Credit Rating Agencies Essay

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Introduction



Today, credit rating agencies such as Moody’s, S&P and the Fitch Group wield global influence by assigning credit ratings to bonds and even countries that have an enormous impact on investor confidence. Following the 2008 subprime mortgage meltdown and the Great Recession of 2009 that resulted, there were growing calls for reform of the rating processes used by credit reporting agencies. To determine the facts with credit rating agencies, this paper reviews the literature to provide an overview of these for-profit organizations and a description of the purposes they serve. An examination of the regulatory environment in which credit rating agencies operate is followed by an analysis of current issues with credit rating agencies in the United States and abroad. Finally, a summary of the research and important findings concerning credit ratings agencies and ways to improve them are provided in the conclusion.

Credit Agencies Overview



What are credit agencies? Today, there are ten statistical rating organizations that enjoy national recognition and whose ratings are used in certain regulations, including the so-called “Big Three”:  Standard and Poor’s (S&P), Fitch and Moody's Investors Service (Regulators OK overhaul of credit rating agencies, 2014). Living up to their designation, the Big Three continue to dominate the credit ratings market today (New rules will fail to reform ratings agencies, 2014). In addition, in recent years, credit agencies have been criticized for their focus on profit-making (Klein, 2009). Notwithstanding these constraints, CRAs play a valuable role in modern society as discussed below.

What purposes do they serve? Credit rating agencies, also known as credit bureaus or credit ratings agencies (CRAs) are organizations that aggregate and disseminate credit information for use by public and private sector organizations in evaluating creditworthiness (Mierzwinski & Chester, 2007). Besides identifying the creditworthiness, CRAs also provide valuable information to public and private sector organizations to facilitate and fine-tune marketing initiatives (Klein, 2009).

Regulatory Environment



Current CRA regulation in the United States. At present, the Credit Rating Reform Act of 2006 and the Dodd–Frank Wall Street Reform and Consumer Protection Act (discussed further below) are the primary controlling laws that regulate CRAs in the United States. Likewise, the all-but-in-name United States of Europe has regulatory guidance in place for their CRA sector as described below.

Current CRA regulation in the EU.  In an effort to harmonize regulatory oversight of CRAs in Europe, these organizations must now follow more stringent guidelines that make them increasingly accountable to EU stakeholders (Hughes, & Augier, 2014). The new rules took effect June 20, 2014 and are also targeted at reducing over-reliance on credit ratings and improving the quality of the rating process as well as requiring credit rating agencies to be more transparent in their rating of sovereign states (Hughes & Augier, 2014). According to the EU’s press release, “The new rules will also contribute to increased competition in the ratings industry currently dominated by a few market players and will reduce the over-reliance on ratings by financial market participants” (Hughes & Augier, 2014, para. 2). These reforms are intended as reassurances to nervous European consumers and investors to prevent future financial crises (Hughes & Augier, 2014).


Recent changes to CRA regulations. In the United States, number of issues that may affect investors may be unregulated to some extent absent further regulatory or legislative action including the unregulated nature of the methodology used by CRAs (Mierzwinski & Chester, 2007). In the European Union, though, revised rules adopted in May 2013 included mandatory rotation of CRAs and approval of the methodology they use in assigning credit ratings (Update on regulation of credit rating agencies, 2013).

Credit Rating Agency Reform Act of 2006. In 2006, Congress passed the Credit Rating Agency Reform Act that required the U.S. Securities and Exchange Commission (SEC) to promulgate clear guidelines to identify credit rating agencies that would qualify as Nationally Recognized Statistical Rating Organizations (NRSROs) (Credit reporting agencies, 2014). The Credit Rating Agency Reform Act also authorized the SEC to regulate NRSRO internal processes concerning record-keeping practices, guidelines for preventing conflicts of interest, and established the protocol whereby NRSRO determinations were subject to review (Credit reporting agencies, 2014). It is important to note, though, that the Credit Rating Agency Reform Act specifically prohibits the SEC from regulating the rating methodologies used by NRSROs (Credit reporting agencies, 2014).

After the 2008 housing bubble. Credit rating agencies use a business model that is characterized by a fundamental conflict of interests (New rules will fail to reform ratings agencies, 2014). In a painful reminder that greed can infect an entire industry, the 2008 housing bubble focused attention squarely on the CRA sector. According to Baker (2008), prior to the 2008 housing bubble burst, “Banks paid for the rating of their bonds by credit agencies,” a practice that “should have prompted more concern from regulators” (2008, p. 73). These lax practices resulted in enormous profiteering at the expense of the American taxpayer. In this regard, Baker notes that, “This situation was a recipe for abuse” (2008, p. 73). Indeed, a representative from Standard and Poor’s emphasized that, “Securities backed by faulty mortgages were an ‘epicenter’ of the crisis, leading investors astray by ‘wrapping serious financial risks in a thin veneer of creditworthiness (cited in Regulators OK overhaul of credit rating agencies, 2014, p. 3). Prior to the 2008 housing bubble burst, investment bankers and securities issuers practiced what is known as “ratings shopping” and hired the CRA that would provide them with the most advantageous ratings (New rules will fail to reform ratings agencies, 2014). Although regulators have encouraged CRAs to offer unsolicited ratings on issuances they have not been hired to rate, ratings shopping has been revived (New rules will fail to reform ratings agencies, 2014).

Most industry analysts agree that the CRAs were responsible for causing the financial crisis, with the overarching motivation being greed (New rules will fail to reform ratings agencies, 2014). For instance, one analyst suggests that, “Financial institutions that created residential mortgage-backed securities (RMBS) needed strong CRA….....

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References

Baker, D. (2008). The housing bubble and the financial crisis. Real-World Economics Review, 40, 73-81.

Harper, S. (2011). Credit rating agencies deserve credit for the 2007–2008 financial crisis: An analysis of CRA liability following the enactment of the Dodd-Frank Act. Washington & Lee Law Review, 68, 1926-1971.

Hughes, C. & Augier, A. (2014). EU credit rating agencies. European Union. Retrieved from http://europa.eu/rapid/press-release_IP-13-555_en.htm?locale=en ontacts.

Klein, D. B. (2009, Winter). Credit-information reporting: Why free speech is vital to social accountability and consumer opportunity. Independent Review, 5(3), 325.

Mierzwinski, E. & Chester, J. (2013, Summer). Selling consumers not lists:  The new world of digital decision-making and the role of the Fair Credit Reporting Act. Suffolk University Law Review, 46(3), 845-850.

New rules will fail to reform ratings agencies. (2014, September 9). Oxford Analytica. Retrieved from https://www.oxan.com/display.aspx?ItemID=DB193228.

Regulators OK overhaul of credit rating agencies. (2014, August 27). Washington Examiner. Retrieved from http://www.washingtonexaminer.com/regulators-ok-overhaul-of-credit- rating-agencies/article/2552504.

Stanton, T. H. (2007, Summer). Opportunities for reducing delinquencies and defaults in federal housing credit programs: A review of new technologies and promising practices. Journal of Public Budgeting, Accounting & Financial Management, 13(2), 157-162.

Traub, A. (2013, Summer). Credit reports and employment: Findings from the 2012 National Survey on Credit Card Debt of Low- and Middle-Income Households. Suffolk University Law Review, 46(3), 983-1001.

Update on regulation of credit rating agencies. (2013). Capital Markets Monitor. Retrieved from http://www.americansecuritization.com/WorkArea/DownloadAsset.aspx?id=9415.

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