Rating Agencies

Role and Assessment of Post-Crisis Regulatory Environment

Final Paper

Solvay Brussels School of Economics and Management

ECON 528 Financial Markets, Governance and Regulation

Felix Peters

Elisabeth Andersen

Natália Hennelová

Supervisor: Pierre Francotte December 01, 2017

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1. Definition of the scope

The focus of this paper revolves around brief introduction to what credit rating agencies (CRAs) do, the

diagnostic of their failures as regards subprimes, and the new regulatory and supervisory framework adopted

after the crisis in response to this diagnostic from European Union (EU) perspective.1

2. Introduction to rating agencies

A credit rating agency is a rating institution that helps investors to determine the risk associated with a debt

investment in a company or country and financial instruments (Scheinert, 2016; Finney, 2017). It is possible to

have both short-term and long-term ratings for securities. Short-term investments are all kinds of investments

that are convertible into cash within one year’s time, while long-term investments have a maturity period of

more than one year (Investopedia, 2017). There are three main firms that issue credit ratings, namely Moody’s,

Standard & Poor’s (S&P’s) and Fitch Ratings. The CRAs typically assign letter grades to indicate

creditworthiness. The AAA investment default probability is only 0,74% over a 10-year period, which indicated

that an AAA-rated bond has an exceptional degree of creditworthiness, because the issuer can easily meet its

financial commitments. Moreover, a BBB debt investment has a default probability of 4,33% over 10 years.

However, if a debt investment is rated worse than that, it is considered a junk bond, which means that it is

more likely to default on loans (Appendix 1).

3. Diagnostic of rating agencies failures with regards to subprime

mortgages

In the 1980s, several subprime lenders such as Household Finance Corp. and thrifts such as Long Beach Savings

and Loan offered home equity loans to borrowers that would not satisfy the banks’ conditions for lending.

They charged higher interest rates to compensate for the extra risk, making the model look financially efficient

for many years. This led to a substantial increase of mortgage debt followed by increasing housing prices.

In the 1990s, mortgage loans including subprime loans became popular trading securities. Investment banks

such as Merrill Lynch, Bear Stearns and Lehman Brothers, as well as, commercial banks such as Citi Bank and

Well Fargo packed and sold subprime loans as ‘non-agency’ mortgages. These packages, however, did not

conform to the standards of Fannie Mae and Freddie Mac, at that point still privately-owned companies

guaranteeing low risk of mortgages in the US. Hence, the subprime loan securities were riskier, offering higher

interest at the same time, making them attractive to investors. However, with the growing supply of these

securities, the need for understanding and valuing their riskiness was growing as well. It created an

opportunity for CRAs to present the method how to assess the riskiness of the mortgage packages by creating

rating systems that define the risk levels of the security according the categories AAA, AA…D (Inquiry Report,

2011).

1 Scope provided by Mr. Pierre Francotte via e-mail, d. 8.10.2017

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Until the 1970s, CRAs used the investor-pays model, meaning that institutional investors and brokers were

charged for the ratings of firms they intended to invest in. With the constant development of technology,

however, it was proven unprofitable for the CRAs, as sharing rating reports among investors, and hence,

circumventing the payment obligation became easier.

As a consequence, CRAs developed the issuer-pays model, in which the fees are paid by the issuer of securities

that the agency rates, making ratings freely available to everyone in the market. With this change of

compensation structure, a conflict of interest arose. This is, because it is in the best issuer’s interest to receive

a rating that is as high as possible, indicating low risk for investors. At the same time the issuer pays for the

rating, making himself a client of a rating firm. During the times of massive securitisation of mortgage loans

this rating business grew immensely, totalling to almost 290 thousand newly originated ratings in the years of

2000-2008 issued only by Moody’s (Appendix 2). Naturally, the companies rated by the agencies strived for

excellent investor relations by trying to optimize their rating. Even though CRAs used some valuation models

for their ratings of mortgage securities, there was a space for adjustment of the final results due to limited

regulatory requirements to enclose reasoning behind rating. Especially after the year of 2000, CRAs gradually

stopped using external third party due diligence firms. According to a OECD HEARING (2010, p. 11) CRAs

realised that the collateral in the subprime market began to deteriorate and the due diligence firms noticed

and started to warn about declines in creditworthiness of subprimes. This resulted in a continuously increasing

number of AAA securities that have been downgraded later on (OECD HEARING, 2010). Solely Moody’s rated

almost 45 000 mortgage-related securities as triple A in the years 2000 – 2007. Analyses show that of those

given in 2006, 83% were subsequently downgraded (Inquiry Report, 2011).

From the year 2000 to 2006, the supply of subprime loans increased enormously in the USA. In 2005 there

were originated new subprime loans with total value over $600 billion, 75% of which were securitised

(Appendix 3). The mortgage institutions believed they decreased their risk of debt default through

securitization of mortgages, but underestimated the greater economic impact. Simpler access to a mortgage

loan led to a dramatic increase of aggregate household debt. Due to a higher demand for housing property this

lead to an increase in housing prices, resulting in the household bubble. By April 2006 housing prices had

doubled in value from the year of 2000 (Appendix 4). These were some of the few triggers of the financial crisis

in 2007-2008. The Financial Commission of the United States of America concluded in their analyses of the

financial crisis (Inquiry Report, 2011) that the crisis could have been avoided, had there been a more controlled

and regulated system in place, and even if not so, then by paying closer attention to warning signs and taking

actions in time. Finally, they also claim, ‘this crisis could not have happened without the rating agencies’

(Inquiry Report, 2011, p. xxv).

The mortgage subprime securities were not the solely failure of CRAs before the crisis. CRAs underperformed

their due diligence for the company ratings as well. One of the largest scandals happened around Enron, a US

energy-trading and utilities’ company. The company filed for bankruptcy December 02, 2001, even though

Moody’s had upgraded Enron’s long-term debt ratings to Baa1 in March 2000 (Moody’s, 03.2000). More

remarkably, Moody's had granted the Prime-1 rating to Enron’s asset-backed commercial paper just 4 days

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prior to the filing for bankruptcy (Moody’s, 11.2001). Receiving Prime-1 for a short-term security from Moody’s

is equivalent to the grades AAA to A3 used for long-term securities (Moody’s, n.d.). Shortly after filing for

bankruptcy, most of the debt ratings of the company were downgraded, causing also downgrading of

numerous Collateral Debt Obligations (CDOs) in USA and Europe, as they also partially consisted of Enron

bonds (Moody’s, 12.2001). The question to ask today is, if there would had been taken more serious regulatory

actions after warning sign of this size, could that prevented some of the securitisation rating issues discussed

above?

The impact of the US financial crisis spread quickly to Europe as well, mainly due the large involvement of

European banks in the US subprime mortgage market. Even though securitisation of subprimes in Europe did

not lead to the same results as in the US, European banks invested in American subprime securities in

exchange for higher interest rates. Thus, after these securities had been downgraded and defaulted, they were

forced to freeze the exposed funds. In the following years, the financial crisis turned into a banking crisis and a

crisis of sovereign debt in Europe, affecting the real economy and leading the European Union to the worst

recession of its history. As a result of these events, the EU has introduced further regulations for the financial

sector and established methods to manage and better prevent possible crises in the future (European

Commission, 2017).

4. The new regulatory and supervisory framework adopted after the

crisis in response to this diagnostic

On both sides of the Atlantic Ocean regulators learned about the role of the freedom of CRAs being one cause

of the 2007-2008 financial crisis. The main focus of this paper is the regulatory response in the European Union

(EU) and its effectiveness in solving the structural industry problem.

Roughly speaking, the EU regulators imposed one first set of rules (CRA I) in 2009 which was followed by two

extending and enhancing pieces of additional legislation (CRA II and III) in the years of 2011 and 2013,

respectively.

I. The first set of rules – CRA I

CRA I introduced a mandatory registration procedure for CRAs operating in the EU. Additionally, the newly

created European Security and Markets Authority (ESMA) was set up to supervise the CRA’s operations. With

the mission of ensuring financial market stability, ESMA started its work in 2011.

i. The ESMA Registration of CRAs

The binding registration of CRAs aiming for operating in the EU was the first step towards a more regulated

rating industry with tighter control of authorities over the players in the market. Moreover, having active CRAs

constantly monitored enables authorities to evaluate individual market shares of CRAs. This, in turn, is the

requirement for taking legal actions against individual CRAs who have gone beyond their scope by abusing a

potentially market dominating position. Current market shares are made publicly available on the ESMA pages

(ESMA, 2016).

ii. The Certification of Non-EU CRAs

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The registration policy as introduced under CRA I was put in place also to bring EU post-crisis requirements in

line with those established in countries such as Japan or the United States. Most of the CRAs operating in the

EU have at least a EU-based subsidiary. There is, however, a number of institutions acting in the EU’s single

market without EU base. The CRA I policy simplified the certification of those CRAs by aligning EU with foreign

standards. This made ratings issued by agencies without EU base (e.g. from Japan) compliant with and

accessible in the EU. The possibility for foreign CRAs without EU base to become certified aimed also for

opening the market by letting in a higher number of active agencies and promoting more competition.

iii. The Rotation Mechanism for Analysts

CRA analysts were from now on required to rotate within the firm after a maximum period of five years. This

rotation scheme aimed for mitigating the risk of potential conflicts of interest arising from long-term

affiliations between CRAs and issuers (Regulation (EC) No 1060/2009). As set out also in the following sections

rotation cycles were also implemented in a broader context in the industry.

Moreover, analysts working for CRAs were from now on also required to prove that they were not related to

those entities that the CRA has affiliation with. Such a “relation” that would pose an objection to a compliant

rating as stated under CRA I is represented in an employment relation between analyst and issuer in the past

or individual financial ownership interest (Regulation (EC) No 1060/2009).

iv. The Increased Transparency Standards of ESMA

CRA I also regulated the transparency of ratings as to their methodological foundation and comparability. The

regulators’ conviction was that generally to validate a rating’s informative value, the underlying risk

assessment model needs to be analysed. In this context independence is a major qualitative requirement for

ratings to have a predictive value, as the post-crisis analyses had shown that biases of ratings caused by

conflicts of interest had often been unrecognized due to a lack of transparency.

To ensure more transparent ratings, three types of model characteristics were determined to be reported to

the authorities under the new rules: Discriminatory power, predictive power and historical robustness (ESMA,

2016; Regulation (EC) No 1060/2009).

First, the proof of discriminatory power of a rating method requires CRAs to rank underlying companies by

their default risk and to subsequently provide the authority with the standard statistical profiles as they are

used in the industry (e.g. cumulative accuracy profile (CAP), receiver operator characteristic (ROC) or the

accuracy ratio).

Second, CRAs are asked to report the predictive power of their models. This involves the comparison of the

real outcomes (default rates) with the previously issued rating of the respective assets. Regulators regard this

policy as a central response to the fact that vast numbers of securities were suddenly downgraded in their

rating during the 2007-2008 financial crisis, implying a poor predictive power of the models. More precisely

speaking, high predictive power asks for a close match of initial rating and final outcome. In statistical terms,

predictive power analyses of default probability models include chi-squared and binominal tests of those

values, that have been predicted (i.e. the rating), against the historic outcome of the underlying asset (ESMA,

2016).

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The third risk model quality that is subject to publication is the historical robustness of the models used by

CRAs. This category focuses on the rating system as a whole by analysing the dynamics of the model over time,

revealing potential inaccuracies or inconsistencies. Precisely, historical robustness is reported by taking

upgrade or downgrade ratios of the ratings for one asset over a certain period of time. Complementary

analyses that can be reported to the authorities include e.g. comparisons of the ratios computed in the step

before and subsequent benchmarking across different CRAs, security classes etc. (Bortlom & Bartlam, 2012).

II. The second set of rules – CRA II

Two years after CRA I, with CRA II the first regulatory update of the large framework was put in place to

broaden the regulatory scope of the existing regulation. Half a year after the ESMA had been made the most

powerful authority of its kind in the EU having control over the entire single market, ESMA received even more

rights with this regulatory update in mid-2011 (Bortlom & Bartlam, 2012).

Under CRA II, law enforcement rules were defined. Agencies that showed incompliant practices could from

now on have their premises inspected by the ESMA or be requested to provide the required information to

cooperate in investigations related to breaches of CRA I legislation. A prominent example of tighter law

enforcement is the 1.24mn Euros fine against Moody’s due to regulatory breaches in the context of the

insufficient disclosure of the methodologies used (ESMA, 2017).

Furthermore, CRA II aimed for higher competitiveness in the rating industry by forcing securities issuers to

disclose information to more agencies than just the ones that had been appointed or maintained affiliations

with the issuers. By supporting more and unsolicited ratings of independent CRAs, the impact of conflicts of

interest on ratings should be reduced. The actual ESMA policy to call issuers forward to disclose (partly

confidential) data can be interpreted as a major step towards higher levels of transparency, as well.

III. The third set of rules – CRA III – and further consequences

In contrast to CRA I and II which had focussed on agencies themselves, the EU regulators put CRA III in place to

decrease the reliance of investors on single investment ratings and to achieve a higher number of ratings

available for a particular security.

To reduce investor over-reliance on a particular rating, CRA III requires issuers (especially those of “structured

finance instruments”) to report even more information about their securities than required under the previous

CRA II standard. This knowledge2 is shared on ESMA’s web page to optimize transparency towards investors.

In order to further reduce the reliance of investors on single ratings, the new policy asks issuers to appoint at

least two CRAs to publish their assessment independently from both each other and the issuer. As investment

ratings prior to the 2008 crash were referred to as “‘common language’ for assessing credit risk” (Deloitte,

2015), this policy clearly addressed the major issue of investor over-reliance. Additionally, policy makers also

2(including “information on the credit quality and performance of the underlying assets, the structure of the

transaction, the cash flows, any collateral supporting the exposure and any further information ‘necessary to conduct comprehensive and well-informed stress tests on the cash flows and collateral values supporting the underlying exposure’” (New Disclosure and Dual Rating Requirements in European Structured Finance).

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addressed the issue of investor over-reliance on CRA ratings indirectly by requiring large (intermediary)

institutions, such as banks or money market funds, to develop and report their own internal rating systems.

For example, money market funds, whose practice it is to invest in short-term securities with low risk, relied to

large extents on ratings and many of them faced liquidity problems after numerous US banks had filed for

bankruptcy in 2008 and clients redeemed their fund holdings amid the dramatic development (Regulation EU

2017/1131). This requirement followed a proposal made in the Basel II framework and also insurance

companies are in focus of such a requirement as set out in the Solvency II framework. In addition to decreasing

over-reliance of investors, higher degrees of institutional independence are achieved by this internalization of

creditworthiness ratings (EBA, 2014; European Parliament, 2017).

In addition to the analyst rotation mechanism introduced with CRA I, a rotation scheme on a higher level was

put in place. To break up existing affiliations between CRAs and issuers who pay for being rated and to reduce

the risk of conflicts of interest issuers had to change “their” CRA hired to carry out the rating. Reducing the

“lock-in effect” also aimed for enhancing competitive pressure in the CRA sector by establishing a four-year

rotation cycle (Regulation (EU) No 462/2013).

5. The Proposal of a Public Rating Agency

For decades, the ’Big Three’ CRAs have conducted business in an oligopolistic position accounting for a

combined 93% share of the total market (2015) for the rating of private and public debt (Appendix 5). One

proposal put forward in the European Parliament’s Economic and Monetary Affairs Committee (ECON) in the

aftermath of the 2007-2008 crisis was the establishment of one or more public CRAs in addition to the existing

private CRAs acting in the EU market to primarily increase competition in the market (Schroeder, 2015). But

the proposal also aimed for reducing conflicts of interest, the over-reliance of investors, the dependence of

CRAs and issuers as well as reducing the lack of transparency in the industry as a whole. So far, however, this

and a number of academic proposals in the US (e.g. Diomande et al., 2009) have not yet been realised for a

number of reasons.

Firstly, assessing the creditworthiness of financial entities requires large amounts of resources as information

on the target companies needs to be collected and complex risk models on the foundation of statistical

calculations have to be developed. It would require a large number of highly qualified staff to engage in the

development of risk metrics that are objective and precise. As by definition the public would have provided the

funding, there was serious political controversy spinning around this topic in the parliament of the EU. Simply

setting up an institution that has to generate output of both such high quality and quantity would be a project

that would require immense resources and take long time to realise.

Secondly, the market position of a public CRA at the beginning would be weak and the chance to increase

competitive pressure on the big firms would be considerably low as it would take time for issuers to ‘switch’

their rating partner. Given the high cost of founding and funding such an entity the prospect of a public CRA

were not seen positive among EU regulators. Simply put, a public entity would despite big financial constraints

not necessarily guarantee a highly competitive market.

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Thirdly and most importantly, the ability of a public agency to defend itself on legal grounds against claims

from investors and issuers would be limited or would cause even more serious funding problems in addition to

those mentioned above. Given the poor mistakes made in the run-up to the 2007-2008 crisis, investors are

increasingly sensitive about the credibility and objectivity of ratings. Hence, a potentially imprecise rating can

be expected to be followed by legal actions undertaken by investors. This legal issue would cause even bigger

problems in the specific case in which a public rating was found imprecise by a court. In such a scenario

accusation of market manipulation would have to be legally defended at the expense of EU taxpayers, leaving

the public entity vulnerable to criticism of various kinds (Scheinert, 2016).

All in all, it can be said that especially after CRA I – III had become effective the objectives of a public CRA

would in an ideal scenario be achieved by the regulation already put in place. In this case it is questionable

whether such an institution had amid the mentioned disadvantages added much to existing industry

restructuring.

6. Conclusion

As with many players in the financial markets, also CRAs have seen a tremendous change in their obligations

after the 2007-2008 financial crisis. Looking back on the regulatory process, the EU has set out quite a number

of standards – namely CRA I to III – to regulate the industry which had been able to act rather freely before the

2007-2008 financial crisis. Measures to reduce over-reliance of investors on ratings and to enhance the

methodological transparency were taken fairly soon after the growth forecasts in the affected economies had

started to recover. Moreover, regulators attempted to put an end to highly dependent relationships between

issuer and agency and to increase the competitive pressure under which CRAs operated in the EU in order to

limit the power of dominant players.

One remarkable fact about the regulatory response of the Basel committee and the regulatory response is

clearly the rapidity with which regulations were initiated, discussed and concluded. Clearly, CRA I – as it was

decided in 2009 already – has laid the foundation for the succeeding regulations with a broad range of

measures addressing a variety of topics, such as transparency, over-reliance, over-dependence and the

limitation of conflicts of interest. Even though the use or misuse of credit ratings was at the heart of all the

conditions which had made the subprime crisis possible in the first place, CRA I represents one of the fastest

and most effective regulatory changes possible. The follow-up regulations in CRA II and III then aimed for

improvements and clarifications in the areas which required more regulations or where rules had been

imprecise, such as implementing a rotating mechanism also for CRA affiliations themselves in addition to the

previously regulated analyst rotation scheme.

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References

Balmar, Y, 2014, Recent Financial Crises and Regulations on the Credit Rating Agencies, Research in World

Economy Vol. 5, No. 1, pp. 49-58.

Bertrand, E, How the CRA Regulation will impact the asset management industry, Deloitte Performance

magazine issue 17, May 2015, Link, accessed on 15/11/2017.

Borod, R S & Bartlam M, 2012, Rating Agency Reform in the EU and the U.S., Practical International

Corporate Finance Strategies, Vol. 38, No. 13, pp. 1-4.

ESMA, 2014, Discussion Paper: The Use of Credit Ratings by Financial Intermediaries Article 5(a) of the

CRA Regulation, European Banking Authority, Link, accessed on 01/12/2017.

ESMA, 2016, Guidelines on the validation and review of Credit Rating Agencies’ methodologies, ESMA

Publication 2016 (ESMA/2016/1575), Link, accessed on 15/11/2017.

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on 15/11/2017.

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decisive EU action, Link, accessed on 15/11/2017.

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resulting from Enron's bankruptcy. 11 December 2001. Available at: Link, Accessed on 28/11/2017.

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November 2001. Available at: Link, Accessed on 28/11/2017.

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Moody's, 2000, Rating Action: Moody's upgrades all Enron Corp long term debt ratings. 23 March 2000.

Available at: Link, Accessed on 28/11/2017.

OECD Hearing, 2010, Competition and Credit Rating Agencies, Link, accessed on 15/11/2017.

Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on

credit rating agencies.

Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money

market funds.

Regulation (EU) No 462/2013 of the European Parliament and of the Council of 21 May 2013 amending

Regulation (EC) No 1060/2009 on credit rating agencies.

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The Financial Crisis Inquiry Report, 2011, Inquiry Report: National Commission on the Causes of the

Financial Crisis in the US, edited by Public Affairs, NY.

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Appendices

Appendix 1

Figure 1: Global corporate cumulative weighted average default rates (%)

Source: Standard & Poor’s at http://thewire.blob.core.windows.net/web/images/default-source/Article-images/global-corporate-cumulative-weighted-average-default-rates.jpg?sfvrsn=0

Appendix 2

Figure 2: Total number of observations, relative frequencies of ratings at origination at the beginning of the year

Note: ‘This table shows the total number of observations and the relative frequencies of ratings at origination. The

panel data is based on securitizations rated by CRA Moody’s Investors Service. The following observations were

excluded: i) transaction observations which cannot be placed into the categories asset-backed security,

collateralized debt obligation, commercial mortgage-backed security, residential mortgage-backed security or home

equity loan security; ii) transaction observations where the monetary volume and therefore relative credit

enhancement and thickness of individual tranches could not be determined without setting additional assumptions;

iii) transaction observations which are not based on the currency USD or transaction observations which are not

originated in the USA; iv) tranche observations which relate to years prior to 1997 due to a limited number of

observations, v) tranche observations which have experienced an impairment event in prior years. The number of

rated tranches has increased at an increasing rate. The rating quality of rated tranches has generally decreased over

time as a smaller fraction of tranches are rated Aaa.’

Source: (Rösch and Scheule, 2011)

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Appendix 3

Figure 3: Subprime Mortgage Originations

Source: Inquiry Report, 2011, p.70. Figure 5.2

Appendix 4

Figure 4: US Home Prices

Note: Sand states are Arizona, California, Florida and Nevada

Source: Inquiry Report, 2011, p.87. Figure 6.2

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Appendix 5

Figure 5: Market share calculation based on 2015 applicable turnover from credit rating activites and ancillary

services in the EU

Source: ESMA