Lehman Brothers, then Bear Stearns, there were many public bailouts for companies that are ‘’too big to fail’’, for instance the case of the insurance company AIG. Moreover, the stock market indexes have plummeted, housing prices noted a record drop, liquidity in money market funds evaporated causing many central bank interventions and bailouts. Substantial number of people lost their jobs worldwide, as a lot of sectors in the economy were struggling. As a lot of leveraging was allowed and too many deregulated risky financial products were trading during the pre-crisis period, after the turmoil and liquidity problems of many corporations, there have even been several countries struggling with sovereign debt issues. Nevertheless, the causes of the credit crunch were greatly debated and discussed in academic journals. The media has put forward a lot of controversies about moral hazard and asymmetric information being present between financial institutions and traders. A lot of fingers were pointed ‘’who’’ should take the blame for the mistakes that caused such an economic distress. Questions of whether better regulation should be enforced in the financial markets were raised and as a response was the Basel III accord. However, during the housing bubble, the credit rating agencies had a special assignment. As new financial instruments were increasingly trading and seizing large portions of the financial markets, the agencies with assigning ratings on each instrument were sending information to investors on the default probability of these products. These instruments were actually derivatives created by pooling many portfolios of different securities, structuring them into tranches and selling them to investors, depending on riskiness of default. The instruments were structured financial products and were very complex, yet very profitable and, as it turned out, highly risky. The structured products were, maybe, the most crucial cause of the crisis. Since the agencies were not able to assign the proper ratings, they marketed these products to investors and with it, they gamed the system and were a cause more for what happened in 2007-2008. The main issue discussed in this Bachelor seminar work is what role did the rating agencies had in the financial crisis, how they affected the credit crunch and how large was their impact. The rating agencies, more concretely, ‘’the big three’’ – Moody’s, Standard & Poor’s and Fitch – had a very intriguing part in the whole game that drove the housing bubble. So, the main question is ‘’what exactly did they do that made things so bad?’’. With regards to the particular discussion in this seminar work, several other important questions are raised, as to whether agencies inflated ratings and if so, what were their incentives. Was moral hazard present in this ratings business and was there a conflict of interests? These are all important issues concerning the credit rating agencies and need to be reviewed in order to present a final conclusion about the role of the CRAs in the crisis. As of the fact that rating agencies really have power in the system and investors and institutions, even governments, rely on their ratings (opinions), another important issue that is shown in this paper is how these rating firms have established such reputations. The sole purpose of this Bachelor thesis is to explicitly present the impact of the CRAs with their

~ 5 ~ ‘’opinions’’ about the structured financial products in the crisis. I put forward the hypothesis that the assigned ratings on the structured financial products were, indeed, inflated and several other theories regarding the main questions in this paper. Furthermore, this paper also considerably shows what ratings are, their role in the economy and the historical development of the rating agencies. It also shows the trends that led to the subprime crisis in 2007-2008, to what level were the CRAs responsible for what had happened and if there was asymmetric information regarding the ratings. The Bachelor seminar work is organized in several sections. The structure is the following: In section II, it is explained what the ratings are, the origins of the credit rating agencies and their rise to power in the financial system, the payment process and the ownership and structure; In section III, there are explicit details of the financial crisis, that is, the trends that led to the financial crash, the unfolding of the crisis and several important events; Section IV discusses the main issue in this paper, the role of the agencies in the subprime debacle, there are also few theories regarding the moral hazard issue; Section V empirically demonstrates the role of the agencies and also backs the theoretical part; Finally, section VI concludes.

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2. The Credit Rating Agencies

2.1 What really ‘’rating’’ is? In a free market economy investors would need information to do business. As financial market complexity and borrower diversity have grown over time, information has proven to be bloodstream of the capitalistic economy and has become a public good. Through ratings, a type of specialized information could be absorbed. Ratings could be made by accounting the preferences of a critical mass of people or after a technical analysis performed by experts having access to public and private information. Hence, it could be affirmed that there could be a rating on almost anything. For instance, a list of highly rated study programs and schools, nightclubs, lawyers, a list of best quality service restaurants, preferred movies, etc. However, the value of the rating resembles itself in the reputation of the rater, in this case the CRA’s. Depending on this, the rating will affect the decisions of the investors, and thus gain strong reliability to potential consumers. For instance, in the capital markets there are players who offer products and players who buy them. The former, the financial institutions, which offer products, compete for the capital that the latter, the investors, have in excess. In this situation a lot of financial products are offered, so the investors base their decision for their capital investment as where they expect to have larger revenue and lower risk (for repayment) at the same time. This is exactly where the ‘’credit’’ ratings come in to play. Ratings should be used to reduce the asymmetry of information between investors and issuers. Hence their critical component has to be ‘’information’’. So, the credit rating is an informational tool facilitating the capability that a certain debt would be repaid. Since the New Deal regulations in the US in 1934 and particularly after the regulatory reforms in the mid 1970’s, credit ratings adopted a secondary function, as being a sort of regulatory license. This function describes the valuable property rights associated with the ability of a private entity, rather than the regulator, to determine the substantive effect of legal rules. Such regulatory licenses have benefited rating agencies to varying degrees since the 1930’s (Partnoy, 1999, p. 623). The final interest that concerned the rating business is the interest of the issuers, those in need of capital. There were times when the issuers believed that the ratings were an ‘’intrusion’’ on their affairs, but as the information from the ratings and the CRA’s themselves became more and more important it was realized that these raters were capable to create or destroy the value that they needed, by upgrading or downgrading a financial instrument (ex. Bond). Currently, with the sovereign debt problems occurring all around the world, we are witnessing the power of these ratings that are affecting governments and countries. For this reason the issuers started to cooperate with CRAs, by providing them with detailed and often confidential information, to ensure a better rating. Today the issuers usually provide investors with ratings from two of the major agencies, in order to foster market reliance in their issuances (Ignacio et al., 2007, p. 1-8). Regarding these attributes, this power the ‘’ratings’’ have, the agencies providing this information, have come to a very important role in the financial world. There is a very famous quote regarding the role of the CRAs in today’s world:

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‘’There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful’’

- Thomas L. Friedman, 1996 Further on in this paper, I will discuss in details the drastic role these big rating agencies had in the credit crunch in 2007 and how they affected the whole world. In the next subsections there is a brief historical overview on the CRAs and some details about their ways of functioning.

2.2 Origins and Historical Development In the previous part, by explaining what actually rating is, the question ‘’why do rating agencies exist?’’ is to some degree answered. To have a more explicit view on how rating agencies conduct business and their impact in the financial world, it is important to answer the question ‘’how did they emerge?’’. The bond rating business traces back its roots with the advent of the railroad corporations in the U.S. After 1850, these railroad corporations grew larger, with enlarged capital needs. To finance the U.S. railroads, a huge market was developed, both domestic and international, in the bonded debt of U.S. railroad corporations. By the time John Moody had begun rating bonds. In 1909 the first bond-rating agency, innovated by Moody was established. However, this bond-rating agency represents a fusion of functions performed by three institutions that preceded it: credit-reporting agency, specialized financial press and the investment banker.

2.2.1 Credit-reporting agency By the 1830’s the expanding scope of American business gave rise to a new institution, the specialized credit-reporting agency. In 1841, Lewis Tappan, a New York dry goods and silk merchant who in the course of his business had compiled extensive records on the creditworthiness of his customers, decided to specialize on the provision of commercial information. He founded the Mercantile Agency, which gathered information on the creditworthiness of businesses all over the US through a network of agents and sold it to subscribers. The company was acquired by Robert Dun and published its first ratings guide in 1859. The company’s subscribers (wholesalers, importers, banks etc.) grew from 7,000 in the 1870s to 40,000 in the 1880s, and by 1900 its reports covered more than a million businesses. A similar mercantile agency was formed by John Bradstreet of Cincinnati in 1849, and by 1857 was publishing what apparently was the world’s first commercial rating book. In 1933, the two agencies were consolidated into Dun & Bradstreet, which became the owner of Moody’s Investor Service in 1962.

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2.2.2 The Specialized Business/Financial Press

Railroad corporations were America’s and perhaps the world’s first big businesses and by 1832, the railroad industry was reported on by a specialized publication, The American Railroad Journal. The journal became a publication for investors when Henry Varnum Poor (1812-1905) became its editor in 1849. Poor published systematic information on the property of railroads, their assets, liabilities and earnings during his editorship of the journal. After the American Civil War, Poor and his son started a firm to publish Poor’s Manual of the Railroads of the US. After his death, in 1916, Poor’s company entered the bond rating business. The company merged with Standard Statistics, another ratings company, in 1941, to form Standard & Poor’s. S&P in the 1960s was acquired by McGraw Hill, the publishing giant. Century later, Moody’s and S&P, the original rating agencies, remain the world’s largest and most dominant such firms.

2.2.3 Investment Bankers Before the first summary ratings of railroad bonds appeared, in 1909, investors were still willing to purchase such securities. One reason is the existence of innovative journalists such as Henry Varnum Poor, who supplied comparative information on the assets and earning power of the companies. Another, maybe even more important reason is that investment bankers, as financial intermediaries put their reputations on the line with every deal they make. As an intermediary, the investment banker, besides being the person to whom an enterprise needing large sums of capital increasingly turned, also had access to the suppliers of capital through a vast network, often international, in which the banker’s reputation counted for a lot. However, the information disclosure by the bankers brought them a lot of power. Nevertheless, by the time, John Moody responded to the public’s request for more and more convenient, publicly available information on the quality of investments with his railroad bonds (Sylla, 2001, p. 6-10). As explained before, the expansion of the ratings business to securities ratings began in 1909 with John Moody. Poor’s Publishing Company started in with its ratings in 1916, Standard Statistics in 1922, and the Fitch Publishing Company in 1924. The most significant new entry in the United States since 1941 when Standard Statistics and Poor’s Publishing Company merged, was Duff and Phelps, which began to provide bond ratings for a wide range of companies in 1982 (Cantor et al., 1994, p. 2). As capital flows in international financial markets have shifted from the banking sector to capital markets, credit ratings also begun to make a mark overseas. Credit ratings were also in use in the financial markets of the developed economies and several emerging market countries as well (see table 1). Besides the four major U.S raters, on other U.S., one British, two Canadian, and three Japanese agencies were listed among the most influential in the world. The main details and characteristics regarding these eleven agencies could be seen in table 1, however, the numbers are out of date and the table should be used as a historical benchmark, all the details needed about the ‘’big three’’ would be shown further.

~ 9 ~ Table 1. Selected Rating Agencies

Year Ratings

First Published

Credit Rating Agency Home Country

Employees (Worldwide)

Ownership Principal Rating Areas

1909 Moody’s Investors Service (‘’Moody’s)

US 674 Dun and Bradstreet

Full Service

1922 Fitch Investors Service (‘’Fitch’’)

US 200+ Independent Full Service

1923 Standard and Poor’s Corporation (‘’S&P’’)

US 700+ McGraw-Hill Full Service

1972 Canadian Bond Rating Service (‘’CBRS’’)

Canada 26 Independent Full Service (Canada)

1974 Thomson Bank Watch (‘’Thom’’)

US 40 Thomson Company

Financial Institutions

1975 Japanese Bond Rating Institute (‘’JBRI’’)

Japan 91 Japan Economic Journal (Nikkei)

Full Service (Japan)

1977 Dominion Bond Rating Service (‘’DBRS’’)

Canada 20 Independent Full Service (Canada)

1978 IBCA, Ltd (‘’IBCA’’) UK 50 Independent Financial Institutions

1980 Duff & Phelps Credit Rating Co (‘’Duff’’)

US 160 Duff and Phelps Corp

Full Service

1985 Japanese Credit Rating Agency (‘’JCRA’’)

Japan 74+ Financial Institutions

Full Service (Japan)

1985 Nippon Investor Service Inc (‘’NIS’’)

Japan 70 Financial Institutions

Full Service (Japan)

Source: (Cantor et al., 1994, p. 2) Worth mentioning is also the transition to charging issuers, as agencies initially provided public ratings of an issuer free of charge and by selling these publications and related materials afterwards they financed their operations. However, the publications were easily copied once published and did not yield sufficient returns to justify intensive coverage. With the growing demand for faster and more efficient services from the agencies, they began to charge issuers for ratings. Thus, they used these revenues to expand services and products and became quite competitive to the private sector analysts at other financial institutions (Cantor et al., 1994, p. 1-4). For further clearance, in this paper, I focus mainly on the ‘’big three’ agencies, thus, Standard and Poor’s Financial Services LLC, Moody’s Investor Service and Fitch Ratings. S&P and Moody’s control about 40% of the market in U.S. and Fitch Ratings about 14% (Klein, 2004). 2.3 How do the CRA’soperate?

Credit rating agencies are specialized companies that conduct complex financial analysis of various parties to determine how credit worthy they are, actually to determine their credit rating.

~ 10 ~ The information from the credit ratings is used as a tool by investors in their investment decision making about bonds or other fixed income securities. In the previous subsections, it was explained in details about what credit rating is, in short, it is an opinion about credit risk. Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Ratings are usually expressed as letter grades, ranging from ‘AAA’ to ‘D’ and that way they communicate the agency’s opinion of relative level of credit risk. Adding as an introduction to this part, few notes about ratings are worth mentioning:

- Credit ratings are opinions about relative credit risk; - Credit ratings are not investment advice or buy, hold, or sell recommendations.

They are just one factor investors may consider in making investment decisions. - Credit ratings are not indications of the market liquidity of a debt security or its

price in the secondary market. - Credit ratings are not guarantees of credit quality or of future credit risk.

Credit ratings could be useful in many ways. For instance, they may play a great role in enabling governments and corporations to raise money from the capital markets. Furthermore, credit ratings can facilitate the process of issuing buying and issuing/selling bonds and other debt securities by providing efficient measure of relative credit risk. It is used by investors as a screening device. At the same time, ratings may be used by companies when raising money for acquisitions, NPV projects, research and development as well as helping states and municipalities to fund public projects or cover trade deficits. Credit ratings are used by investors, intermediaries, issuers, business and financial institutions. When investors are using the official ratings, they are assessing the credit risk and comparing different issuers for their investment decisions. Individual investors may use the ratings in evaluating municipal and corporate bond from risk tolerance perspective. Institutional investors, as pension funds, banks, mutual funds and insurance companies, on the other hand, often use credit ratings to supplement their own credit analysis of specific debt issues. Intermediaries, investment bankers for instance, help to facilitate the flow of funds from investors to issuers. So, they use the ratings as a benchmark for the relative credit risk of different debt issues and also to set the initial pricing for individual debt issues they structure and to help determine the interest rate these issues will pay. Issuers, including governments, municipalities, financial institutions, corporations, need credit ratings as to provide independent opinions and reviews of their creditworthiness and quality of the debt issues. The general rule regarding the anticipation of interest rate to be offered by the issuers is as follows: the more creditworthy an issuer is, the lower the interest rate the issuer would have to pay to attract funds (investors). Businesses and financial institutions use credit ratings to assess risk that the counterparty in the credit agreement may not fulfill its obligations (Standard & Poor's, 2011). According to information gathered from Moody’s Investors, getting rated is a few-step detailed process and the agency’s analysts have to gather information sufficient to evaluate risk to investors, they have to develop a conclusion in committee on the appropriate rating, monitor the security in order to determine whether it should be changed and inform the marketplace of the agency’s actions. If an issuer is new to the agency, first there is an introductory meeting or teleconference call. This meeting with the management is generally held at the company’s head office

~ 11 ~ location, it may last from a half day to a full day and during the meeting the following subjects are discussed: background and history of the company; industry trends; national, political and regulatory environment; management quality, experience, track record, and attitude toward risk-taking; management structure; basic operating and competitive position; corporate strategy and philosophy; debt structure; financial position. Upon completing the analysis, the analyst team will make a recommendation to the agency’s rating committee. The second step is the gathering of Moody’s rating committee, in front of which the analyst will present the rating recommendation and rationale, and discuss all the relevant issues related to the credit. The role of the rating committee is to introduce as much objectivity into the process as possible. The next step is the rating process timeline, which from the time of the preliminary discussion to the public release of the rating, takes approximately 60-90 days. Furthermore, once the rating committee has made the decision, the issuer is informed and the public rating is distributed by press release and also appears on the agency’s websites. First-time rating applicants are allowed to determine whether their rating will be made public. The sixth step is the treatment of confidential information, as confidential information will not be publicly disclosed by the agency’s, but, if relevant will be used in the formulation of the public rating opinion. And finally, after the assignment and the publication of the rating, there will be an on-going relationship between the rating agency and the management of the entity being rated (Moody's, 2012). When assigning ratings there are also some criteria on which these ratings are based. Ratings criteria are published principles, methodologies and assumptions that analysts use when making a rating decision. It is a sort of a framework by which the creditworthiness is assessed. Principles are the fundamental elements of analyzing credit risk and the qualitative and quantitative treatment of information we consider in reaching a ratings opinion. Methodology refers to the methods that govern the application of criteria principles to a particular rating or practice. The methodologies are specific frameworks for applying criteria principles to reach a rating. Assumptions are projections, estimates, input parameters to models, and all other types of qualitative or quantitative expectations that we use to arrive at ratings opinion. An agency’s ratings criteria should be a balance of qualitative assessments and quantitative measures used in the rating process, also transparent and accessible. The formulation of the ratings opinions is a well-documented process that is based on a thorough analysis according to the relevant criteria and most certainly is enhanced by knowledge, experience and judgment of the credit analysts. In order to have a more explicit understanding of the whole ratings process, I have presented the whole idea in picture 1. As it can be seen from the picture, the analysts first apply the relevant ratings criteria to each issuer and issue they rate. Then they analyze creditworthiness of a corporation or a structured finance issues by evaluation each ratings factor according to the relevant criteria. In applying criteria during the ratings process, analysts undertake analysis and prepare ratings-related documentation that is then presented to a rating committee. The large amount of analytical work that informs the ratings process is packaged in the form of a Ratings Analysis Methodology Profile (RAMP), which covers the rating factors prescribed by the applicable criteria (Standard&Poor's, 2010).

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Picture 1. Ratings Process

Source: (Standard & Poor's, 2010) When the rating agencies publish the credit ratings they have special symbols for certain default possiblities and creditworthiness of entities (ex. corporations). Most rating agencies have long had their system of symbols-some using letters, others using numbers, many both- for ranking the risk of default from extremely safe to highly speculative. The system of simbols is shown in table 2, with mere details about each level of rating. In this table, I only present the simbols that the ''big three'' use, as those agencies are most reliable in this research work. Nevertheless, to provide finer rating gradations to help investors distinguish more carefully among issuers, Fitch in 1973, Standard and Poor's in 1974, and Moody's in 1982 started attaching plus and minus symbols to their ratings. Other modifications of the grading schemes – including the addition of fg a ''credit watch’’ category to denote that a rating is under review – have also become standard (Cantor et al., 1994, p. 3-4).

Ratings Criteria

Qunatitative analysis+

Qualitative analysis

RAMP

(Ratings Analysis Methodology Profile)

The Ratings Committee

Presentation and discussion of ratings factors→ Vote→ Assignment of rating

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Table 2. ABC of Credit Ratings

Fitch Ratings Moody’s S&P Highest credit

Quality AAA Highest

Quality Aaa Highest credit

Quality AAA

Very high credit quality

AA High quality Aa Very high credit quality

AA

High credit quality

A Upper-medium quality

A High credit quality

A

Good credit quality

BBB Moderate risk Baa Good credit quality

BBB

Speculative BB Substantial credit risk

Ba Speculative BB

Highly speculative

B Speculative – high credit

risk

B Highly speculative

B

Substantial credit risk

CCC Very high credit risk

Caa Substantial credit risk

CCC

Very high levels of credit risk

CC Highly speculative – near default

Ca Very high levels of credit risk

CC

Exceptionally high levels of

credit risk

C Lowest rated - default

C Exceptionally high levels of

credit risk

C

Restricted default

RD Default D

Default D Source: Standard & Poor’s, Fitch Ratings, Moody’s Investor Service

2.4 Ownership and payment process The ownership structure of the rating agencies do not generally present serious conflict of interest problems. However, it is of a great importance to explain the owners and the methods for profiting. When reviewing the role these agencies had and their crucial mistakes in the subprime mortgage crisis in 2007-2008, these two factors (owners and payment) are major substances in the analysis. All of the major agencies are either independent or owned by non-financial companies. Following several decades of ownership by Dun & Bradstreet, Moody’s Investor Service became a separate company in 2000. Moody’s corporation was established as a holding company and it is the parent company of Moody’s Investor Service. It is publicly listed (NYSE:MCO) and there are 678 owners, most of them mutual funds and institutions. The largest shareholder is Berkshire Hathaway Inc. with 12.77% shares held. Standard and Poor’s is a subsidiary of McGraw Hill, a major publishing company with a strong business information focus. It is actually a limited liability company. On the other hand, the McGraw Hill company is a publicly listed company (NYSE:MHP) and its major shareholder is Capital World Investors with 8.99% of shares held. Fitch Ratings and Fitch

~ 14 ~ Solutions are a part of the Fitch Group, which is a jointly owned subsidiary of FIMALAC and Hearst Corporation. On April 12, 2012, Hearst increased their stake in the Fitch Group up to 50%. Institutions like Capital World Investors, Vanguard Group Inc., State Street Corp, Independent Franchise Partners LLP etc. are shareholders of both, the Moody's Corporation and the McGraw Hill Companies Inc (Moorningstar, 2012). It was mentioned in the previous subsections that in the early 1970s, the basic business model of the large rating agencies changed. The ‘’Investor pays’’ model, established by John Moody in 1909, was converted to an ‘’issuer pays’’ model. This means that the entity issuing bonds pays the rating firm to rate the bonds. The reasons for this change are not very clear, yet there are several assumptions. First, the agencies feared that the sales of the rating manuals would easily be copied by other investors and allow them to free ride. Second, with the bankruptcy of the Penn-Central Railroad in 1970, which shocked the bond markets and made debt issuers more conscious of the need to assure bond investors that they (the issuers) really were low risk and that they would even pay the agencies to have them rated. Third, the rating firms may have realized that the bond issuers needed their bonds to have the ‘’blessing’’ of one or more rating agencies in order to get those bonds into the portfolios of financial institutions. Fourth, the bond rating business involves a ‘’two-sided market’’, where payments come from one or both sides of the market. For instance, information can be paid for by issuers of debt, buyers of debt, or mix of the two (White, 2010, p. 214-216).

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3. The Financial Crisis in 2007-2008 After the brief explanation how rating agencies work and how they developed, for better understanding of their impact in the subprime mortgage crisis that shocked the world, in this section I summarize and explain the main events that occurred in 2007-2008. Starting with the trends that led to this crisis, I show how these events unfolded with big losses in the mortgage market that turned into turmoil and dislocation in the financial markets. The 2007-2008 financial crisis was one of the most severe crisis since the Great Depression and had large repercussions on the real economy. It was a turmoil that shocked the world. In overall there were large mortgage losses but still relatively modest comparing to the $8 trillion of U.S. stock market wealth lost between October 2007 and October 2008 (Brunnermeier, 2009, p. 77). In this section I present some of the key factors leading up to the housing bubble, for instance the low interest-rate economic environment in the U.S. because of large capital inflows from abroad (especially from Asian countries) and because the Federal Reserve had adopted a lax interest rate policy (Brunnermeier, 2009, p. 77). Furthermore, this section shows also the economic mechanisms that caused the downfalls in the mortgage market to amplify into enormous dislocations in the financial markets all over the world.

3.1 Trends in the Banking Industry that led to the liquidity squeeze Together with the other factors, which would be discussed sequentially later on in this paper, there are two main trends in the banking industry that contributed greatly to the credit boom and housing frenzy that laid grounds for the crisis. The first trend is the transition of holding loans on banks’ balance sheets to an ‘’originate and distribute’’ model (securitization). Second, the banks changed their asset holdings financing with shorter maturity instruments, which in turn left banks exposed to a dry-up funding liquidity (Brunnermeier, 2009, p. 79). The IT improvements led to financial innovations. So, with these financial innovations and the change from traditional banking to ‘’originate and distribute’’, banks created ‘’structured’’ products referred to as collateralized debt obligations (CDOs) and offloaded risk (figure 1). In the first step of the securitization process, as it is explicitly shown in figure 1, diversified portfolios of mortgages and other types of loans, corporate bonds, and other assets is formed. Thereafter comes slicing these portfolios into different tranches. These tranches are grouped by probability of default. So, the safest tranche is known as the ‘’super senior tranche’’ and offers investors a low interest rate and is the first to be paid from the cash flows. The riskiest tranche is the ‘’junior tranche’’ and it will be paid only after all other tranches have been paid. The mezzanine tranches are between these

~ 16 ~ extremes. Therefore, the diversified portfolio is turned into a ‘’special purpose vehicle’’ (SPV).

Figure 1. Securitization

Source: (Bijkerk, 2012) This SPV is a financial entity whose purpose is to collect principal and interest cash flows from underlying assets and pass them on to the owners of the various tranches. In short, bundling all sorts of mortgages, from safest to riskiest, and other financial products with computer technology into standard debt securities is named securitization. The cutoffs between tranches are chosen to ensure a specific rating for each tranche. For instance, the senior (top tranches) are formed to satisfy and receive an AAA rating. The constructed and rated tranches are then sold to various investors. Risk-averse investors would buy the most senior tranches, while the junior ones (the toxic waste) are being sold to hedge funds or usually held by issuing banks to ensure that it adequately monitors the loans. Buyers of these tranches can protect themselves by purchasing credit default swaps (CDS). The CDS are contracts that insure investors against the default of particular tranche or, in general, a bond. These derivative instruments work in a way that the buyer of the CDS pays a fixed fee in exchange for a contingent payment in the event of a credit default. Of what importance were these new financial instruments? – Well, enormous, as the notional amount of outstanding credit default swaps in 2007 range from $45 trillion to $ 62 trillion.

~ 17 ~ Anyone who invested in the CDO’s or, in other words, the SPV, and on the other hand protected himself with a CDS, had a reason to believe that the investment had a low risk, as the possibility that the issuer of the CDS would default was thought to be very small (Brunnermeier, 2009, p. 79-80). Moreover, the banks were financed through shorter maturity instruments. Investors prefer more liquid assets or to say, with shorter maturities, so they can accommodate their funding needs or it can serve as a commitment device to discipline banks with the threat of possible withdrawals. However, usually investment projects or mortgages have long term maturities. The banks filled in this system by granting loans with longer maturities and financing it with short term deposits, this was the traditional banking model. This maturity mismatch with the changes in the banking system became grater and molder, as this system consisted of off-balance-sheet investment vehicles. The investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year. These assets were ‘’backed’’ by a pool of mortgages or other loans as collateral. If a default occurs on the down-payment of the paper, than the holder of the asset-backed paper had the power to seize and sell the underlying collateral assets. During the housing bubble the asset-backed commercial paper became a dominant form of outstanding commercial paper. With this strategy, now, the banks became exposed to funding liquidity risk. If investors stopped buying the short-term commercial paper, the vehicles would not be able to roll over their short-term debt. In order to ensure liquidity for the vehicle, the sponsoring bank grants a credit line called a ‘’liquidity backstop’’. So, the banks hold long-term assets and make short-term loans, but the liquidity risk from this way of working is still in the banking system even though it does not appear on the banks’ balance sheet. The maturity mismatch was increased with a move towards financing with short-term repurchase agreements – ‘’repos’’. In addition, investment banks were largely financed in the period 2000 to 2007 by overnight repos, which required the banks to roll over a large part of their funding on daily basis (Brunnermeier, 2009, p. 80-81). These were the trends that led to the crisis, but what led to the popularity of securitization and the off-balance-sheet vehicles? – The structured financial products were able to satisfy different investor needs risk appetites. So, the risk was shifted to those who wish to bear it. This allowed for lower mortgage rates and lower interest rates on loans. However, the credit risk never left the banking system, as the banks were primarily selling the products among themselves (Duffie, 2008). Other force that led to popularity of the investment vehicles was regulatory and ratings arbitrage. Banks pooled the loans into off-balance-sheet vehicle that was rated AAA by the agencies and got around the capital charges which were enforced by the Basel I and II accords. A very important detail in this banking combination is that these models (with the SPV) were based on historically low mortgage default rates, because in the past the USA had not experienced a nationwide decline in housing prices since the WWII. In addition, the products may have received more

~ 18 ~ favorable ratings compared to corporate bonds because the rating agencies collected higher fees for structured products. Another important fact is ‘’rating at the edge’’ which contributed to favorable ratings of structured product over corporate bonds. When a security is rated AAA, its risk ranges from near zero default to a risk that just makes it in the AAA group of securities. So the banks through a close relationship with the agencies worked to slice the tranches of the products just to satisfy the minimum requirements to be AAA rated. This ‘’rating at the edge’’ attracted fund managers, because these products offered high expected returns with a small probability of a catastrophic loss. With a low risk-free rate at the time, fund managers whose payoffs are linked to a percentage share of the upside but do not become negative in the event of losses, are especially attracted in buying such structured products as the risk-free rate offers very low compensation. With the securitization and the new structured products a flood of cheap credit occurred and lending standards fell. The banks only faced the ‘’pipeline risk’’ of just holding a loan for some short term and pass it on, which gave them no incentive to monitor and approve loans. But this is only one side of the story. Global imbalances, which can be seen in picture 2, are another source of credit growth. In sum, capital outflow of emerging countries (Brazil, India, China etc.) financed the deficit in the US, Europe and UK. These global imbalances caused cheap credit in especially the US, giving rise to asset bubbles, for example the housing market (Brunnermeier, 2009, p. 81-82). Picture 2. Another source of credit growth: Global imbalances

Source: (Bijkerk, 2012)

~ 19 ~ Increased securitization and cheap credit led to a decline in credit quality(Keys et al., 2008)For instance, mortgage brokers offered teaser rates, no-documentation mortgages, piggyback mortgages (a combination of two mortgages that eliminated the need for a down payment), and the rise of the NINJA (No Income No Job or Assets) loans. These granted mortgages were based on the assumption that background checks are unnecessary because the housing prices would only rise and a borrower could refinance his loan using the increased value of the house. All of what I mentioned before laid grounds for the crisis in 2007. Many observers were worried about the ‘’liquidity bubble’’, but they were reluctant to bet against it. As from a theoretical model from Abreu and Brunnermeijer (2002, 2003), it is believed to be more profitable to ride the wave than to lean against it (Brunnermeier, 2009).

3.2 Common Structured Products While there were many players in the crisis and many causes, the structured financial products were maybe the crucial instruments that have overtaken enormous portion of the financial market and triggered the crisis. As the sole purpose of this seminar work is to describe the role of the agencies in the crisis, a brief description of the most common types of structured instruments is provided, as they were used for collateral for the CDOs. Described by Benmelech and Dlugosz (2009):

Ø Asset-backed Securities (ABS) – term for bonds or notes backed by pools of assets, for example: loan receivables, student loan receivables.

Ø Mortgage-backed securities (MBS) – term used for securities which cash flows are backed by the principal and interest payments of a set of mortgage loans. Depending on the type of property underlying the mortgages, the MBS could be divided as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities.

Ø Home Equity Loans securities (HEL) are RMBS which are backed by a pool of home equity loans.

Ø Collateralized Debt Obligations (CDOs) – these financial products are pooled and tranched, backed by pool of assets and they issue classes of securities with some investors having priority over others.

Ø Collateralized Bond Obligations (CBOs) are CDOs backed by corporate bonds. Ø Collateralized Loan Obligations (CLOs) are CDOs backed by leveraged high-yield

bank loans. Ø Collateralized Mortgage Obligations (CMOs) are CDOs backed by mortgage

collateral.

3.3 Beginning and Unfolding of the Crisis

The liquidity crisis began unfolding with the increase in subprime mortgage defaults, which was first noted in February 2007. From picture 3 can be seen the default rate in each

~ 20 ~ year prior to the beginning of the crisis in 2007. UBS closed its internal hedge fund on 4 May, 2007, after accounting approximately $125 million of subprime-related losses. Picture 3. Default Rate on US Mortgage subprime increases

Source: (Bijkerk, 2012)

Afterwards, Moody’s put 62 tranches across 21 US subprime deals on ‘’downgrade level’’, which actually means that these tranches will be downgraded in near future. After this review, there was a deterioration of the prices of mortgage-related products. Bear Stearns had trouble with its two hedge funds and injected $3.2 million dollars just to protect its reputation. Then Countrywide Financial Corporation announced an earnings drop on July 24. On July 26 an index from the National Association of Home Builders has shown that the new home sales had declined 6.6 percent year-on-year. From that point on the housing prices and sales continued to drop. From picture 4 in the appendix can be seen how the house prices have been moving since 1988, and plummeted in 2007-2008 (Brunnermeier, 2009, p. 82-85).

~ 21 ~

Picture 4. House Prices in the US plummet

Source: (Standard&Poor's, S&P/Case-Shiller Home Price Indices, 2012) After a little turmoil, in 2007, there was a concern in the financial world about how to value structured products and the reliability of the ratings weakened, so the asset-backed commercial paper markets began to dry up. Figure 2 shows that non-asset backed securities were affected only slightly, but on the other hand shows that the instability in the financial sector was primarily driven by asset-backed securities, or to say more concretely, mortgage-backed securities (Brunnermeier, 2009, p. 82-85). In Europe, the German bank IKB was the first one caught by the wave. In July 2007, the bank could not roll over asset-backed commercial paper and it was unable to provide the promised credit line. After negotiations, €3.5 billion rescue package for both private and public banks was announced. Furthermore, American Home Mortgage Investment Corp. announced losses and its inability to cover its financial obligations and declared bankruptcy on August 6. Then BNP Paribas, on August 9, froze redemptions for three investment funds because of their inability to value structured products. So, after a few similar events a lot of signals indicated that banks became reluctant to lend to each other. The interest rate on commercial paper jumped from 5.39 percent to 6.14 percent over the

.....US National, index level (left)

__US National, %chya (right)

Record low decline of 18.9% in 2009 Q1 (solid line)

Nationally, home prices are back to their 2003 Q1 levels

~ 22 ~ period August 8-10, 2007. The rating agencies continued to downgrade structured investment vehicles all through 2007 (Brunnermeier, 2009, p. 82-85). Figure 2. Outstanding Asset-Backed Commercial Paper and Unsecured Commercial Caper

Source: (Brunnermeier, 2009)

3.4 Several Events from the Crisis

3.4.1 The Mono-line insurers Bond insurance is a type of insurance from a specialized insurance company which guarantees payment of principal and interest on a security in the case of a default by the issuer of the bond (Wikipedia, 2012). As a reward for the insurance, the insurance company is paid a premium by the issuer or owner of the security to be insured. This could be seen as a credit enhancement that typically results in higher rating of the insured security. Type of securities that are usually insures ranges from municipal bonds to asset-backed securities, such as the collateralized debt obligations. The mono-line insurers were not like the insurance companies, but instead they insured solely municipal bonds. However, these insurers also extended their business line to insuring mortgage-backed securities. As with other financial institutions there were also worries for potential downgrading of the mono-line insurers. With this potential downgrade there would be a loss of AAA-insurance for

~ 23 ~ dozens of bonds and structured products, resulting in a downgrade across financial instruments with face value of $2.4 trillion and subsequently triggering a sell-off of these securities (Brunnermeier, 2009). Nevertheless, on January 19, 2008, Fitch downgraded Ambac, a mono-line insurer and unnerved worldwide financial markets. On 21 January share prices dropped significantly worldwide. Asian markets lost about 15 percent, Japanese and European markets around 5 percent. The sell-off in Asia and Europe continued the next day too. Dow Jones and Nasdaq futures were down 5 to 6 percent, which indicates a drop in the U.S. equity market as well. In continuation, the Fed cut the federal funds rate by 0.75 percent, being the first ‘’emergency cut’’ since 1982. The potential downgrade of the mono-line insurers also pressured a significant sell-off on municipal bond markets and on so-called auction rated securities (ARS) (Brunnermeier, 2009).

3.4.2 Bear Stearns The Bear Stearns Companies, Inc. was a global investment bank, with its main business areas in capital markets, wealth management and global clearing services. During the housing boom, the company was involved in securitization, as many other companies, and issued large amounts of asset-backed securities. The events that occurred in 2007 put a lot of pressure to the bank. On July 16, 2007, Bear Stearns revealed that two of their subprime hedge funds amid to a rapid decline in the market had lost nearly all of their value. Then in March 2008, for instance, the credit spreads between agency bonds and Treasury bonds, was widen. After the widening spread, Carlyle Capital hedge fund which invested in agency bonds was hurt and it could not meet its margin calls. The action of seizing and partially liquidating Carlyle Capital collateral assets depressed the price of agency bonds even more. Bear Stearns in the case of Carlyle was one of the creditors and besides this, it held large amounts of agency bonds on its own. On March 14, 2008, the FED announced to provide $25 billion loan to Bear Stearns in order to provide the liquidity for up to 28 days that the market was refusing to provide. However, because of certain events that were, maybe mistakenly interpreted, Bears Stearns situation have become even worse. The Fed had a change of heart and apparently the loan was unavailable to the investment bank. However, Bear Stearns had about 150 million trades spread across various counterparties and was ‘’too interconnected’’ to be allowed to fail. The forthcoming weekend, the NY FED granted $30 billion loan JPMorgan and Chase and helped them acquire Bear Stearns for $2 per share, in total $236 million. This move was accepted positively by the markets, however, the shareholders of Bear Stearns lost almost everything. JPMorgan on the other hand, increased its offer to $10 per share (Brunnermeier, 2009).

~ 24 ~

3.4.3 Lehman Brothers, Merrill Lynch & AIG Lehman Brothers Holdings Inc. was a financial services company, an investment bank which at the time of operating was the fourth largest in the USA. During the crisis, like other financial institutions, Lehman Brothers also faced big liquidity problems. Their share price fell significantly, and after the announcement that Korea Development Bank would not acquire the firm, their shares plunged. Thereafter, Barclays and Bank of America were listed as potential buyers. However, they did not do business as the government denied to offer a guarantee. So, unlike Bear Stearns, Lehman Brothers on September 15, 2008, filed for bankruptcy. The night before, Merrill Lynch, the world’s largest brokerage, had sold itself to Bank of America for $50 billion (Brunnermeier, 2009). Despite the bankruptcy of Lehman Brothers which really rippled the financial markets, AIG, a large international insurance company, announced their serious liquidity shortage. The insurance company was active on the derivative markets, especially credit default swaps. On September 16, 2008, AIG’s stock fell more than 90 percent. Amid to AIG’s interconnectedness they were ‘’too big to fail’’ and the Federal Reserve made a bailout, with which they bought 80 percent equity for $85 billion. In October, the same year, the FED extended the bailout to another $37 billion and in November they injected another $40 billion. If it were not for the Federal bailout, the collapse of AIG would have had enormous consequences on the world financial markets and the real economy. This also brings the question of whether there should be more regulations on companies becoming too big to fail and the moral hazard in their operations (Brunnermeier, 2009). The turmoil created from the securitization and the subprime mortgages, has left enormous effects on the real economy. This has really put academicians, CEOs, CFO’s, even governments to the test. The International Monetary Fund estimated that large U.S and European banks lost more than $1 trillion on toxic assets and from bad loans in the period 2007-2009 (Cutler et al., 2009). In 2007 the S&P 500 index was down 45 percent from its 2007 high. Housing prices dropped 20 percent from the peak in 2006 during the housing bubble. Furthermore, the home equity in the U.S. has dropped from $13 trillion in 2006 to $8.8 trillion in 2008 (Altman, 2009). These are just some rough numbers, but enough to represent the seriousness of the financial distress that began in 2007. In this section from the bachelor paper, I explained in details how the crisis developed as well as its importance. This is an important part as in this paper I discuss the impact of the rating agencies in the credit crunch in 2007-2008. However, there are few trends that led to the financial collapse, as the securitization and the creation of structured financial products. These products were like tempted bombs rated by the agencies with AAA, the highest possible insurance of the impossibility of default. In the next part of my paper I will show

~ 25 ~ why the agencies made this mistake with the structured products, if they were biased or just had the wrong incentives when rating these financial instruments. Were there certain institutions that were lobbying the agencies and giving the wrong incentives? In order to be more explicit regarding these questions, I also briefly described some events from the crisis like the fall of one of the biggest investment banks, Lehman Brothers, then Merrill Lynch, AIG and Bear Stearns. These are all great names in the business and their mentioning in my paper is important, as there are some institutions giving wrong incentives to the rating agencies (one of the questions in the paper) so it is crucial to see the relationship with the fall out of these corporations.

~ 26 ~

4. The Role of the Agencies in the Crisis So far, I have discussed several points that are very important for the main question in this graduate paper. Through this paper, I showed how the rating agencies do business, how they are paid, their origins and ‘’rise to power’’. Furthermore, in this paper it was explained in details how the crisis developed, the trends that led to the credit crunch. Most certainly, there are few stages of the crisis, which in many ways I tried to capture in my detailed discussion about it. Also, there are a lot of ‘’players’’ involved in the securitization process and the creation of the structured finance products, which led to this financial turmoil. However, this paper tries to capture the role these agencies had in the financial turmoil and their impact in the creation of the structured products or asset-backed securities that were conducive to financial failure. In this paper, with the term ‘’rating agencies’’ I addressed the three largest firms in the rating business in the World, as they are the main subjects involved with the securitization process that led to the crisis, as already mentioned before. The ‘’big three’’ in this business would be, Moody’s Investor Service, Standard and Poor’s and Fitch. These agencies gave high ratings to derivatives that were ‘’walking on thin ice’’. These structured products, exploded and left the governments struggling with high debts, unemployment rates, caused ‘’currency wars’’ etc. Nevertheless, there has been a lot of noise in the media regarding the work of the rating agencies. There were a lot of controversies about how the agencies had too much power and with close ties to certain corporations and made large profits. This close relationship between the agencies and corporations is hard to explore and discuss on scientific level and it is more for the media and their speculations. The question ‘’who’s to blame for the financial distress?’’ is still greatly discussed between academicians. Despite of the speculations, in this paper there is a step by step overlook on the role these firms played. As in the previous parts there was an explanation of the securitization process, in the next subsection there is also another detailed look on the role of the agencies in the securitization.

4.1 The Agencies and their role in the creation of the structured products The main focus and the main thesis in this paper is the role these rating agencies played in the financial crisis, moreover, their impact in causing the crisis. After the crunch in 2007-2008 a lot of noise occurred about the irresponsibility and the game the rating firms had. Many attacks from the media, academicians, investors, managers, even conspiracy theorists, were directed to the agencies. Questions and discussions regarding their approach to the structured financial products were unavoidable. Were the agencies biased when rating the tranches in the special purpose vehicles? Was there moral hazard, and, if so, what were the incentives for that kind of decisions? Were there some companies profiting from the mistakenly rated financial instruments on behalf of others that were struggling

~ 27 ~ with liquidity and defaulted? These particular questions will be discussed in continuation and certain theories will be offered. Thus far, it is assumed that the reader would have a clear overview and perception of what caused the crisis and how it emerged. Regarding this fact, in continuation of my paper I would give brief details from the crisis with particular weight given to the role of the agencies in the whole situation. As this is an important background for the questions and thesis discussed in my paper and for the whole paper in general. Two causes created the crisis and that would be the housing frenzy and the flood of cheap credit, as presented previously. Through the securitization process banks offloaded risk to the created ‘’structured’’ products. Banks formed diversified portfolios from mortgages, loans corporate bonds etc. and sliced them into different tranches, which in turn were sold to investors. The safest tranche offers investors low interest rate but it is the first to be paid from the cash flows of the portfolio and the riskiest tranche is vice versa. When slicing the portfolios into tranches, the rating agencies come into play. The agencies rate these tranches, which are then sold to a particular group of investors, depending on their risk appetite. With rating the tranches the agencies actually ‘’advertise’’ these financial products to the investors. The ratings that are assigned to each financial instrument are used as a comparison with other corporate bonds with the same rating. What is important, and I have already discussed in section 3, is that structured products (CDOs) with same ratings as corporate bonds yield higher returns for the banks and also for the agencies (Brunnermeier, 2009). Investors and issuers of financial instruments use ratings to set an interest rate for the offered instrument, which is set as a comparable to a corporate bond and it is, actually, a particular spread from the risk-free rate (Brealey et al., 2010) Furthermore, to tap into demand from money market funds, banks shorted the maturity structure (Brunnermeier, 2009). Usually, commercial banks financed its long-term loans with short-term deposits and there was a maturity mismatch, which is one of the characteristics of the banking industry. For banks not to take excessive risks there were bank-capital regulations known as the Basel accords (Basel I and II). Under the Basel accords, banks must maintain at least an 8 percent capital buffer against a risk-adjusted measure of their assets. In the United States, the F.D.I.C. has interpreted ‘’at least’’ 8 percent to mean 10 percent, if a bank is to be designated ‘’well capitalized’’ (Richardson et al., 2009, str. 198). However, the same maturity mismatch was transferred to a ‘’shadow’’ banking system consisting of off-balance-sheet investment vehicles and conduits. These off-balance-sheet vehicles raised funds by selling short-term asset-backed commercial paper and medium-term notes primarily to money market funds. If, for instance, investors suddenly stop buying asset-backed commercial paper, it would prevent the vehicles from rolling over their short-term debt and that is why the above strategy exposes banks to funding liquidity risk. To ensure funding liquidity risk for the vehicle, the sponsoring bank grants a credit line to the vehicle, called a ‘’liquidity backstop’’. This is also an important

~ 28 ~ issue, as with this credit line granted by the bank, the vehicles typically received AAA ratings from the agencies (Brunnermeier, 2009). What can be inferred by now is that, due to modeling mistakes or maybe particular interests agencies granted the vehicles or the structured products high ratings (usually the highest –AAA-). According to Acharya and Richardson (2009), rating agencies may have been more interested in generating fees than doing careful risk assessment. Moreover, maintaining the capital buffer, demanded by the Basel accords, would be inherently costly for the banks. For one thing, it cannot be lent out as interest. So, securitization allowed banks to avoid holding costly capital by essentially turning them into underwriters that still originate loans, but then sell them off to others. The legitimate and worthy purpose of securitization is to spread risk, however, this process ended up keeping the risk concentrated in the financial institutions, at a magnified level, because of the over-leveraging that it allowed (Richardson et al., 2009, p. 197-198). Behavioral economics also provides feedback, as to why investors demand AAA securities. Thus, if investors use heuristics to classify investment opportunities, and AAA rated assets are accounted as riskless, then issuers of these securities would cater to investors needs and demands by having large portions of their deals rated AAA (Benmelech et al., 2009). It is clear, how the credit rating agencies played an important role for turning this housing bubble into a fiasco. With their high ratings, what the agencies at least did is advertise the financial instruments to the market. They motivated and insured investors and with this they laid the foundations for the crisis. However, they are not the only ones to blame, as the large banks (investment banks) and other large financial institutions played even more important role with creating the off-balance-sheet vehicles and trading with these risky securities. Before important conclusions are taken, in the next subsection, there are a few points as to why rating agencies rated the structured products the way they did.

4.1.1 Importance of the ratings in the securitization

There were few problems concerning the system how these agencies operated. Thus, ‘’the big three’’ were working as oligopoly and this kind of system is conducive to becoming lazy or complacent. The ‘’issuer pays’’ model, also, opens door to insidious abuses. These theoretical problems have been in the business since the 1970’s, however, the clients (banks, corporations, governments etc.) had this problem checked. On the other hand, from thousands of clients the threat that one of them would seek other agencies to do business, is very little, actually, it is not even a problem. In the securitization process, the ratings from the agencies were very important in setting the interest rate, or in other words, the profitability of the structured products. Nevertheless, in the securitization there were only a small number of investment banks whose bonds were being rated and if they were not satisfied, than there was a real threat of moving its business to a different agency. This

~ 29 ~ gave an incentive to agencies to be compliant, but even participated in the creation of the structured financial products. According to this theory it can be inferred how the rating agencies had the incentives to assign more favorable ratings to these mortgage-backed securities (CDO’s). But according to White (2009), there were at least four reasons why the ratings on subprime-backed papers were indispensable to the securitization of the subprime mortgages and that would be the following:

1. The rating agencies, through time, with their accurate ratings on corporate and government bonds, and, proven integrity among large diversity of clients–including the world’s largest corporations and event amongst governments-have established credibility and trust. Given this, investors and bond purchases had no reason why not to rely on the agencies’ ratings for the asset-backed bonds, including those backed by mortgages, even when the yields on subprime mortgage-backed bonds were higher than on comparably rated bonds by blue-chip corporations.

2. Certain institutional investors (ex. Pension funds) are obliged to invest only in AAA rated bonds or securities. This is a reason more why rating agencies assigned higher ratings which were marketed to some institutional investors.

3. Knowing that banks not only originated the structured products, but they also traded them amongst each other would imply another reason for the importance of high ratings. Banks could get around the capital requirements and generate more cash flows if they traded a portfolio of mortgages for a portfolio of mortgage securities-even on backed by subprime mortgages-with the only condition that securities are rated AA or higher. Under the Basel capital accords, a capitalized bank was required to hold $4 in capital against every $100 in individual mortgages, but only $1.6 in capital against every $100 of AA- or AAA-rated mortgage-related securities. So, by trading mortgages for the mortgage-backed securities (rated at least AA) the banks could use the $4 of capital to invest in $250 of these ‘’senior tranches’’. Despite of the fact that yield on the senior tranches was less than the yield on the underlying mortgages, the higher leverage made the exchange worthwhile (Schnabl et al., 2009).

4. Besides holding high-rated securities on the balance sheets, banks also held a huge quantity of subprime mortgage-backed securities off-balance-sheet in, previously explained, structured investment vehicle. The purchase of these SIV had a zero capital requirement and was financed through the issuance of short-term asset-backed commercial paper (ABCP). Furthermore, if the CDOs that were purchased by the SIV were highly rated, then the ABCP could also be highly rated. Such high ratings were essential the ABCP were to be bought by money-market funds, which were required by law to hold almost entirely high-rated securities.

In addition, according to the International Monetary Fund (2008, 59), approximately 75 percent of the U.S subprime mortgage originations were securitized. Of these, about 80 percent have been funded by AAA-rated MBS ‘’senior’’ tranches, and about 2 percent by

~ 30 ~ noninvestment grade (BB+ and lower) ‘’junior’’ tranches. Over 90 percent of a typical high-grade, structured-finance CDO liability structure is composed of AAA-rated tranches. Taken into the account, the importance of the securitization in the crisis, the above mentioned reasons why ratings were indispensable to the securitization and the estimation of the IMF, than it can clearly be understood what kind of a role the agencies had. In addition to what has been inferred so far from the theory in this seminar work, White (2009) states that:

- ‘’Without the high credit ratings that were conferred on 80-90 percent of the tranches of mortgage-backed CDOs that had subprime mortgages as their collateral, such mortgages surely would not have been issued in the huge quantities seen during the run-up to the crisis, since there would have been much less reason to securitize them: Subprime mortgages would not have been in such high demand if very high percentages of their derivative securities had not then been stamped AAA. Nor could they have been concentrated on the banks’ balance sheets and in the banks’ SIVs—which is what directly led to the financial crisis. It is safe to say, then, that without those high ratings, the financial crisis either would not have happened at all or would have been substantially less severe.’’

4.2 Ratings Oligopoly and Moral Hazard

Given that the credit ratings and the credit rating agencies play such an important part in the financial world, it is of great importance to discuss the possible moral hazard problem and the incentives which determine the CRAs behavior. The agencies created the AAA tranches of the collateralized debt obligations, the structured financial products, and actually, stating that these securities were of similar risk as some blue-chip corporate bonds or even U.S. government bonds. These securities became attractive to a lot of institutional investors spreading them all over the world and laid grounds for the financial disaster that came afterwards. Then, a more recent failure of the CRAs is related to the sovereign debt crisis in Europe, which began in 2010. They failed to predict the crisis and accelerated it with downgrading the ratings of Eurozone sovereigns too far and too fast (Ryan, 2012). The paper as a whole and the occurrence of the crisis that was explained in the previous sections, even the example of the recent sovereign debt crisis, are all indications of a possible moral hazard problem with the credit rating agencies. There are several academic articles presenting models how moral hazard occurs in the rating industry and its possible solutions. Also, there are some real situations that have happened even before the sovereign crisis and the credit crunch that show of a moral hazard within the ratings business.

~ 31 ~ Before I move to a discussion about the possible moral hazard problem and give examples of moral hazard in the ratings industry, I would say a few words about the oligopoly of the agencies, which is one of the most important reasons for the moral hazard issue and mention the criticism towards their way of operating.

4.2.1 Criticism and Oligopoly

The way the whole financial system has been functioning with the credit ratings has provoked some criticism from academicians (Ryan, 2012). First of all it would be the lack of competition. The ratings industry has been greatly dominated by Standard and Poor’s and Moody’s. This constitutes duopoly, including Fitch, with the smallest market share, it is an oligopoly. However, since two ratings are needed to issue rated debt, the two major agencies do not compete with each other and are able to charge issuers large fees. The problem of conflict of interest is also present. Nevertheless, the Securities and Exchange Commission (SEC), the organization that regulates which companies would be ‘’nationally recognized securities rating organizations’’ (NRSRO), has never recognized more than five companies since early 1900s, making Moody’s Investor Service, Standard & Poor’s and Fitch Ratings to be the ‘’big three’’ in the ratings business (Ryan, 2012). According to Ryan (2012) there are two reasons for the occurrence of oligopoly in the ratings industry. The first would be that the regulation is limiting entry backed by the fact that the SEC admitted no company in the NRSRO between 1991 and 2003. The second reason leading to oligopoly is the need for strong reputation which is limiting entry for other firms. Other criticism can be addressed to the lack of accountability. Despite the fact that rating agencies are viewed by investors as a primary assessment tool to financial markets, the CRAs have stated that their evaluations are merely opinions and cannot be verified in courts. Lack of Independent CRAs, even though the agencies assert that their independence is crucial to their role, there has been difference between solicited and unsolicited ratings, which speaks of the conflict of interest problem. Furthermore, the Lack of Timeliness and Pro-cyclical Behavior, not providing an early warning signals and there is also the ‘’rating triggers’’, stating that agencies can, at any time, downgrade a firm’s or country’s rating thus having effect of demolition in creditworthiness.

4.2.2 Moral Hazard Whether the CRAs are engaging in moral hazard activities, is difficult to prove, and, therefore unknown. However, the list of critics that was mentioned before and the oligopoly of the ‘’big three’’ is a fair indication of a possible moral hazard problem.

~ 32 ~ Examples of failures, as discussed in this seminar work, are also a great example of moral hazard. Before the agencies are accused of moral hazard in this seminar work, let’s stress out some of the facts that lead to an obvious problem of moral hazard. First, the agencies work is unobservable and they rate according to the ‘’issuer pays model’’. The company that issues debt pays for the services of the agencies, it actually pays to get rated. So in general, the CRAs are inclined more towards the firms’ interests, as damaging ratings will in turn lead to lower probability that a firm will get rated by the agency. Second, the rating industry is a regulated oligopolistic industry all over. These facts lead to an obvious moral hazard problem. So far, in this seminar work it has been presented how the ratings game functions and several failures of the rating agencies were mentioned, which indicate that the structure of the market of these firms leads to moral hazard problems. I already put two reasons for the occurrence of moral hazard, so the purpose of this section is to enlighten some of the main issues. The first issue that leads to moral hazard problems, that has been already put forward in this paper, is the ‘’issuer pays model’’. The ratings are either both solicited, in the case when the issuer of the security being rated pays for the rating, or unsolicited, when it is done by the rating agency without a pay. Rating agencies are in fact a profit-maximizing corporations, thus the conflict of interest is obvious. CRAs could issue inflated solicited rating in order to get a repeated business from the issuer. The only ‘’regulation’’ for this kind of problem is their fear of losing reputation, meaning that avoiding long-term loses will overcome the desire or, incentive, for short-term gains. (Božovič et al., 2011) Another important note regarding the occurrence of moral hazard is whether the issuers shop for ratings. That is, the agency is paid only if the credit rating is issued, if on the other hand, the issuer is unhappy with the rating, it may solicit another one (Bolton et al., 2009), or go to other rating agency which would rate higher. Božović et al. (2011) summed in his paper important facts concerning this issuer. Before Fitch has entered the market as a serious player and knowing that S&P and Moody’s, were almost giving completely correlated ratings, then ‘’shopping’’ for ratings would not be possible. However, with the introduction of a new player (Fitch) did not necessarily make the situation better. A finding presented in the paper by Božović et al. (2011) indicates that enhancing competition was followed by reduction of predictive power of corporate bond ratings by the CRAs. They also find that, when it comes to corporate bond ratings, ‘’shopping’’ does not explain their results. Therefore, increased competition reduces motivation of CRAs as it reduces their long-term rents. On the other hand, asset-backed securities are more prone to ‘’shopping for ratings’’, as they are more complicated and it requires a lot of sophistication to rate them. It is assumed that the issuer of the security collaborates with a particular rating

~ 33 ~ agency to structure the deal. So the issue ‘’shopping for ratings’’ has ambiguous effect as a cause of moral hazard. Bolton at el. (2009), offered two explanations regarding the discrepancy between solicited and unsolicited ratings. It is stated that companies self-select. Actually, companies that are of lower risk than unsolicited rating would try to correct the market perception by soliciting their rating. Thus, with more in-depth analysis it would be proven that these companies are indeed of lower risk than the initial rating suggested. Another explanation the authors offer is that, the agencies issue lower unsolicited ratings on purpose in order to make companies prone to ask for a solicited rating. The empirical evidence rejects the first explanation in favor for the second, thus seeming to show another example of how the agencies game the system and the moral hazard in the ratings business. To sum up, it is very difficult to prove if the credit rating agencies engage in moral hazard activities. Straight facts or proofs of moral hazard cannot be put forward. However, it can be noted that these agencies have many possible ways of gaming the system. First there is a great debate regarding the oligopolistic nature of the credit ratings market. Some academicians state that higher competition would enhance the problems with the ratings industry. Nevertheless, European leaders have expressed concern about the oligopoly of the agencies. Wolfgang Schauble, the German Finance Minister, stated in July 2011 that he wanted to break the oligopoly of the rating agencies (Ryan, 2012). Furthermore, certain issues concerning the ‘’ratings game’’ have been presented and discussed through this section. For instance, the pitfalls of the ‘’issuer pays model’’. In terms of high profits there is suspicion, actually a theory, that the agencies inflate the solicited ratings. The issue ‘’shopping for ratings’’ has an ambiguous effect as a cause or indication of moral hazard, yet it shows another possibility for gaming the system. Through academic papers, benchmark models have been created regarding the ratings market, based on certain assumptions, which theoretically also show to be leading to moral hazard. The problems with Enron, WorldCom and Parmalat in 2001 are a prime example of the failure of the three major rating agencies (Ryan, 2012), a prime example of a possible moral hazard. To stress out the moral hazard issue, there is no better example but the failure with the asset-backed securities in the credit crunch in 2007-2008. The agencies rated these ‘’tempted bombs’’ with AAA, however denied any responsibility for the occurrence of the crisis by stating that they only give opinions and could not be taken to court. Whether a better regulation is needed or it should be implemented, is left out for further discussion.

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5. How large the impact of the ratings in the crisis was: empirics

During the housing bubble, enormous number of asset-backed securities, mortgage-related loans and CDO were issued. These structured finance products were marketed by the credit rating agencies by being assigned with high ratings. Since the credit rating agencies have established a historical reputation in the financial markets, investors strongly relied on their opinions about the structured tranches and did not predict the disaster that was tempted to happen. In the previous section it was explained how the agencies did the ratings, their incentives for doing so and, in general, the possibility of moral hazard in the whole ratings industry. In the following part, I would put forward numbers explicitly presenting the role the agencies had, what exactly they did and also discuss the fees they charged for job they did with the tranches.

5.1 Credit Analysis After the information about the pool of securities is submitted to the CRA, an analyst is assigned to evaluate the proposed financial instrument and their first step is to use credit rating model. With the credit rating model, the analyst assesses the rate of probable default or loss from the pool of assets. RMBS rating models use statistical data on past mortgage performance to calculate expected returns and default rates. S&P used model called the Loan Evaluation and Estimate of Loss System (LEVELS) and Moody’s Mortgage Metrics Model (M3). These models are highly complex and contain certain criteria for assigning ratings to the structured products. There have been several indications that were common for a CRA analyst to speak with the arranger or issuer of the CDO to gather additional information, which is believed to have biased the analysts on their judgment on the ratings (Senate, 2011). Rating CDOs and MBS required special groups of analysts who were responsible for the rating process. Moody’s had the RMBS group of about 25 analysts and a Derivatives group with about 50 derivative analysts responsible for the ratings for their specializations. Each group was headed by a Team Managing Director who reports to a Group Managing Director. The Derivatives Group and the RMBS group were combined in the Structured Finance Group. In S&P the structure was similar, as RMBS group had 90 analysts, while the CDOs were issued by the Global CDO Group, which had around 85 analysts. After the credit ratings surveillance was conducted. Moody’s had 15 RMBS surveillance analysts and 24 Derivatives surveillance analysts. S&P on the other hand, had about 20 surveillance analysts in each group (Senate, 2011).

5.2 Rise of structured finance and record downgrades In a submission to the SEC, S&P indicates that from 2004 to 2007 has issued more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings. Moody’s, on the

~ 35 ~ other hand, has issued over 4,000 RMBS ratings and over 870 CDO ratings (Senate, 2011).Through the complexity of mixed causes of the financial crisis in 2007-2008, it is known that the rating agencies’ role was to rate and ensure of the default rate of the structured financial products. On the other hand, structured financial products emerged greatly over the worldwide financial markets. By January 2008, there were 111,988 individual rated tranches outstanding all over the world and structured finance becoming the largest financial market in the world (Benmelech & Dlugosz, 2009). From table 3 the evolution of the structured finance market could be seen from 1983 to 2008. Table 3 demonstrates that CDOs have been the fastest growing sector from the structured finance instruments. Another interesting fact is the growth of global CDO issuance in dollar value from 2004 being $157.4 billion to $551.7 billion in 2006, but after the 2007 turmoil investors lost confidence and CDO issuance fell to a total of $53.1 billion (Benmelech et al., 2009). Table 3. Structured Finance Tranche Issuance by Year and Type

Year ABS(%) CDO(%) CMBS(%) MBS(%) PF(%) RMBS(%) Other(%) Number of deals

1983 0 0 0 100.0 0 0 0 1 1984 16.7 0 0 16.7 0 66.7 0 6 1985 3.6 0 0 0 0 96.4 0 28 1986 9.1 0 0 0 0 90.9 0 77 1987 11.3 0 0 0 0 88.7 0 142 1988 11.3 0 0.3 0 0 88.3 0 300 1989 10.6 0.1 0.9 0.1 0.1 87.8 0.3 705 1990 13.4 0.7 1.0 0.1 0.2 83.8 0.9 1010 1991 18.5 1.1 1.0 0.3 0.2 77.9 1.2 1333 1992 22.6 1.0 1.2 0.3 0.2 73.2 1.5 1704 1993 25.3 0.8 1.9 0.2 0.3 69.5 2.0 2105 1994 26.4 1.9 2.3 0.2 0.5 66.6 2.2 2571 1995 29.8 1.8 2.6 0.2 0.8 62.1 2.7 2988 1996 32.7 1.7 2.6 0.2 1.6 56.3 4.9 3567 1997 37.0 2.1 2.7 0.2 4.1 49.4 4.5 4088 1998 37.7 3.3 3.0 0.1 8.1 40.9 6.9 5050 1999 38.2 4.5 3.5 0.1 13.0 33.6 7.2 6010 2000 39.0 6.1 4.0 0.1 14.7 28.2 7.8 6856 2001 39.0 7.4 4.5 0.1 15.1 25.3 8.5 7667 2002 37.9 8.9 5.1 0.1 14.9 23.6 9.5 8704 2003 36.8 10.8 5.4 0.1 14.7 22.1 10.2 9893 2004 35.6 13.5 5.6 0.1 14.6 19.8 10.8 10964 2005 34.1 15.5 5.8 0.1 15.0 18.8 10.8 12208 2006 31.6 16.6 5.8 0 16.5 20.2 9.3 14371 2007 29.4 18.9 5.8 0 16.5 21.0 8.3 16890 2008 (a) 26.3 20.4 5.5 0 20.0 20.8 7.1 19715 This table presents percent of total issuance by number for main deal types as well as total issuance by number. (a) Rating actions as of 9/22/2008 Source: (Benmelech et al., 2009)

~ 36 ~ According to Benmelech and Dlugosz (2009), downgrades of structured products spiked in 2007. The issuance of tranches increased by 31.7 percent, that is, from 71,462 to 94,127, the number enormously increased from 986 in 2006 to 8,109. In addition, there were 36,889 tranches that were downgraded in the first three quarters of 2008. Not only were there many downgrades, but these downgrades were also severe in 2007 and 2008. The downgrades in 2007 on average were by -4.7 notches and in 2008 by -5.8 notches. A downgrade of one notch is a downgrade of, say from A2 to A3 and a downgrade of -3.0 for instance, would be decreasing the ratings from Aa2 to Aa3 to A1 and then to A2. In figure 3, the relationship between tranches that were upgraded and downgraded is demonstrated. Upgraded tranches were on average were not significantly increasing, however the number of tranches that were downgraded was instantly increased in 2007, when more than 35,000 tranches were downgraded. Figure 3. Number of Downgrades vs. Upgrades of Structured Finance Products

Source: (Benmelech et al., 2009) In comparison to the structured finance market, the number of rated bonds in 2008 was roughly 4 times than its total level in 1990. The average change in upgrades or downgrades through time has also been fairly stable. Even when 30 percent of the bonds outstanding

~ 37 ~ were downgraded instantly after the tech bubble burst in 2000-2001, the average downgrade was 1.8 notches. Compared together, corporate bonds and structured finance products, it can be concluded that corporate bonds were well calibrated to the economic risk of defaulting of the issuer (Benmelech et al., 2009). In addition, from figure 4 it can be seen that of all downgrades done in 2008, 11,327 or around 31 percent were AAA rated products, which is an indication more that the initial distribution of structured finance credit ratings was inflated. A detail more is that the tranches (1983-2008) that suffered the most severe downgrade were the AAA rated tranches (19 percent). The next largest portion of downgraded financial instruments would be the tranches rated Baa2 (12 percent) and A2 (9 percent). Furthermore, nearly all of the tranches, around 86 percent, were issued between 2006 and 2008, stressing the bad deals that occurred and the possible moral hazard (Benmelech et al., 2009). Figure 4. Total number of downgrades and number of AAA-structured finance securities downgrades

Source: (Benmelech et al., 2009)

5.3 Credit Rating Agencies Revenues

According to the report from the Subcommittee on Investigation, the two biggest rating agencies noted a record amount of revenues between 2004 and 2007. Standard & Poor’s

~ 38 ~ had issued more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings between 2004 and 2007. Moody’s also accomplished similar increase in issuance of ratings (RMBS and CDOs). Nevertheless, both of the companies charged high fees in order to rate a structured financial product. S&P charged issuers to rate tranches of a RMBS approximately from $40,000 to $135,000. For rating tranches of a CDO it charged from $30,000 to $750,000. Surveillance fees for the mortgage backed securities varied from $5,000 to $50,000. Gross revenues increased substantially, for instance Moody’s increased from $61 million in 2002 to $260 million in 2006. In figure 5 it can be seen how Moody’s share price, for instance, increased in comparison to other big corporations during the bubble. Figure 5. Change in Moody's Share Price vs. S&P 500 index vs Major Investment Banks

Source: (Senate, 2011) S&P’s gross revenues increased from around $ 64 million to over $265 million in 2006. In addition, S&P’s structured finance ratings revenues were 36 percent of the bottom line, in 2007, however, revenues from these products contributed to 49 percent of all S&P’s revenues from ratings. The revenues from the ‘’big three’’ were approximately $3 billion in 2002 and doubled to $6 billion in 2007. The figure 4 in the appendix shows how

~ 39 ~ Moody’s share price increased in comparison to other investment banks, like Merrill Lynch, and the S&P 500 Index. The McGraw-Hill Companies with its division, S&P, also noted a share price increase during this period. Furthermore, Raymond McDaniel, the CEO of Moody’s, earned more than $8 million in compensation in 2006. Brian Clarkson, as the head of the structured finance group, made earnings of around $3.8 million in total compensation in 2006. Other managers also received nice bonuses during this period (Senate, 2011).The above details back the theory of the presence of moral hazard in the ratings business and the incentives the analysts, or in general, the agencies had.

5.4 Investment Bank Abuses

All of the above mentioned instruments, which were crucial for the occurrence of the crisis, were traded by major U.S. investment banks. Between 2004 and 2008, around $2.5 trillion in RMBS securities and over $1.4 trillion in CDOs were issued by financial institutions in the United States. In this process, the investment banks charged fees as the underwriter of RMBS from $1 to $8, and from $5 to $10 as a placement agent for a CDO. Those fees were a substantial portion of the total revenues by the investment banks. Investment banks placed these products to investors, participated in developing a secondary market and took part in buying and selling these securities on the secondary markets. Some investment banks, including Goldman Sachs and Deutsche Bank, were involved in abusive practices with the origination of these securities. For instance, Goldman Sachs used CDS and ABX contracts to bet against RMBS securities or other collection of assets in CDOs and at the same time marketed new RMBS and CDOs to investors (customers).In one instance, Goldman Sachs with the CDO known as Hudson 1, made $1.7 billion gain at the expense of the clients to whom it had sold the securities. In another instance, Goldman with the CDO known as Abacus 2007-AC1, again gamed the investors and its clients, and made large profits. Deutsche Bank sold the CDO known as Gemstone 7, which included 115 RMBS that carried BBB or BBB- ratings, yet received AAA ratings for its top three tranches, and made $700 million. Furthermore, the bank shorted a position in RMBS securities with $5 billion, later cashing a profit of approximately $1.5 billion. However, the bank had an overall loss of about $4.5 billion from its mortgage related proprietary investments. These prime examples are an indication of how investment banks profited from the structured finance products, had little incentive to stop producing and selling high risk and also giving incentives to rating agencies (Senate, 2011).

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6. Conclusion & Limitations

6.1 Conclusion The financial crisis from 2007-2008 was the most severe and disturbing crisis since the Great Depression, also largely widespread, leaving large repercussions onworldwide real economy. One of the main causes for the credit crunch that occurred, were the structured financial products (CDOs, ABS, RMBS etc.). Credit rating agencies are a special type of companies that rated these structured financial products during the housing boom. The CRAs, since the first publishing by John Moody in 1909, have established credibility with investors and institutions, however, they made a lot of failures in their ratings business that have raised questions on their reliability, regulation and moral hazard. Nevertheless, in this Bachelor seminar work the financial crisis 2007-2008 is explained with certain details and it could be concluded that a crucial element which produced this catastrophic debacle in the financial markets worldwide, was the securitization. This laid grounds for doubt and debate about the hazardous role of the rating agencies. In the paper, I put forward several theories concerning the importance of the ratings in the securitization process. Hence, it could be concluded that the ratings played a crucial part in the securitization and in the subprime debacle. This was also backed by several academic papers and investigation done by the federal government selected committees. In section VI there is empirical evidence of inflated ratings and increased returns from it, which also backs the main hypothesis of this paper. These empirical findings indicate the moral hazard in the ratings system. The Bachelor seminar work also suggests few issues, for instance regulation of the CRAs, for further research and discussion.

6.2 Limitations As a few theories were presented in the paper and also backed by empirical findings, worth mentioning are some research obstacles that were a difficulty when combining the theories and the evidence that back them. First of all, there were research papers indicating increased returns from the agencies during the housing bubble, yet it is difficult to find who really stands behind these increased earnings from inflated ratings on securities. There is also an indication in the Bachelor thesis that CRAs worked closely with certain investment banks, or other issuers of securities, in order to structure these complex products exactly to rate them with AAA. However, this ‘’close’’ relationship is very mold and difficult to investigate. Some important numbers and analysis, only available from the databases of these CRAs, are very costly to obtain. Despite the limitation, important details, theories and empirics were enclosed in the Bachelor paper and a reasonable conclusion has been determined.

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7. Abstract The financial crisis of 2007-2008 severe and disturbing crisis since the Great Depression in 1929. There have been huge losses, which had large effects on the real economy throughout the world. Many companies bankrupted due to the inability of payment of the financial liabilities, for instance one of the largest investment banks, Lehman Brothers. Bear Stearns investment bank was acquired by JP Morgan & Chase, then a large number of public bailouts for corporations that were ‘’too big to fail’’, as in the case with the insurance company AIG. In addition, the stock market indices fell sharply, house prices noted a historical record drop and the liquidity of money markets evaporated, thus have led to several interventions from central banks. A significant number of people lost their jobs around the world and many sectors in the economy were facing enormous problems. Since it too much leveraging was allowed and excessive trading of OTC derivatives occurred, it led to other problems for the financial world, i.e. the sovereign debt crisis. Nevertheless, in the subprime mortgage crisis, the credit rating agencies had a specific task. As the new financial instruments have become very popular and they became a large portion of the financial market, the rating agencies with assigning ratings for each instrument, were sending information to investors regarding the credibility of the issuer of the security. These instruments were actually derivatives that are generated by combining a number of diversified portfolios of different securities, which were then sliced into tranches and sold to investors, according to the risk of default. Structured financial products are maybe, the most important cause of the crisis. Because agencies were not able to allocate the appropriate rating, with the inflated credit ratings they advertised these products to the investors and thus became a reason more for what happened in 2007-2008. The main issue discussed in this seminar paper is, what role the rating agencies had in the financial crisis, how they affected the financial crisis and how large was their impact. Credit rating agencies, more specifically, ‘’the big three’’ – Moody’s, Standard & Poor’s and Fitch – had a very interesting part in the whole game, which laid grounds for the mortgage crisis. So the main question is, ‘’what exactly did the rating agencies do that caused the crisis, which had such disastrous effects on the economy?’’. The main discussion in this seminar work raises further questions about whether assigned inflated ratings and what were their incentives. Is the moral hazard present in the system of credit ratings and whether there is a conflict of interests. These are all important issues and details relating to credit rating agencies and should be reviewed and discussed in order to present a final conclusion on the role of the agencies in the crisis. So the main aim of the Bachelor thesis is to answer these questions, present different theories concerning these problems and also, show an empirical background of the role of the rating firms. At first, the seminar paper explains the rating agencies and their characteristics, the analytical models for assigning a rating and the owners of the agencies. Since the first

~ 42 ~ official publication of ratings by John Moody, in 1909, the CRAs have achieved great credibility and power in the financial system. Many academicians have criticized that the agencies were operating in oligopoly and in that kind of a system the moral hazard is always present. Despite that fact, agencies with the largest impact in the financial market are, Moody’s Investor Service, Standard and Poor’s and Fitch Ratings. Furthermore, in this seminar paper a detailed explanation about the financial crisis from 2007-2008 is shown and the trends that led to it. The process of securitization or in other words, the creation of the complex financial instruments, which was the main cause for the crisis, is also explicitly presented. With reference on how the crisis emerged and what was the main cause for those issues, in the bachelor seminar paper many theories are shown as to why the agencies assigned inflated ratings and with it, they created wrong image for the financial products that were very risky. Did the agencies work with the investment banks very closely in order to create these highly rated financial products. These products with their characteristics, yield, high ratings from the agencies, became very attractive to investors. On the other hand, the raise of the share price of the agencies, which came especially from the inflated ratings on the structured financial products, is an indicator of moral hazard. The seminar paper concludes that, the ratings from the rating agencies have played a key role in the securitization process in the subprime crisis. That was also supported by several academic articles and investigations prepared by a federal committees. In a separate section in this seminar paper, empirical evidence is shown regarding the inflated ratings and the high returns from them, which supports the main hypothesis and discussion in this seminar work. These empirical results also point to a moral hazard in the system of ratings. The Bachelor seminar paper also suggests several questions, such as the degree of regulation of the rating agencies, for further research and discussion

Key Words:

Credit rating agencies, Financial crisis, Structured financial products, Securitization, Inflated ratings, Moral hazard

Povzetek Finančna kriza leta 2007-2008 je bila najbolj huda in moteča po Veliki Depresiji v letu 1929. Nastale so ogromne izgube, ki imajo velike posledice na gospodarstvo povsod v svetu. Veliko družb je šlo v stečaj zaradi nezmožnosti izplačila finančnih obveznosti, kot enega izmed največjih investicijskih bankah Lehman Brothers. Bear Stearns investicijska banka je bila odkupljena od J.P. Morgan & Chase, potem je bilo veliko javnih podpiralnih ukrepov za korporacije, ki so ''too big to fail'', kot je primer z zavarovalnico AIG. Poleg

~ 43 ~ tega so borzni indeksi strmo padli, cene nepremičnin so bile rekordno znižane, likvidnost denarnega trga je evaporirala in to je povzročilo številne intervencije centralne banke. Precejšno število ljudi je izgubilo svoje delovno mesto po celem svetu in veliko sektorjev gospodarstva je bilo v problemah. Ker je bilo dovoljeno veliko zadolževanje (eng:leveraging) ter preveliko trgovanje z nereguliranimi tvegananimi finančnimi produkti, je prišlo tudi do problemov, oz., krize državnega dolga. Torej, v hipotekarni krizi, so bonitetne agencije imele posebno nalogo. Ker so novi finančni instrumenti postali zelo aktualni in so zasedali velik delež finančnega trga, so bonitetne hiše z dodeljevanjem bonitetnih ocen za vsak inštrument pošiljale informacije do investitorjev v zvezi z kredibilnostjo izdajatelja teh inštrumentov. Te inštrumenti so bili dejansko izvedeni finančni inštrumenti, ki so nastali z združevanjem številnih portfeljev vrednostnih papirjev, ki so jih potem strukturirali v obrokih in prodali investitorjem, glede na tveganost neplačila. Inštrumenti so strukturirani finančni produkti in so zelo kompleksni, vendar zelo donosni in, kot se je izkazalo, zelo tvegani. Strukturirani finančni produkti so morda, najpomemgnejši vzrok krize. Ker agencije niso mogle dodeliti ustrezne ocene, z napačnimi bonitetnimi ocenami so reklamirale produkte za investitorje, in s tem so postali en vzrok več za tisto kar se je zgodilo v letih 2007-2008. Glavni problem obravnavan v diplomskem seminaru je, kakšno vlogo so imele bonitetne hiše v finančni krizi, kako so vplivali na finančno krizo in kako velik je njihov učinek. Bonitetne agencije, bolj konkretno, ''velika trojka''-Moody's, Standard & Poor's in Fitch- so imeli zelo zanimiv del v celotni igri, ki je postavila temelje za hipotekarno krizo. Torej glavno vprašanje je, ''kaj točno so bonitetne hiše naredile da so povzročile takšno krizo, ki bi imela tak katastrofalni učinek na gospodarstvo?''. V zvezi z glavno razpravo te seminarske naloge, se postavljajo še druga vprašanja o tem, ali so agencije dale napihnjene ocene in kakšne so njihove spodbude. Ali je moralni hazard prisoten v sistemu bonitetnih ocen in ali je tudi bil prisoten konflikt interesov? Vse to so pomembna vprašanja in podrobnosti ki se nanašajo na bonitetne agencije in jih je treba pregledati, da bi predstavili končnega sklepa o vlogi bonitetnih agencij v krizi. Torej, glavni cilj diplomskega seminarja je, odgovoriti na ta vprašanja, predstaviti različne teorije v zvezi s teh problemov in tudi prikazati eno empirično sliko o vlogi bonitetnih hiš. Najprej v diplomskem seminarju so predstavljene bonitetne agencije in njihove lastnosti, ter modeli dodelitev bonitetnih ocen in lastniki agencij. Že iz časa prve oficijalno objavljene ocene s strani Johna Moodyija leta 1909, bonitetne hiše so dospele do velik kredibilitet in moči vo finančnem sistemu. Veliko avtorjev so kritizirali da so agencije delale v oligopolu in da je v takšnem sistemu vedno prisoten moralni hazard. Kjub temu, agencije z največjim vplivom oziroma deležem na finančnem trgu so, Moody's Investor Service, Standard & Poor's, ter Fitch Ratings. Potem, vo diplomski nalogi podrobno so predstavljeni finančna kriza iz leta 2007-2008 in trendi ki so prispevale za pojavo krize.

~ 44 ~ Vendar, proces securitizacije, oziroma nastajanje teh kompleksnih strukturiranih finančnih produktov, ki so bili glavni vzrok za finančni krizo, je tudi eksplicitno predstavljen. Glede na to kako se je odvijala kriza in kaj je bil glavni vzork za te probleme, v diplomskem seminarju je predstavljeno več teorij ''zakaj so agencije dale napihnjene ocene in s tem ustvarili napačno predstavo o finančnih instrumentov ki so bili zelo tvegane''. kaj se je res zgodilo da so agencije delali z investicijske banke zelo ozko pri ustvarjanju teh visoko ocenjene finančne produkte. Te produkte s svojih lastnostih, donosnost, ter visoko oceno iz bonitetnih hiš, so postale zelo primamljive za investitorje. Z druge strani pa agencije so zvišale ceno delnic oziroma dobiček, z oceno dodeljene na te kompleksno strukturirane finančne produkte, to pa je indikator za moralni hazard. Zaključek v diplomskem seminarju je da so ocene iz bonitetnih hiš igrali ključno vlogo pri listinjenju in hipotekarni krizi. To je bilo tudi podprto z več akademskih člankov in preiskav ki so jih pripravili federalne odbore. V posebnem oddelku diplomskega seminarja so predstavljeni empirični dokazi o napihnjenih ocen in višjih donosov iz tega, ki prav podpira glavno razpravo in hipotezo v diplomski nalogi. Te empirične rezultate kažejo tudi na moralnega hazarda v sistemu bonitetnih ocen. Diplomski seminar tudi ukaže na nekaj vprašanj, kot naprimer stopnje regulacije bonitetnih hiš, za nadaljnje raziskave in raspravo.

Ključne besede: Bonitetne hiše, Finančna kriza, Strukturirani finančni produkti, Listinjenje, Napihnjene kreditne ocene, Moralni hazard

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