We Can’t All Get A’s: Why We Must Reform Credit Rating Agencies

Almost everyone today can remember the 2008 financial crisis. Over the course of a very short time, over $10 trillion in assets were lost, and 2.6 million Americans lost their jobs. In the aftermath of the crisis, people naturally endeavored to find out what went wrong. They wondered how is it that banks so poorly evaluated risk, issuing mortgages that people could not pay off, yet believing they could still turn a profit. While there are many answers and no one factor bears all of the blame, a significant portion of the problem came from the private credit rating agencies.

Credit rating agencies first arose in the 1800s as a means to rate the value of railroads so investors could accurately gauge the risk of investment. Over time, these agencies began to rate all forms of tradable bonds and securities rather than just railroads. In 1975, Congress passed a law mandating that all publicly traded securities receive a credit rating from at least two different agencies. Today, credit rating agencies play a critical role all around the world in the movement and investment of capital.

In theory, credit rating agencies provide a score based on how likely a security is to fail. For some background, bonds are a way of buying debt from corporations or governments. You pay for a bond, and then over time, you get your investment back plus interest. This interest rate is based on the risk of the bond. Higher yielding bonds means that there theoretically is a higher likelihood that a corporation will go bankrupt and therefore be unable to pay back the debt. Securities can also include assets with a guaranteed payout, such as mortgages whose rating reflects the likelihood that the homeowners will default on their payments. In the case of government bonds, since governments cannot go bankrupt, bond ratings evaluate the risk that governments will print money, thereby inflating their currency and diminishing the value of the bond. Credit rating agencies provide a letter grade ranging from “AAA,” which is supposedly guaranteed, to “d,” which essentially signifies a current default. However, there exist many market factors in the world today that prevent and disincentivize credit rating agencies from accurately providing assessments of risk.

Given that so many mortgages failed in the subprime mortgage crisis of 2008, one would expect that many of the mortgage backed securities had been given a bad credit rating. In actuality, as many as 75 percent of these securities were given AAA ratings. This unfortunate masking of risk and failure to accurately predict risk arose from a variety of factors. First, credit rating agencies are paid by the owners of the securities they rate. This incentivizes the agencies to rate as many securities as possible, and to give these securities favorable ratings to attract new potential clients, since companies seek out high ratings for themselves. Because Congress only requires a security to receive two ratings from the three companies, owners can play different credit rating agencies off of each other, forcing them to bid up their rating for fear of losing customers.

Second, it remains very difficult for credit rating agencies to actually assess the real value of assets. This is because the safety of a security relies almost as much on the behavior of other investors as it does on the intrinsic value of an asset. Banks in the modern world operate only with fractional reserves, meaning that they hold only a portion of all their debt on hand as liquid cash. Therefore, if enough of their bonds and securities default, or the value stock they hold as collateral significantly decreases, they are forced to sell other assets they have in order to pay off the losses. The problem is that when they sell their assets, they lower the price of those assets in the market, which signals to other asset holders that they also need to sell in order to protect their investments. In this manner, a few badly rated bonds can actually torpedo the entire financial system, as we saw in 2008.

Improving the accuracy of our credit rating agencies will ensure that financial institutions are better able to assess risk, making it a bit less likely they will sink the economy, a goal that we can all rate as worthwhile.

Credit rating agencies, by virtue of being unable to predict investor behavior, cannot capture this aspect of risk when assessing securities. Instead, credit rating agencies act as signalers of investor behavior. If, perhaps, an investor sees that a credit rating agency has devalued a security, it is reasonable for the investor to expect other investors to respond to this information by selling that asset. It is therefore in that investor’s best interest to sell the asset. Basically, credit rating agencies cannot continuously update their ratings, because any, even a small downgrade in the rating of a security could signal a huge selloff, completely tanking the value of an asset.

There are many proposed solutions to address the shortcomings of credit rating agencies. At the forefront is nationalization, or replacing the private agencies with a government rating agency. In theory, nationalization would remove the practice of bidding up ratings, as the government would be the only entity involved in rating. In the world today, if one of the credit rating agencies decided to go against the market while the other two did not, it is likely that the one agency would just lose credibility, readership and prominence. However, if it follows the trends of the other two agencies, then it is likely that no one company will take the blame for problems that ensue, making going with the market a much safer move.

In contrast, a nationalized agency faces no such incentives, so it theoretically has the ability to rate securities on a somewhat objective basis. Even though it is hard to predict the safety of an asset, nationalization would still be comparatively more accurate given that it doesn’t suffer from agencies bidding up ratings. Lastly, a nationalized credit rating agency would be much better at preventing bubbles. Credit Rating Agencies are publicly traded, with Berkshire Hathaway holding a significant portion of the stock in Moody’s. Unsurprisingly, a Columbia University study found that Moody’s rated other corporate bonds higher which Berkshire Hathaway owned large portions of. Bubbles are caused when the market overvalues securities. Public rating agencies would not face the same perverse incentives.

However, for all of its potential benefits, nationalization presents enough serious concerns that it does not constitute a workable solution. In the United States, corporations, through lobbying, have a large influence on governmental policy. Many of these are financial institutions that would love to see their securities given high ratings because it draws more money to them. Therefore, there will always be pressure on government to appoint people to credit rating agencies who are likely to overvalue securities to the benefit of corporations.

Even ignoring American corruption, a public entity would still likely want to rate securities that are based in its country of origin over securities that are owned abroad simply to promote local prosperity and investment over foreign investment. Investors would then not be able to trust the validity of ratings, rendering them relatively useless. Secondly, without the checks of the free market, there are not means to reform the credit rating agency once it is established. There would be no institution to measure the performance of the public agency, so even if it performs poorly, there will be little means to force reform. Credit rating agencies also uniquely need a competitive market to compare to. No matter who is doing it, ratings will never be perfect. Therefore, having multiple rating agencies will at least provide some means to measure performance.

Although nationalization would be problematic, there are options available that could solve some of the problems that currently arise. First, credit rating agencies should not be funded by those that they rate. Instead, all holders of securities that need ratings should have those securities rated through a third party mediator, and not directly from the agencies. This would make it harder for banks to shop around and have the safety of their securities bid up.

This would be a strong step, but the biggest change that must happen is changing the way we evaluate securities. The absolute grading system should be replaced with a comparative scale; instead of giving bonds a letter grade, agencies should rate bonds relative to each other. The newly created Comparative Rating Index of Sovereigns (CRIS) scale attempts to do just this. The CRIS rates government debt of different relative to each other rather than giving a letter grade. It would not be too difficult to adapt a scale like this to one where bonds and securities were categorized into percentile groups for investment safety relative to each other.

Even though 75 percent of the mortgage backed securities in the 2008 crisis were rated AAA, many were clearly better than others. By forcing agencies to rate securities relative to each other, it eliminates this ambiguity. Furthermore, because the value of securities depends on market trends, a relative grade is a more objective measure in accurately comparing risk. Additionally, in this system, the government could oversee the agencies. If they frequently rated securities that failed better than securities that succeeded, those companies would lose government funding, and new institutions would be hired to take over the rating process.

In order for this policy to be implemented, Congress would have to enact a government organization to oversee the process. They would then have to mandate that all securities receive a rating through this agency rather than through the standard private CRAs. Then, the government organization could mandate that all rating agencies follow these new guidelines to receive funding. As long as we live in a where banks only hold a small fraction of their debt on hand as cash, lending out the rest as additional debt, we will always live in a world at risk for a financial collapse. However, improving the accuracy of our credit rating agencies will ensure that financial institutions are better able to assess risk, making it a bit less likely they will sink the economy, a goal that we can all rate as worthwhile.

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