General criticism levelled at CRAs

In 2007, the credit rating system was said to go “hand in hand with the development of large, deep and international markets. It is a precondition and a tool for ensuring the smooth functioning of these markets”.⁵⁶ And yet, by 2008, CRAs - alongside references to “fat-cat (investment) bankers”⁵⁷ and “casino banking”⁵⁸ - were generally disparaged in publications by academic scholars and tabloid journalists alike. The notion of CRAs as a reliable and cost-efficient method of constraining and disciplining the behavior of asset managers and issuers⁵⁹ was quickly eroded as a consequence of the financial markets’

heightened sensitivity to the successive downgrading of securities during the GFC. The heightened media exposure also highlighted the public’s perception of the power and influence conveyed in CRAs’ ratings, especially when concerning the downgrading of sovereign debt. However, not all of the criticism levelled against CRAs were either new or unique to the GFC.

56 Jonathan Katz, Emanuel Salinas & Constantinos Stephanou, Credit Rating Agencies: No Easy

Regulatory Solutions, 8 CRISIS RESPONSE, Oct. 2009, at 7 (comments by Christian Noyer, Governor of the Bank of France).

57 Keith R. McCullough, Economic Commentary - Fat Cat Bankers, FORBES, Dec. 14, 2009, http://www.forbes.com/2009/12/14/fat-cat-bankers-markets-economy-obama.html.

58 See e.g., Stephen Spratt, Why King is right about Casino Banking, GUARDIAN, Oct. 22, 2009

http://www.guardian.co.uk/commentisfree/2009/oct/22/mervyn-king-casino-banking-regulation; Howard Davies, Casino banking' days are over, TAIPEI TIMES, July 17, 2009 available at

http://www.taipeitimes.com/News/editorials/archives/2009/07/17/2003448850; and Thomas

Katzensteiner & Ulric Papendick, Das Spiel Ist Aus [transl.:The Game is Over], MANAGER MAGAZIN, Dec. 2011, at 56-66.

59 Richard Sylla, A Historical Primer on the Business of Credit Ratings (2001), at 27.

This chapter introduces some of those most common criticisms that were already being leveled against the industry prior to the GFC, which are summarized in Figure 2 below. The diagram classifies the criticism along industry, internal, external and investor specific lines to demonstrate how these factors, which although falling short of asserting causality,⁶⁰fc still highlight the interconnectedness and in some instances the co-dependency, of various intrinsic and extrinsic drivers that when taken together propagate the sustained production of poor quality ratings.

In the U.S., a bipartisan study by the U.S. Senate Subcommittee on Investigations led by Senators Levin and Coburn, reported that “… []high risk lending by U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality financial products designed and sold by some investment banks [had] contributed to the financial crisis”.⁶¹ In Europe, a February 2009 report by the ‘High-Level Group on Financial Supervision in the EU’ chaired by Jacques de Larosiere, had also listed credit rating agencies among the main contributors to the financial crisis.⁶²

This report also cited the failure by senior executives to understand the “new, highly complex financial products they were dealing with”; and “the over-reliance on the risk

60 See e.g., Basic Inc. v Levinson, 485 U. S. 224, 243 (1988) In order to establish liability (“[the] requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury” is necessary. See also Aff’d Ute Citizens of Utah v United States, 406 U. S. 128, 154 (1972) (“causation in fact” requirement).

61 Carl Levin & Tom Coburn, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, SENATE COMM.HOMELAND AND GOVERMENTAL AFFAIRS, April 13, 2011, passim,

http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf.

62 The other contributors identified by the report were: macro-economic issues (e.g. ample liquidity and low interest rates); risk management failures (e.g. failures in assessing risk by market participants,

regulators and supervisors); Corporate Governance failures (e.g. failure by senior executives to understand the “new , highly complex financial products they were dealing with”); and Regulatory, Supervisory and Crisis Management failures (e.g. “the over-reliance on the risk management capabilities of banks and the adequacy of ratings”).

management capabilities of banks and the adequacy of ratings”.⁶³ Next, the report also found that CRAs had lowered the perception of risk by assigning AAA ratings to structured products and thereby putting them on par with similar ratings assigned to standard sovereign and corporate bonds in the minds of investors. Support for this position is found in a 2009 study which concluded that the ABS risk properties differ systematically and significantly from those of similarly rated straight bonds.⁶⁴

Figure 1: Criticism overview

A further criticism arose from the observed higher profitability margins earned by CRAs from rating structured products relative to other security types. AAA-rated

63 de Larosiere, Jacques, “The High-Level Group on Financial Supervision in the EU report” European Commission, 25 Feb., 2009, at 9-10

http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf (last accessed May 23, 2016).

64 See e.g., Jan-Pieter Krahnen & Christian Wilde, CDOs and Systematic Risk: Why Bond Ratings are Inadequate, (CFS Working Paper No. 2009/11, June, 2009) at 16 (“risk management based on traditional bond ratings applied to structured finance transactions is not reliable”).

structured products tended to pay relatively higher yields than the sovereign and corporate alternatives and thus attracted large numbers of investors. CRAs were often able to earn as much as three times more (e.g. $300K-$500K, and sometimes even up to $1 million per structured product rating) ⁶⁵ from a rating structured financial product than from rating corporate bonds.

S&P and Moody’s have experienced similarly excellent financial performance⁶⁶ and charge similar rates, in the region of 11 bps (i.e. basis points) for structured finance products as opposed to 4.25 bps for corporate bonds.⁶⁷ CRAs also earned fees for rating structured investment vehicles (i.e. SIVs) on top of the fees for rating their underlying assets. Moody’s Structured Finance generated 43 % (i.e. $715 Mio) of the firm’s revenue in 2005, and 53% in 2007. Such growth enabled Moody’s to achieve stellar average operating margins of 53% in the period 2000-2007; higher than either Exxon or Microsoft.

In fact, Moody’s achieved the highest operating margins in the S&P 500 -- five years in a row.

In their defence, CRAs do not appear to have propagated the notion that AAA-rated structured products were as likely to default as AAA-rated German sovereign bonds.

Furthermore, it is worth re-emphasizing that “any rating necessarily describes a real chance of default. In other words, a default per se says nothing on the quality of the rating analysis”.⁶⁸ Hill asserts that the commonly-levelled accusation that CRAs have been

65 e.g., FCIC, Report on the Causes of the Financial Crisis (2011) (rating agency fees were typically between $250K and $500K for CDOs), at 146.

66 California Public Employees’ Retirement Systems v. Moody’s Corp., 09-490241, Superior Court of California, County of San Francisco, at 8 (S&P revenue increased 800% (2002-2006), cited in Plaintiff’s Complaint (hereafter “CalPERS Complaint) filed with the court), available at

http://online.wsj.com/public/resources/documents/calpers.pdf; (S&P revenue increased 800% (2002-2006). Plaintiff’s arguments in Complaint filed with the court), at 8.

67 Id., CalPERS Complaint.

68 Fabian Dittrich, The Credit Rating Industry: Competition and Regulation, Note, (2007) at 144.

willing to sell high ratings to the issuers “cannot in any straightforward way be correct”;

suggesting instead that CRAs and other market actors erred in convincing themselves that the ratings awarded to subprime securities were in fact warranted.⁶⁹

However, the implication from the afore-mentioned reports suggests that CRAs were either not deliberate enough about explaining the distinction between the classes of AAA-rated securities or even if they had been, that they nevertheless still unfairly benefitted financially from the public’s continued misconception and ignorance about the material differences in inherent risk between the two security classifications. Either way, a compelling argument can be made to support the view that CRA rating quality under-performance has been correctly cited and that steps should now be taken to rectify the problem.