The history of the credit rating agencies and their relationship with financial regulators is central to understanding how the agencies achieved their current overly influential position in the debt market. Beginning in the 1930s, the financial regulators began to create a financial regulatory framework reliant on credit rating agencies, whereby regulators used credit ratings as a means to oversee the financial markets. After the banking crisis of 1931, the Office of the Comptroller of the Currency (OCC) sought to regulate banks’ capital reserve requirement by requiring credit rating agencies to value banks’ bond portfolios. In 1936, the OCC and the Federal Reserve directed banks to hold investment grade bonds, which were bonds that were rated BBB or higher by at least two designated credit rating agencies. Essentially, the ratings indicated the likelihood of the debt being repaid, whether for corporate debt or mortgage-backed securities. As a result, banks were required to obtain opinions on their assets from credit rating agencies such as S&P to determine whether they meet federal capital reserve requirements.
Furthermore, in 1973, the Securities and Exchange Commission (SEC) created a new select category of rating agencies called the Nationally Recognized Statistical Rating Organization (NRSRO) to ensure proper compliance for measuring banks’ leverage ratio. In this way, the SEC empowered NRSRO designated rating agencies, which included the big three ratings agencies (S&P, Moody’s Investors Service, and Fitch Ratings) to give endorsements to banks. While the financial regulators were growing increasingly dependent on the rating agencies, at the same time, a fundamental shift occurred in the business model of the rating agencies. The new NRSRO designation and the resulting oligopoly of rating agencies incentivized the three big ratings agencies to change their business model from charging investors to charging issuers for ratings fees. This change to the “issuer pays” business model created high potential for conflicts of interest, and the alleged abuse of this business model and fraudulent practices in relation to subprime mortgage securities is at the heart of the DOJ’s lawsuit against S&P.
What is Credit Risk and How Do You Measure It?
To explain the role of credit rating agencies, we must first explain credit risk. Credit risk, which is also referred to as default risk, is the risk that a borrower will not be able to pay back the lender. For example, banks usually take on credit risk by lending short-term money or long-term capital to companies. In exchange for credit, the debtor must pay interest on the loan as well as the principal by the end of the loan period. When default occurs, companies usually declare bankruptcy and go through a liquidation process. The amount that can be gathered relative to all outstanding debt is called the recovery rate. Also, all debts are ranked by seniority to decide who gets paid first, which is referred to as debt waterfall.
The amount of money involved in the bankruptcy process for large public companies is substantial and a major disruption in the economy. In 2012, a total of 86 publicly traded companies in the U.S. filed for bankruptcy protection with a total of $70.8 billion in combined pre-petition assets.
Table 1: Top 10 Largest Public Company Bankruptcy Filings in 2012
Credit risk measurement is based on two fundamental concepts: default probability and recovery rate. Estimating default probability is often the job of a rating agency (for S&P, an AAA rating stands for best credit quality while below BBB is considered non-investment or speculative grade). The following 3 tables illustrate global corporate default rates:
Table 2: Annual Number of Global Corporate Defaults 
Table 3: Annual Global Corporate Default Rates By Ratings Category
Table 4: Largest Global Corporate Defaulters Each Year by Outstanding Amount
Together, the default probability and recovery rate can give measurements as to the quality of debt and are often referred to as credit spread. Credit spread is the difference between the yield of a bond and the yield of a risk-free government bond (a good proxy would be a U.S. treasury bond). This difference in yield measures how much riskier a bond is compared to a risk-free bond.
How Credit Derivatives Can Be Used to Transfer Risk or to Speculate
In general, derivatives are financial contracts whose value is derived from the performance of some underlying assets or market factors, created to enable investors and individuals to trade in specific risks. Since banks are in the business of giving loans, they constantly face a great amount of credit risk. Over the past several decades, banks have developed various ingenious credit derivatives to deal with the credit risk of loans. In addition to seeking various ways to reduce credit risk from debtors themselves, banks can use credit derivatives to transfer the credit risk of a loan to a third party.
Theoretically, credit derivatives can help banks and investors to isolate credit risk, price it, and transfer it to others who are willing to take on the risk for a premium. One key accounting benefit of credit derivatives is that they allow banks to transfer away credit risk of loans while still keeping the loans as assets on their balance sheets. With the development of the credit derivatives market, it is also common practice for banks and investors to speculate by holding a derivative position without having the underlying loans. Derivatives are often highly leveraged (often 20 to 1), which means speculators can make or lose large amounts of money off a small movement in price. Speculators add liquidity to the derivatives markets.
Not all derivatives are credit derivatives. There are at least five main categories of derivative products that banks engage in: interest rate swaps, currency futures, equity derivatives, commodity derivatives, and credit derivatives. According to the OCC, four banks dominate the derivatives market ($200 trillion!), and in the 4th quarter of 2012, 80 percent of the U.S. derivatives market consisted of interest rate swaps, while credit derivatives took up 6 percent. The following tables show the total amount and the breakdown of derivative contracts engaged in by these banks:
Table 5: Notional Amount of Derivative Contracts
Table 6: Percentage of Total Derivative Contract Notional Amounts by Category
How Credit Derivatives are Assessed
There are several different types of credit derivative instruments. The most widely used credit derivative is called a credit default swap (CDS). In “The End of the Beginning for the Global Credit Crisis,” the authors explained how banks can use CDSs to insure against default of mortgage-backed securities. In a CDS, two parties enter into an agreement whereby one party pays the other party a periodic premium (usually quarterly) over the life of the contract in exchange for a larger payment should a “credit event” occur. A credit event is a specified event that materially affects the cash flow of the referenced debt such as bankruptcy or insolvency. If the credit event does not occur, the other party does not have to pay any amount. Essentially, a CDS is a form of financial default insurance.
Pricing credit derivatives accurately is a huge challenge. Pricing credit derivatives is more difficult than pricing other types of derivative instruments such as equity derivatives because the underlying asset for credit derivatives is not a traded security. Furthermore, prior to default, it is difficult to distinguish firms that will default from those that will not. Since credit risk is a matter of probabilities, assessing the probability of bankruptcy is difficult:
- One way to price credit default swap is to use historical probabilities. Since S&P has extensive historical data on defaults for publicly issued bonds based on their credit rating and the recovery rates according to the seniority of the debt, this information can be used to estimate future default and recovery rates. However, this methodology has several problems: first, all bonds within a particular rating category are not identical; second, the recovery rates within each level of seniority can vary widely from one bankruptcy to another; and third, historical data can ignore more recent, unique regulatory and economic circumstances—for example, historical default data provided no guidance as to future default rates for subprime cases when house prices were artificially inflated due to banks’ reckless lending practices.
- The second and most widely used method for pricing credit default swaps is based on a mathematical model of the default process developed by Nobel laureate Robert Merton. Starting by mathematically determining the process of valuing debtor’s assets, this asset valuation process is used to assess the likelihood that the future value of the assets might fall below the debt to trigger a default. (In this model, Merton applied the option pricing theory developed by Black and Scholes to model firm’s assets and liabilities. Merton’s model has been extended further by Black and Cox and Longstaff and Schwartz.) Overall, this methodology also has some significant limitations because producing workable solutions based on mathematical models requires many simplifying assumptions.
Despite these weaknesses in the pricing models of credit default swaps, the CDS market exploded with the passing of the Commodity Futures Modernization Act of 2000, which completely deregulated credit derivatives trading (Senator Gramm (R-TX) was the head of the Senate Banking Committee who pushed through this bill in the Senate). This bill included what is now referred to as the “Enron loophole,”a financial regulation that allowed for the creation of speculative energy derivative instruments. (Interestingly, Wendy Gramm, the wife of Senator Gramm, was a former chairman of the Commodity Futures Trading Commission and later a board member of Enron.) As of the end of 2012, the global CDS market reached $25 trillion, surpassing the equity derivatives market and the corporate bond market.
How Banks Can Remove Risky Debt Off Their Books Using Collateralized Debt Obligations
While a CDS can allow banks to transfer away the credit risk of a loan, while keeping the underlying loan on their balance sheets, a collateralized debt obligation (CDO) can remove risky debts off their books. After CDSs, CDOs and variations such as collateralized mortgage obligations (CMOs) constitute the next biggest share in the credit derivatives market. Usually, a CDO requires a special purpose vehicle (SPV), a separate legal entity setup by the bank that buys a pool of loans from the bank and issues the CDOs (payment is made after CDOs are created and sold). This way, the pool of loans can be moved off the balance sheet of the bank and into the SPV. The SPV then issues “tranches” of notes, based on the cash flows generated by the pool, to be distributed according to the seniority and the risk profile of each class of CDO.
These tranches are examined by the rating agencies and receive different ratings based on their seniority and various characteristics of the underlying assets. The general robustness of a CDO can be measured by overcollateralization and interest coverage ratios. The ingenuity of a CDO structure is: 1) it creates the flexibility of varying products with different risk profiles for the investors to choose from; and 2) it produces investment grade products from a pool of not-so-creditworthy loans with the help of the rating agencies. The CDO construction, with its reshuffling of risk profiles, can create a more liquid market for banks’ underlying, poorly traded, risky debt. This process in turn helps banks to clear more debt off their balance sheet and maintain a better equity/debt ratio.
Although a traditional CDO contains a pool of debt as collateral, the pool can be modified to include derivative products as well. When a pool of CDSs, which are derivative instruments, is used as collateral to produce a CDO, it is called a synthetic CDO. When other CDO notes are used as collateral, it is called CDO squared. It is easy to see how the collateral can be “diversified” to include as many different types of debt and derivatives of debt as one can imagine, as long as there is a market for them.
According to the lawsuit, during 2004 to 2007, S&P rated $1.8 trillion worth of CDOs alone. The complaint alleges that S&P knew that their ratings were material to the investment decisions of financial institutions investing in CDOs, and that better ratings on CDOs benefited the issuers (i.e., banks). In turn, helping the issuers with better ratings brought more businesses to S&P, who charged $500,000 to $750,000 for each CDO it rated. During the years 2005 to 2007, the CDO ratings business produced close to $500 million in revenue for S&P. The complaint alleges that S&P defrauded the investors by favoring the issuers, and that they recklessly underestimated the risks of CDOs which produced higher profits for the issuers.
Conclusion: How the Ratings Game Must Be Corrected
There is a clear conflict of interest between the banks that issue these credit derivative instruments and the rating agencies: higher ratings mean more business for the rating agencies who receive fees from the issuers. Admittedly, one could argue that the root problem lies neither in derivative instruments nor the rating agencies, but in the fact that banks use unreasonably high leverage and rely upon short term debt to sustain their capital. Because derivatives can create huge counter party risks which can wipe out banks’ equity quickly, it can also deplete the banks’ market for short term capital to sustain them and cause bank failures.
Although this line of reasoning highlights the dark side of banks’ business tactics and bailout politics, the “ratings loophole” must still be corrected to prevent future breakdowns. How?
- Break up the oligopoly of rating agencies: First, it is apparent that financial regulations in the past have helped to create the current oligopoly of the big three ratings agencies. By requiring regulated financial institutions to rely on the ratings of specified ratings agencies, it has unnecessarily boosted the position that private rating agencies play in the global financial market. If the regulatory dependencies on rating agencies can be decreased and the NRSRO designations loosed, market forces can reduce the power concentration of the big three rating agencies.
- Change the business model: Second, the issuer-pay business model of these ratings agencies created obvious conflict of interest that not only fueled the inflated demand for credit derivative products, but also caused the eventual meltdown. If the business model of rating agencies can be changed to investor-pay only and prohibit issuer-pay, the conflict of interest can be resolved.
In July 2009, the Obama Administration, as part of its proposal for financial reforms, offered legislation that would require more stringent efforts on the part of the rating agencies to deal with the conflicts of interest and to enhance transparency. More specifically, the proposal sought to limit conflicts of interest by barring rating firms from consulting with companies they rate and allowing investors access to all the pre-ratings a corporation received for a particular security before a final rating firm is selected. However, the proposed reform failed to address either of the root causes discussed above and left the rating agencies largely unscathed.
In conclusion, despite the DOJ’s attempt at a civil lawsuit, which will eventually end in a settlement, the regulatory root causes still remain unfixed. How long until the next crisis?
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