Role of credit rating agencies in the subprime crisis

Credit rating agencies played an important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with mortgage backed securities (MBS).

Impact on the crisis

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were justified by various credit enhancements including overcollateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks. [ [http://www.economist.com/finance/displaystory.cfm?story_id=9769471 Buttonwood | Credit and blame | Economist.com ] ] On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers. [cite web | title = SEC Proposes Comprehensive Reforms to Bring Increased Transparency to Credit Rating Process | U.S. Securities and Exchange Commission | url=http://www.sec.gov/news/press/2008/2008-110.htm | accessdate=2008-07-2008 | year = 2008]

Rating actions during the crisis

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower. [ [http://money.cnn.com/2008/08/04/magazines/fortune/whitney_feature.fortune/index.htm Fortune Article] ]

As of July 2008, Standard & Poor's (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P. [cite web | title = Structured Finance Rating Transitions | Standard & Poors | url=http://www2.standardandpoors.com/spf/xls/media/2005_2007_SF_Performance.xls |accessdate=2008-07-2008 | year = 2008] Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation. [cite web | title = Credit markets | CDOh no! | Economist.com | url=http://economist.com/finance/displaystory.cfm?story_id=10113339&CFID=3251978&CFTOKEN=ed7695a32a6236e5-1442B051-B27C-BB00-012985EE3191127D | accessdate=2008-05-19 | year = 2008 ]

Actions taken to improve rating approach

Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt. [cite web | title = SP downgrades ratings on 1,413 classes of subprime-backed securities worth $22.02 billion - International Herald Tribune | url=http://www.iht.com/articles/ap/2007/10/19/business/NA-FIN-US-S-P-Ratings.php | accessdate=2008-05-19 | year = 2008 ] In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates. [ [http://www2.standardandpoors.com/spf/pdf/media/Leadership_Actions_Full_Update.pdf S&P Rating Process Oversight] ]

References