PART 4: System-Wide Effects of Credit Rating Downgrades
I. Core Activities of the Credit Rating Agencies
CRAs are business institutions dealing with information relevant to the fi-nancial markets. They are involved in several activities that can directly satisfy the needs of investors as well as issuers. Broadly speaking, their business activities concentrate on two key aspects. First and foremost, CRAs typically provide investors with external credit ratings, i.e., they help them make investment decisions. Second, they may also engage in offering ancillary services to issuers.
135 See PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 644.
136 Technology makes information easily available on a large scale.
1. Providing Investors with External Credit Ratings
“Ratings are a fact of life in modern society where non-specialists want complex information distilled by experts into easy-to-use symbols and rankings.”137
a. Definition of a Credit Rating
The traditional CRA activity consists of selling external credit ratings.
Through their credit ratings CRAs assess the creditworthiness of borrowers and debt instruments.138 This activity allows for the transfer of information from borrowers to investors. Credit ratings reflect a CRA’s opinion of how likely it is that an issuer will repay a particular debt or financial obligation, or its debts generally.139 Two elements are at the core of every credit rating decision. First, the credit information is based on the probability of default of a borrower or a debt instrument. Second, CRAs assess the expected re-covery in the event of default. Third, for investments with multiple assets, CRAs also determine the correlation of defaults.140 The resulting credit rat-ings give a single ranking that accounts for these relevant assumptions.
The rating scale developed by Standard & Poor's is the best-known and the most widely used by CRAs: AAA; AA; A; BBB; BB; B, and so on.141 The triple-A credit rating is the highest rating. Rating scales make an important distinction between investment-grade and speculative-grade ratings.142 On Standard & Poor's scale the investment-grade rating comprises BBB- or above.143
Further, there is a distinction between external and internal credit ratings.
On the one hand, external credit ratings are the credit ratings provided by independent private entities such as CRAs. On the other hand, internal
137 COFFEE JR., Gatekeepers: The Professions and Corporate Governance, at 283.
138 US Credit Rating Agency Reform Act of 2006, Sec. 3(a) (codified as amended in the US Securities Exchange Act of 1934) (describing a credit rating as an assessment of the credit-worthiness of an obligor as an entity or with respect to specific securities or money market instruments).
139 IOSCO, Report on the Activities of Credit Rating Agencies, at 1.
140 COMMITTEE ON THE GLOBAL FINANCIAL SYSTEM (CGFS), Ratings in Structured Finance: What Went Wrong and What Can Be Done to Address Shortcomings, at 13.
141 See, e.g., BCBS, International Convergence of Capital Measurement and Capital Standards, A Revised Framework (Basel II), para. 50 and accompanying note (stating that the notations of the Basel II framework follow the methodology of Standard & Poor's as a reference); see also WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 29.
142 SINCLAIR, The New Masters of Capital, American Bond Rating Agencies and the Politics of Creditworthiness, at 35; BLAUROCK, Verantwortlichkeit von Ratingagenturen – Steuerung durch Privat- oder Aufsichtsrecht?, at 604.
143 See, e.g., WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 30.
credit ratings are generated directly by debt issuers and investment entities of financial institutions such as banks.144
Finally, CRAs have always insisted that their credit ratings merely provide the markets with their own opinions without actually recommending any rated product.145 However, although CRAs deliver mere opinions about the creditworthiness of borrowers or debt securities, credit ratings are not un-testable assertions given that rating performance can be measured ex post.146 Moreover, the trend toward the establishment of a liability regime for CRAs acknowledges the fact that credit ratings are more than opinions protected by the constitutional freedom of speech.147 CRAs provide com-mercial speech and need to be accountable.148 Therefore, CRAs are judged by the investing community in regard to credit rating accuracy and can be judged by the courts in regard to potential securities fraud.
b. Financial Information Embedded in Credit Ratings
Broadly speaking, CRAs assess the creditworthiness of borrowers and debt instruments. Credit ratings are traditionally assigned to the credit risk of long-term corporate bonds, and additionally to the credit risk of Asset-Backed Securities (ABS), bank certificates of deposit, commercial paper and medium-term note programs, sovereign bonds, municipal bonds, pre-ferred stock, private placements, and shelf registrations.149 Either the debt-issuing entity or the debt instrument is rated. Over the last four decades CRAs have entered the business of rating innovative financial instruments.
New business opportunities have led them to rate increasingly complex products.
CRAs gather and select relevant information, eventually issuing credit rat-ings. Through this process, a vast amount of qualitative and quantitative information on credit quality is distilled into a simple ordinal ranking.150 In
144 BLAUROCK, Verantwortlichkeit von Ratingagenturen – Steuerung durch Privat- oder Aufsichtsrecht?, at 604.
145 See, e.g., Credit Rating Agencies and the Financial Crisis: Hearing Before the House Committee.
on Oversight and Government Reform, at 117 (statement of RAYMOND W.MCDANIEL, Chairman and Chief Executive Officer, Moody’s).
146 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 165-166.
147 See infra Part 2, Chapter 4(IV) (discussing the removal of the special treatment for CRAs with respect to liability).
148 See infra Part 2, Chapter 4(IV)(2)(a) (explaining that credit ratings should be regarded as commercial speech).
149 ESTRELLA ET AL., Credit Ratings and Complementary Sources of Credit Quality Information, at 97.
150 Id. at 126.
fact, CRAs only assess credit risk.151 Generally speaking they do not evalu-ate the other risk components which must be assessed by investors them-selves.
Credit ratings can be classified into three main categories: corporate ratings, structured finance ratings and sovereign ratings.
(i) Corporate ratings
Corporate ratings are assigned to all kinds of companies in the private sec-tor. For instance, rated entities can be financial institutions such as banks, securities firms, insurance, real estate and non-bank finance companies.
With respect to corporate ratings, CRAs are active in both equity and debt markets.
(ii) Structured finance ratings
Structured finance ratings comprise the assessment of novel instruments by CRAs. Indeed, CRAs started to operate in the structured finance segment in the mid-1970s.152 The central assumptions at the core of CRA models in structured finance are default rates, recovery rates and correlations.153 Leading CRAs argued that their credit ratings were consistent between tra-ditional and novel instruments, but this was seriously questioned in the af-termath of recent financial debacles.154
(iii) Sovereign ratings
CRAs rate government debts. In comparison to the assessment of private entities through corporate ratings, sovereign ratings are attributed to entities in the public sector. The art of forecasting the likelihood that a government will default on its debt is particularly challenging due to the fact that the central issue in sovereign borrowing is not the ability to pay but rather the
151 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 157.
152 IOSCO, Report of the Task Force on the Subprime Crisis, at 20 (stating that the leading CRAs first issued credit ratings for Mortgage-Backed Securities (MBS) in the mid-1970s).
153 CGFS, Ratings in Structured Finance: What Went Wrong and What Can Be Done to Address Shortcomings, at 13.
154 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 161. In structured finance ratings, the estimate of recovery rates plays a crucial role in contradistinction to its lesser importance in corporate ratings (in corporate ratings, default rates play the most significant role; in structured finance ratings, the highest tranche of a CDO – for instance – may have a relatively low default rate but a very low recovery rate so that investors lose almost everything in the event of default).
Estimating the correlation of defaults plays a crucial role in structured finance ratings but is irrelevant in corporate ratings.
willingness to pay.155 This requires interpretive work on the part of the CRAs. At any rate, sovereign ratings affect every other bond rating in the private sector because of sovereign ceilings. Sovereign ceilings mean that CRAs do not generally rate domestic firms’ foreign-currency debt higher than that of their government.156
2. Counseling Issuers in Doing Ancillary Business
In addition to issuing credit ratings, some CRAs also offer ancillary busi-ness services. Although this activity is not regarded as the typical agency product, it has gained momentum over the past decades. Accordingly, ancil-lary business grew at an extraordinary pace until generating substantial profits for CRAs. The significance of these new activities eventually raised concerns about CRAs’ corporate governance. Confusion has especially arisen during the 2007-2009 financial crisis.
For instance, ancillary services include ratings assessment services whereby issuers present hypothetical scenarios to the CRA to determine how their credit rating might be affected by a proposed business activity; other ser-vices may include risk management and consulting serser-vices to help finan-cial institutions manage credit and operational risk.157 CRAs provide this service in exchange for a fee.
The practical importance of CRAs’ ancillary services is mainly linked to structured products. In fact, CRAs advise arrangers about the rating conse-quences of proposed structures. Before issuing the financial product, the arranger can change its structure according to the feedback of the CRA.
Ancillary services give the issuers the opportunity to work with CRAs on the composition of structured products.158 This process allows issuers to get higher credit ratings than they would have had had theynot implicated the CRA in the structuring process.
Concerns have especially been raised about ancillary business services with respect to the financial crisis triggered in 2007. In the subprime mortgage market in particular, issuers did not purchase these ancillary services to get professional advice but rather to know how to take advantage of the rating
155 ABDELAL, Capital Rules, The Construction of Global Finance, at 162 (explaining that no third party can enforce a sovereign debt contract; moreover, sovereign governments never really run out of assets to cover their obligations although they may fall short of foreign exchange or choose to repay one debt instead of another).
156 See ABDELAL, Capital Rules, The Construction of Global Finance, at 162.
157 IOSCO, Report on the Activities of Credit Rating Agencies, at 4.
158 MORGENSON &STORY, Rating Agency Data Aided Wall Street in Deals.
process.159 Doing ancillary business may generate conflicts of interest.160 The purchase of ancillary services remains therefore closely connected with the issuance of credit ratings. The question therefore arises as to whether the formulation of credit ratings should be completely separate from the ancillary services offered to issuers on the engineering of complex financial products.161