The Bond Raters Still Need to Be Fixed
The reforms adopted after the financial crisis didn’t resolve the industry’s inherent conflicts.
Bloomberg, August 14, 2019
Have you been paying much attention to the credit ratings agencies (CRAs) lately?
Recall that Standard & Poor’s and Moody’s, the biggest of the credit ratings agencies (CRAs), were major causative factors in the great financial crisis (GFC).
You probably have not thought about that recently. I think about the CRAs all the time, but I’m weird.
The Wall Street Journal does, too. They provided a public service last week writing that those ratings agencies – and their problems – have not gone away. “Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back” was a reminder the of the CRA influence on, (and the notoriously short memories of) Wall Street.
Note the Journal was one of the first media outlets to point out the huge role ratings agencies played in the subprime securitization debacle way back in 2007.
The rating agencies were key enablers of the financial crisis. They have yet to really be held to account in a meaningful way. Sure, they were fined for their malfeasance. S&P, for example, paid $1.5 billion to settle fines with U.S. and individual states.
But their business models remain as broken today as they were in 2001-08, a period when they helped to festoon investment grade bond portfolios with lots of junk paper, much of which defaulted and became nearly worthless.
The history here is that of overreach and moral hazard: The rating agencies became much more significant after regulatory changes in 1975, when the Securities and Exchange Commission (SEC) altered minimum capital requirements for large wire houses. They rule changes allowed holders of higher-rated bonds to have less capital in reserve; lower rated bonds required more capital in reserves.
Note the importance of ratings above. The new moniker created for the companies formerly known as bond analysts was nationally recognized statistical ratings organizations, or NRSROs. This turned the credit ratings a very important component of the bond market, as well as any project that required public funding.
The unanticipated consequence of these regulatory changes was to let companies hold less — and in many cases, much less — reserves. Ratings became extremely important. Eventually, the CRAs figure out that they could make a whole lot more money SELLING RATINGS to issuers and underwriters than merely doing analysis about bonds/credits.
Thus, a new business model was born. It was a major factor in the financial crisis; And here is the really crazy thing: nothing much has changed. That dangerous crisis creating model of selling a Triple AAA rating for junk paper still exists today.
This whole thing really bother me, so I wrote a column about it today.
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I originally published this at Bloomberg, August 14, 2019. All of my Bloomberg columns can be found here and here.
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Disclosure: The original publisher of my book about the financial crisis, Bailout Nation, was McGraw Hill, which owns Standard & Poors. After a disagreement about my chapter on the rating agencies, including S&P, I withdrew my manuscript from McGH. The book was published a year later by Wiley.
