Midway through 2007 financial markets began to collapse on news of heavy write-downs by major financial institutions. The housing market in the United States (US), which had been experiencing consistent growth since 1975, began to contract in the third quarter of that year while the delinquency rate had been rising since 2006 (Mortgage Bankers Association, 2008). Investors were uncertain how severe the losses would be but it was becoming more likely by the end of the year that a financial crisis was imminent: the amount of subprime and collateralized debt obligation (CDO) losses had surpassed US$120 billion and were expected to increase in 2008 (Gaffen, 2008). As economic conditions turned from bad to worse investors, academics and practitioners began to wonder how such a crisis could have been precipitated in the first place. Blame was placed on mortgage originators, the Federal Reserve and on the investment banks, to name a few. The credit rating agencies (CRAs), seldom in the spotlight, were also heavily criticized for their role in causing the crisis. CRAs certainly do play an important part in financial markets and Thomas Friedman, the Pulitzer Prize winning New York Times columnist, once remarked that there are two superpowers in the world: the US and Moody’s (Lowenstein, 2008). But did the CRAs really deserve blame or were they being held as scapegoats? In the past the agencies generally avoided significant criticism for their rating of corporate debt and government issues, but their role in the burgeoning structured finance market in the early 2000s was characterized by conflict of interest issues, poor risk modeling and ineffective government regulation. As a result low quality ratings proliferated the market for mortgage-backed securities (MBSs) and CDOs on the false pretence of low credit risks. Therefore the agencies should be held partly responsible for one of the most profound market crashes of the century. Several remedial measures have been taken by the Securities and Exchange Commission (SEC) in the US which will likely have little impact, but academics and practitioners have recommended some very thoughtful solutions. The most insightful proposal comes from John Hunt of the Berkley Center for Law. He suggests that the agencies should disclose their belief
that ratings for structured finance products may not be accurate or disgorge profits if they turn out to be wrong. This solution addresses the core issue with the CRAs’ role in the subprime crisis: their inability to accurately assess the risks of structured financial products.
2.1 Overview of Credit Rating Agencies
CRAs offer ratings which indicate the likelihood that financial obligations will be repaid. Almost all agencies issue ratings on an ordinal rather than a cardinal basis, meaning ratings are relative, not absolute. The CRAs emphasize that the ratings are simply opinions and should not be misconstrued as investment advice. They rate...