PART 4: System-Wide Effects of Credit Rating Downgrades
II. Concerns about the Level of Competition in the Credit
2. Distortions of Competition among Leading Credit
“We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals.[...] Lose the CDO and lose the base business – a self reinforc-ing loop.”545
Concerns have been raised about the level of competition among CRAs.
Some scholars and market participants contend that competition still exists despite the oligopoly of the Big Three.546 Other scholars argue that there is no competition since well-established CRAs keep their market share de-spite their poor rating performance. Some refer to an absence of competi-tion in the credit rating industry.547 Although disparate opinions exist con-cerning the level of competition in the credit rating industry, little research has been carried out to analyze the competition issue. This academic work focuses on the causes and consequences of the competitive concerns in the credit rating industry. It is crucial to understand the competitive environ-ment in the credit rating industry in order to draw meaningful regulatory conclusions.
a. Oligopolistic Market Structure
CRAs operate in an oligopolistic market that offers limited incentives to compete on quality ratings.548 Since the first CRA was founded at the
543 CANTOR &PACKER, The Credit Rating Industry, at 4.
544 JACKSON, The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy, at 312 (arguing that to preserve the value of their credit ratings in this market CRAs need to maintain a good reputation for accurate credit ratings, and that this desire to maintain their reputation enhances the credibility of their credit ratings).
545 CHAN, Documents Show Internal Qualms at Rating Agencies; see also SEC, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, at 26 (quoting a Standard & Poor’s employee).
546 They mainly argue that CRAs compete on prices.
547 See, e.g., Assessing the Current Oversight and Operation of Credit Rating Agencies: Hearing Before the Senate Committee on Banking, Housing and Urban Affairs (statement of GLENN L.
REYNOLDS, Chief Executive Officer, CreditSights), at 8 (specifically referring to the Moody’s and Standard & Poor’s duopoly).
548 EU Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies, at 2.
ginning of the twentieth century, the same three leaders – Moody's, Stan-dard & Poor's and Fitch – have dominated the industry, and continue to dominate it.
The question arises as to whether CRAs are driven by private market forces.
As regards market structure, there is no doubt that the credit rating industry is heavily concentrated.549 Of the Big Three, the most dominant CRAs are Moody’s and Standard & Poor’s since they control over 80% of the credit rating market.550 Some speak of a duopoly of these two CRAs alone.551 The third leading CRA Fitch is also significant, hence reference to an oligop-oly.552 From the point of view of smaller competitors, the credit rating in-dustry is purported to be a 5 to 6 billion US dollars market with Moody's, Standard & Poor's and Fitch controlling more than 90 percent of the mar-ket.553 Further, there are only five global CRAs altogether if we add A.M.
Best and DBRS to the three leading CRAs. Overall there are approximately a hundred and fifty other smaller CRAs which are regional or sectoral.554 Nevertheless, the high level of concentration in the credit rating industry is not sufficient to state that CRAs are immune to competitive forces. It is also important to highlight the impact of high concentration on the market be-havior of the leading CRAs. Above all, regulations created high barriers to
549 See supra Part 2, Chapter 5(I)(3) (addressing the relationship between general competition law and sector-specific regulation).
550 See EU Commission Staff Working Document, Accompanying the Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies, Impact Assessment, at 9 (stating that Moody’s and Standard & Poor’s have a combined market share in excess of 80 percent, and Fitch approximately 14 percent).
551 See generally US Credit Rating Agency Reform Act of 2006, Sec. 2(5) (stating that the two largest CRAs – Moody’s and Standard & Poor’s – serve the vast majority of the market); see, e.g., Assessing the Current Oversight and Operation of Credit Rating Agencies: Hearing Before the Senate Committee on Banking, Housing and Urban Affairs (statement of GLENN L.
REYNOLDS, Chief Executive Officer, CreditSights), at 8; see also CAMANHO,DEB &LIU, Credit Rating and Competition, at 3 (modeling competition amongst CRAs in a duopolistic setting).
552 FLOOD, Rating, Dating, and the Informal Regulation and the Formal Ordering of Financial Transactions: Securitisations and Credit Rating Agencies, at 161 (describing the three leading CRAs as the only CRAs of global reach); FROST, Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies, at 471 (referring to the three leading CRAs as the most influential in the financial markets).
553 Credit Rating Agencies and the Financial Crisis: Hearing Before the House Committee on Oversight and Government Reform (statement of SEAN J.EGAN, Managing Director, Egan-Jones Ratings), at 42.
554 See, e.g., ESTRELLA ET AL., Credit Ratings and Complementary Sources of Credit Quality Information, at 14; see also SHORTER &SEITZINGER, Credit Rating Agencies and Their Regula-tion, at 1 (stating that there are approximately hundred CRAs); see further EU Commission Staff Working Document, Impact Assessment, Accompanying Document to the Proposal for a Regula-tion of the European Parliament and of the Council Amending RegulaRegula-tion (EC) N° 1060/2009 on Credit Rating Agencies, at 7, 38 (stating that approximately fifty regional CRAs are estab-lished in the EU).
entering the credit rating industry, thereby shielding CRAs from competi-tion. The leading CRAs became more powerful and gained market domi-nance due to regulatory reasons. Certified CRAs may, as a result, have little incentive to be responsive to investors’ needs because they can take advan-tage of an oligopolistic market structure.555
Relevant with respect to competition is the price of credit ratings in com-parison to their informational value. Some researchers contend that the credit rating industry is competitive because credit rating prices are low in proportion to the value of the markets in which they operate. However, rat-ing prices are actually very high in terms of the additional value provided by credit ratings. CRAs are excessively profitable compared to the value of the financial information that they provide to the markets. Therefore, com-petition is not about the level of credit rating prices in absolute means, but about the level of credit rating prices as compared with the value of infor-mation. In a competitive market, information of little value should not be sold even at a discount. Absence of competition would imply that CRAs could sell their credit ratings even if they do not provide valuable infor-mation.
In addition, as a signal of anticompetitive practices it is worth mentioning that CRA profit margins are very high.556 Profit margins at the leading CRAs climbed as structured finance revenues rose. Leading up to the sub-prime mortgage crisis Moody's enjoyed profit margins far outpacing those of the mightiest companies including Microsoft and Exxon.557 From 2000 to 2007, Moody's documents revealed operating margins averaging 53 cent, whereas in 2007 Microsoft and Exxon had margins of 36 and 17 per-cent respectively.558
555 BEAVER,SHAKESPEARE &SOLIMAN, Differential properties in the ratings of certified versus non-certified bond-rating agencies, at 305 (adding that Moody’s unresponsiveness to investors’
needs could simply be due to the lack of competition in the credit rating industry).
556 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 655; GILLEN, In Ratings Agencies, Investors Still Trust (quoting DAVID EINHORN, hedge fund manager, Greenlight Capital: “As a classic oligopolist, Moody’s earns exceedingly high margins while paying only the needed lip service to product quality”).
557 MORGENSON, Debt Watchdogs: Tamed or Caught Napping?.
558 Id.; see also 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 (memorandum of Senator CARL LEVIN, Subcommittee Chairman & Senator TOM COBURN, Ranking Member), Exhibit 1a, at 5.
b. Deformation of Incentives in the Credit Rating Industry
“Now, it was a slippery slope, what happened in 2004 and 2005 with re-spect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade. It didn’t really matter. We tried to alert the market. We said we’re not rating it. This stuff isn’t investment grade. No one cared because the machine just kept going.”559
The lack of competition in the credit rating industry is associated with mis-aligned incentives.
In modern financial markets, the quality of credit ratings may not be as high as would be the case if the credit rating industry were more competitive.560 Indeed, credit rating inaccuracies can result from distortions of competition.
With respect to the subprime mortgage market, inaccuracies were observed in the form of inflated credit ratings. For instance, an extreme example was the case of Moody's: Moody's was eager to find a way for the novel instru-ments to be rated triple-A; when Moody's discovered flaws in its rating models, it adjusted the models so that the instruments could maintain their high credit ratings.561 Moody's would not have maintained inflated credit ratings if its behavior had been driven by competitive market forces. CRAs should face reputational costs when rating so that they are incentivized to generate accurate and timely information.
The behavior of the leading CRAs – Moody's and Standard & Poor's – in the years preceding the subprime mortgage crisis has been referred to by the US Federal Crisis Inquiry Commission (FCIC) as the consequence of competitive pressures.562 Critics contend that CRAs inevitably compete for a share in the market, either on price or by lowering their rating standards to attract their clients.563 However, the problem did not result from competi-tion in general but from ill-conceived competicompeti-tion. Competitive pressures can be counterproductive if they create wrong incentives. The response to past rating failures comes from competition based on credit rating quality.
Above all, regulation can distort competition. Rating-based regulations pre-vent reputational constraints from playing their disciplining role in the
559 Id. at 161 (quoting RAYMOND W.MCDANIEL, Chairman and Chief Executive Officer, Moody’s).
560 HILL, Regulating the Rating Agencies, at 44 (proposing to address the problem with regulation).
561 HILL, Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?, at 9.
562 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, Exhibits, at 1-4.
563 VAN DUYN, Reform of Rating Agencies Poses Dilemma (quoting WARREN BUFFET, Chairman and Chief Executive Officer, Berkshire Hathaway Inc., who adds that a monopoly might be the best answer since one CRA would not need to compete).
it rating industry. Regulatory reliance on credit ratings artificially gives recognition to a few certified CRAs.
Finally, one major source of a lack of competition among leading CRAs comes from the payment structure. Since the 1970s, the leading CRAs have increasingly been paid by issuers and not investors. The resulting conflicts of interest jeopardize credit rating quality. CRAs have less need to be re-sponsible to investors. Issuer-paid CRAs tend to rate as high as possible to generate issuers' fees but in so doing disregard investors' interests.