PART 4: System-Wide Effects of Credit Rating Downgrades
II. Crucial Role Played by Credit Rating Agencies in the
“Rating agencies continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”688
1. Credit Rating Agencies’ Key Position in Structured Finance The rapid expansion of structured products is closely associated with the issuance of structured finance ratings. The leading CRAs first issued credit
685 WHALEN, The Subprime Crisis, Cause, Effect and Consequences, at 6.
686 SOROS, Do Not Ignore the Need for Financial Reform.
687 Id.
688 Wall Street and the Financial Crisis: The Role of Credit Rating Agencies, Hearing Before the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Governmental Affairs, Exhibit 27, at 124 (quoting a Standard & Poor’s employee).
ratings for MBS in the mid-1970s.689 Relating to securitized assets they be-gan rating cash CDOs in the late 1990s and synthetic CDOs in the early 2000s.690
In fact, the shift to a market-based financial system has raised new issues as regards the role of information intermediaries such as CRAs. Banks needed novel instruments to be rated by an independent and reputable third party, and the three leading CRAs offered this service.691 CRAs have thus played a significant role in the functioning of the originate-and-distribute model of intermediation.692 The objective of the study is to examine how CRAs helped the financial institutions that developed the complex financial in-struments. They were an essential part of the chain. Without their invol-vement, structured finance could not have grown at such an extraordinary pace.
The favorable credit ratings of the leading CRAs were crucial for investor acceptance of the new financial instruments.693 Investors relied on CRAs’
assessments of the riskiness of securitization products because of their complexity and because the contents of the underlying asset pool were fre-quently not revealed.694 Lack of transparency in the financial markets in-creased the importance of credit ratings.
The traditional rating scale was used by CRAs in the structured finance segment. CRAs argued that their credit ratings were consistent between tra-ditional and novel instruments.695 They were not willing to develop differ-ent credit rating methodologies for traditional products and structured products because investors were already familiar with corporate ratings, and were reassured by the comparison made possible between traditional and novel products.696 Linking the risk of novel products to the traditional rating scale was therefore crucial to the growth of structured product mar-kets.697
689 IOSCO,Report of the Task Force on the Subprime Crisis, at 20; see also HILL, Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?, at 5.
690 IOSCO,The Role of Credit Rating Agencies in Structured Finance Markets, at 5.
691 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 18.
692 ARNER, The Global Credit Crisis of 2008: Causes and Consequences, at 22.
693 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 119.
694 HOUSE OF LORDS,Banking Supervision and Regulation Report, at 40.
695 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”, at 161 (adding that, however, ratings on novel financial products behaved differently from corporate ratings during the recent financial crisis).
696 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 16.
697 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”, at 161.
As a consequence of the evolving financial market structure, the leading CRAs may have acted as gatekeepers in the development of the structured finance market.698 The dramatical growth of the structured finance segment would not have been possible without their involvement. In practice the leading CRAs’ gatekeeper status seems unlikely to change in the near fu-ture.699
2. Credit Ratings as a Marketing Tool for Securitized Assets The involvement of CRAs deserves particular attention in the securitization process. The key to a successful securitization is a high credit rating by one of the leading CRAs.700 Without the sanction of the leading CRAs, most securitization would fail.701 Therefore, the sale of most structured securities in the primary market was rating-dependent.702
Issuers take advantage of high credit ratings to sell their products. Debt rat-ed investment-grade tends to have more marketability, liquidity, and a low-er intlow-erest rate than othlow-erwise identical debt that is not rated.703 As a conse-quence, to obtain a high credit rating can become a motive for the creation and marketing of securities.704 The best example in the subprime mortgage market was the pooling and re-packaging of triple-B-rated tranches into a new CDO structure with a view to enhancing the overall rating of the asset pool. Securitization offered the opportunity to transform below-investment-grade assets into triple-B to triple-A assets, i.e. investment-below-investment-grade assets.705 The newly obtained triple-A-rated tranches could be sold off to a broad in-vestor base eager to buy highly rated assets.
The reason is that triple-A assets with higher yields than other triple-A as-sets were especially appealing to investors. Indeed, the use of credit ratings permitted investors to buy triple-A-rated assets that paid 20 times the spread of other triple-A-rated instruments.706
698 Id. at 176.
699 Id. at 178.
700 FLOOD, Rating, Dating, and the Informal Regulation and the Formal Ordering of Financial Transactions: Securitisations and Credit Rating Agencies, at 154.
701 Id. at 160-161.
702 ROSNER, Toward an Understanding: NRSRO Failings in Structured Ratings and Discreet Recommendations to Address Agency Conflicts, at 12.
703 HILL, Regulating the Rating Agencies, at 53.
704 THE ECONOMIST, Exclusion zone, Regulators Promise a Belated Review of the Ratings Oligopoly, at 65-66.
705 CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 4.
706 PARTNOY, Do away with rating-based rules.
To some extent, there is a regulatory explanation since a certain category of investors was restrained from buying speculative-grade assets. Accordingly, investment-grade ratings remained an important requirement in marketing structured finance products to a broader investor base.707 Due to regulatory concerns, investment-grade ratings enhanced the marketability of the rated assets, thereby making them available to a broader investor base. CDOs allowed these investors to gain exposure to assets that, on their own, had been too risky.708 Through the securitization process, issuers could make these investment available to a broader investor base.
As a consequence, investors subject to regulatory investment limitations were particularly attracted to triple-A-rated structured credit products that had a higher yield than other safe assets.709 For institutional investors in particular they seemed to constitute a great opportunity for gain as they were simultaneously considered safe.
3. Proliferation of Rating-Driven Transactions
Some transactions are merely designed to capture high credit ratings.710 To some extent, financial institutions learned how to take advantage of rating models and build structured products with the sole purpose of attracting higher credit rating from the CRAs. CDO structures reflect the situation in the most illustrative way. Since the tranching could raise the credit rating of some parts, many of the subprime mortgages were included in structured finance products.711 In some structured finance products, the sum of the parts could even be greater than the whole, which should not be possible in a competitive and efficient market.712 This situation led banks to re-package triple-B CDOs and make a profit from the transaction. The CDO machine generated significant revenues partly thanks to generous credit ratings.
The rating process helped issuers get around the rating models.713 Issuers first hired a CRA to rate the financial instruments. If not satisfied with the
707 CGFS,Ratings in Structured Finance: What Went Wrong and What Can Be Done to Address Shortcomings, at 9.
708 BARNETT-HART, The Story of the CDO Market Meltdown: An Empirical Analysis, at 7.
709 INTERNATIONAL MONETARY FUND (IMF), Global Financial Stability Report, Containing Systemic Risks and Restoring Financial Soundness, at 57.
710 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 668-670.
711 IMF, Global Financial Stability Report, Containing Systemic Risks and Restoring Financial Soundness, at 57.
712 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 667.
713 MORGENSON &STORY, Rating Agency Data Aided Wall Street in Deals.
determination of the CRAs, issuers had the opportunity to adjust the struc-ture to provide the requisite credit enhancement of the “senior” tranche in order to get the triple-A rating.714 This endeavor is evidence that the trans-action was rating-driven. The added credit enhancement was merely pro-vided in order to get a higher credit rating.
Last but not least, the investment-grade ratings allowed a market for side bets to develop alongside the subprime mortgage market. Depending on the way they were used, synthetic CDOs allowed market participants to place giant bets that had no other economic purpose than to bet against the sub-prime mortgage market. Synthetic CDOs replicated the cash flow structures of cash CDOs and significantly increased market exposure to the subprime mortgage market. High credit ratings allowed the market for synthetic CDOs to grow at an extraordinary pace. Without the labeling provided by leading CRAs, this market would have never reached such a significant proportion. Criticism has been voiced about the fact that synthetic CDOs did not add economic value to the financial system.715 Only high credit rat-ings were able to make investors purchase securities without caring about the content of the assets. Hence synthetic CDOs were able to find investors as long as they were marketed as safe by the leading CRAs.