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The role of credit rating agencies in the global financial system and the associated problems

A critical analysis based on the example of the subprime mortgage crisis

Seminararbeit 2019 16 Seiten

BWL - Investition und Finanzierung

Leseprobe

Contents

1. Introduction

2. Background on credit rating agencies
2.1 The role of ratings in the financial system
2.2 The rating process

3. Problems with CRAs
3.1 General criticism
3.2 The market of CRAs
3.3 Who pays the rating?
3.4 Consulting
3.5 Lack of accountability

4. The subprime mortgage crisis
4.1 The formation of the bubble
4.2 Conversion from mortgages into CDO's
4.3 The role of the CRAs in subprime mortgage crisis

5. Conclusion

List of abbreviations:

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

Credit rating agencies have been a very important part of the financial system for a long period of time. The purpose of a CRA is to provide a reliable rating about the creditworthiness of a lender. The rating gives investors information about the risk of an investment. Moreover, since interest rates are strongly correlated with the risk of credit default, market participants are able to use this information to calculate an appropriate interest rate for an investment.

The area of conflict in which the credit rating agencies operate is characterised by an extremely great responsibility as gatekeepers of the financial markets and institutions in the financial system in general and their natural pursuit of profit as private companies.

One the one hand the rating agencies have been playing a big role in healing the information asymmetry on the capital markets between creditor and debtor but on the other hand there is a lot of criticism about their role in the subprime mortgage crisis in 2008 and their business practices in general.

The objective of this seminar paper is to illuminate the work and role of credit rating agencies in the global financial system and to explain and understand the general criticism directed at them. In addition, their special part in the subprime crisis of 2008 will be analysed and an estimation will be made of how much responsibility they bear in the crisis.

2. Background on credit rating agencies

The CRAs originated in the United States in the early 1900s with the advent of the railway companies, which entailed the growth of a large corporate bond market.1 The sheer number and geographical distances between borrowers and lenders reached a point where the financial press, investment bankers and the creditor himself could no longer adequately certify the creditworthiness of a debtor.

In times of industrialisation and later globalisation the relation between borrower and lender got even more complex and indirect. With the growth of the complexity of debtor and creditor relationship the role of CRAs became even more important too.

Obviously big international companies evaluate the creditworthiness of organisations like companies or even countries. So, they do not provide information about the creditworthiness of consumers like the SCHUFA Holding AG in Germany. In the following terms like debtor and creditor or borrower and lender are generally used to describe not individuals but organisations.

2.1 The role of ratings in the financial system

Nowadays CRAs play a crucial role in the financial system. They have a huge impact on an issuer’s existence by opening the global financial market for him and strongly influence his funding cost with their judgment about his creditworthiness respectively the one of his financial instruments.2

They act like a gatekeeper for the global capital markets because many investors only deal with financial instruments that are rated by the CRAs. In addition, there are institutional investors such as pension funds who are not permitted by law to invest in financial products below a certain rating or without a rating. This shows the undeniable benefit resulting from the existence of the CRAs. The rating agencies provide information and valuations on which all market participants can agree, which are standardised and internationally recognised. Without this authority, a globally networked and active financial system such as we are experiencing would be hardly imaginable.

2.2 The rating process

Ratings can be initialised in two ways. The usual procedure is as follows: A potential creditor asks an agency for a rating in order to attract investors and thus capital. In this case the potential creditor contacts a CRA and provides them with internal data, that illuminates the financial situation of the company and the expectations for the upcoming years. In this case, the costs of the rating are borne by the audited party.

The other possibility is an unsolicited rating. In this case the CRA may not take the support of the organisation for granted. So, in some cases the agency needs to use secondary sources of information about the debtor, which are already available for the market, in order to evaluate the situation of the organisation.

On the basis of this information, the CRAs then use mathematical models for the quantitative rating with which various scenarios of events and cash flows are simulated in order to provide a probability that the debtor will meet his obligations entirely and on schedule. With the rating, the CRAs also publish the key assumptions underlying their quantitative analysis. However, more detailed information on the calculations remains in the dark. The rating agencies refer to the protection of business secrets. Just as untransparent for both debtors and creditors is the selection of debtors respectively their securities that are examined. The same applies to the modification of a rating.

As mentioned earlier, the rating of the CRAs is an assessment of the creditworthiness of a financial instrument or its issuer. In general, they reflect the probability that lent capital, including interest, will be repaid to is owner at the scheduled time.3 In order to depict to risk of a financial instrument or its issuer, the CRAs classify the risk into classes. The following table shows the possible rating a debtor can get from the three biggest CRAs.

Abbildung in dieser Leseprobe nicht enthalten

The grade should reflect the risk of credit default. For example, Moody,s Five-Year Default Rates (between 1983 and 200) were 0.8 percent for all companies rated A3 or higher; 11.4 percent for Ba3 or higher. Companies with grade C have a 52.4 percent Five-Year-Default Rate.4

The rating grade is especially important for institutional investors because, as already mentioned, some of them may only invest in financial instruments that have a certain minimum grade. The standard for this is a "BBB"- respectively "Baa"- rating. Investments with these or higher ratings carry a so-called investment grade.

3. Problems with CRAs

3.1 General criticism

In general, it is criticized that the ratings of the agencies often only react to events on the market instead of forecasting them. The downgrade only happens when problems with the issuer actually arise. The investment bank Lehman Brothers, for example, had an investment grade rating from all the three big rating agencies on the day of its insolvency.5

Furthermore general, the IMF claims that earlier crises also showed that rating agencies amplify systemic risks because they act procyclical. In other words, they promote investment in periods of strong economic growth, through their ratings, which can promote the formation of speculative bubbles, and in periods in which companies or countries find themselves in financial difficulties, they intensify the problem by lowering their ratings. They can therefore act as a form of multiplier.6

As already mentioned, the ratings are relatively opaque. Due to the protection of business secrets, the rating agencies do not publish the mathematical models behind the ratings. In this way it is not possible even for large international investors but also for companies to recognize the quality of a rating.

3.2 The market of CRAs

A major point of criticism is the market structure of the Credit rating industry. Indeed, there are many CRAs, but the market is an oligopoly. As is known from the oligopoly theory, markets with a few suppliers with strong market power are problematic because there are strategic dependencies regarding price and quantity setting between the oligarchs. In many cases, this results in coordinated behaviour, the so-called collusion or even cartel formation. Oligopoly markets are beyond that characterised by weak competitive pressure and a tendency towards price rigidity. The following graphic shows the market shares of CRAs in the European Union.

[...]


1 Cf. Levich et al. 2002

2 Cf. Kiff et al. 2012

3 Ulrich Chiwitt 2014

4 International Monetary Fund 2010 p.90

5 Ulrich Chiwitt 2014 p. 3

6 Sy 2009 p. 3

Details

Seiten
16
Jahr
2019
ISBN (eBook)
9783668993914
ISBN (Buch)
9783668993921
Sprache
Englisch
Katalognummer
v494202
Note
Schlagworte
Credit rating agencies subprime crisis regulation conflict of interest

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Titel: The role of credit rating agencies in the global financial system and the associated problems