Conflicts of Interest in Credit Ratings : How are they regulated? by Patrick Bolton Columbia University
Credit ratings agencies as information intermediaries Public information Investors Commercial Banks Bond Issuers CRA Ratings Investment Banks Insurance companies Confidential information Pension funds 2
Pre 1970: Investors Pay Investors Commercial Banks Bond Issuers CRA $ Investment Banks Insurance companies Pension funds 3
Post 1970: Issuer Pays Investors Commercial Banks Bond Issuers $ CRA Investment Banks Insurance companies Pension funds 4
Financial Regulatory Context Investors Commercial Banks Bond Issuers CRA Investment Banks Insurance companies Pension funds Regulators 5
History of outsourcing regulatory risk control policy Switch to issuer-pays model 1936 Bank regulators prohibited banks from investing in speculative investment securities as determined by recognized ratings manuals 1975 1980s SEC created the NRSRO (Nationally Recognized Statistical Rating Organization) category in order to use their ratings to determine minimum capital requirements for broker-dealers (i.e. investment banks and securities firms) and grandfathered Moody s, Standard & Poor s and Fitch. SEC limited money market funds to investments in Eligible Securities determined by NRSROs Similar regulations on insurance companies, pension funds Basel I and Basel II base minimum capital requirements of banks on ratings 6
Current market structure and profit A triopoly (Moody s, Standard & Poor s, Fitch) with the joint dominance of the first two Market shares (based on revenues or issues rated): 40%, 40%, 15% Moody s: 2008: total revenue $1.8 billion & net revenue $456 million; Average pretax profit margin of 52% since 2003! 7
Two opposing views: Reputational intermediaries or Sellers of Regulatory Licenses? Reputational intermediary: - CRA certify confidential information of issuers without disclosing it. - This mechanism works only if CRA have reputational capital to be trusted by investors Seller of Regulatory licenses (Partnoy, 2006): - CRAs do not provide new information but sell regulatory licenses; - regulations impose costs that can be reduced by a good rating Such sales do not need to be based on reputational capital 8
Recent credit rating crisis: structured finance Structured finance securities are made by pooling and/or tranching multiple financial assets CDO (Collateralized debt obligations) and CDO 2 : structured finance securities that are pooled and tranched Senior and Junior tranches: in the event of default, losses are first absorbed by junior tranches before senior tranches are affected A large fraction of CDO issued over the course of the last decade were CDO and CDO 2 of subprime residential mortgages 9
Recent credit rating crisis: structured finance Alchemy of making AAA-rated securities from junk securities (Coval, Jurek and Stafford, 2009): - Structured finance securities are engineered to have AAA-rating - Roughly 60 percent of all global structured products were AAA-rated, in contrast to less than 1 percent of the corporate issues (Fitch, 2007). By December 2008, structured finance securities accounted for over $11 trillion worth of outstanding U.S. bond market debt (35%). 10
Recent credit rating crisis: structured finance Credit Ratings Downgrades by vintage From Ashcraft Goldsmith-Pinkham and Vickery (2010) 11
Recent credit rating crisis: structured finance Source: FSOC Report 2012 12
Recent credit rating crisis: structured finance Estimation of default probability of tranches is very sensitive to assumptions about default correlation and exposure to macroeconomic shocks For instance, Fitch used a model assuming constantly appreciating home prices in 2007 Their model would break down with 2% decline in house prices. 13
Conflicts of Interest Conflicts of interest are generated by issuer-pays pricing and rating shopping Pay-if-rating-is-good: Today, the rating agency receives one fee to consult with a client, explain its model, and indicate the likely outcome of the rating process; then, it receives a second fee to actually deliver the rating (if the client wishes to go forward once it has learned the likely outcome). The result is that the client can decide not to seek the rating if it learns that it would be less favorable than it desires. (Coffee, 2008, Testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs) 14
Conflicts of Interest Bolton-Freixas-Shapiro (2012, JF) Explain ratings inflation arising from pay-if-ratingis-good, rating shopping, and structuring to the rating A model of competition among CRAs with three conflicts : 1. CRA conflict of interest possibly leading to ratings inflation; 2. Issuer shopping; 3. A trusting or regulation-driven investor clientele, who takes ratings at face value. 15
Conflicts of Interest Bolton-Freixas-Shapiro (2012, JF) When combined, these conflicts produce 3 equilibrium distortions: 1. Competition among CRA reduces market efficiency 2. CRA are more prone to inflate ratings in boom times (when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower) 3. Rating structured products: Tranching and Credit Enhancement distorts market efficiency Regulatory intervention: i) upfront payments for rating services; ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology to mitigate ratings inflation and promote efficiency. 16
Conflicts of interest: some evidence Griffin and Tang (2011): Within the same CRA, the assumptions used by the issuance division lead to more inflated ratings of CDOs than the assumptions used by the surveillance division Benmelech and Dlugosz (2010): - tranches rated by one rater only were more likely to be downgraded than tranches rated by multiple raters. - But more than 80% of all tranches were rated by two or three agencies 17
Regulation Dodd Frank Wall Street Reform and Consumer Protection Act (July 2010): 1. Liability: New standards under Subtitle C of Title IX; Section 933(a) same standards as for analysts and accounting firms; Section 933(b) plaintiff must prove that CRA knowingly or recklessly failed to conduct a reasonable investigation or obtain reasonable verification of the factual elements it relied upon to evaluate credit risk. SEC: Disclosure of ratings in registered offerings and expert liability? 18
Regulation Dodd Frank Wall Street Reform and Consumer Protection Act (July 2010): 2. Supervision: Creation of Office of Credit Ratings (within the SEC) under section 932; look-back requirements 3. Disclosure: underwriters of ABS must disclose thirdparty due diligence reports 4. Ratings Methodologies: new SEC rules 5. Reduced regulatory reliance on Credit ratings 19
Regulation Proposed EU Rules: 1. Rotation: limited to CDOs 2. No ratings of large shareholders issues: Moody s banned from rating Berkshire Hathaway debt issues 3. European credit rating agency? 4. Liability in case of gross negligence Australia: Judge Jagot ruling on S&P AAA ratings of ABN Amro C.P.D.O issues 20
Conclusion Credit Rating Agencies are Public Utilities Beware of imposing too strict Liability standards Allow for more entry and more diversity of opinions More research needed on pro-cyclical effects of ratings SP label for ratings of structured debt? 21