1. Credit Rating Agencies Background

CORE Metadata, citation and similar papers at core.ac.uk Provided by DSpace at Tartu University Library UNIVERSITY OF TARTU Faculty of Economics and Business Administration Institute of Business Administration Chair of Finance Merit Leib THE EFFICACY OF THE REGULATIONS AIMED AT THE CREDIT RATING AGENCIES Thesis to obtain Master of Business Administration degree in Business Administration Supervisor: Meelis Angerma Tartu 2013 Supervisor …………………………………………………………………………………... (Supervisor‘s signature) Accepted for defence ― ― ……………………………… 2013.a. ……………………….. Chair of Manager ……………………………………………… (Chair of Manager name and signature) Herewith I declare that this thesis is based on my own work. All ideas, major views and data from different sources by other authors are used only with a reference to the source. The thesis has not been submitted for any degree or examination in any other university. ………………………………….. (Author‘s signature) TABLE OF CONTENTS INTRODUCTION ................................................................................................................ 5 1. CREDIT RATING AGENCIES BACKGROUND ..................................................... 12 1.1. The History of the Credit Rating Agencies ............................................................... 12 1.2. Credit Ratings ............................................................................................................ 18 1.3. Credit Rating Agencies Business Model ................................................................... 24 1.4. Securitization ............................................................................................................. 27 2. THEORETICAL CONSIDERATIONS IN CRA REFORM ..................................... 37 2.1. Role of the Credit Rating Agencies in the Capital Markets ...................................... 37 2.2 The Meaning of Credit Ratings .................................................................................. 41 2.3 Conflicts & Problems faced by the Credit Rating Agencies ...................................... 47 2.4. A Survey of the Academic Literature ........................................................................ 51 3. EMPIRICAL FINDINGS .............................................................................................. 63 3.1. The Role of the Credit Rating Agencies in the Sub-prime Mortgage Crisis, the Housing Bubble, and the Global Financial Collapse........................................................ 63 3.2. Credit rating performance ......................................................................................... 66 3.3. Government hearings on the Rating Agencies and Litigations ................................. 73 3.4. Regulatory efforts to Control the Rating Agencies ................................................... 83 3.5. Regulations and Reforms continue to fail- the evidence ........................................... 96 AUTHOR’S ANALYSIS & DISCUSSION OF POTENTIAL SOLUTIONS ............ 110 3 SUMMARY ...................................................................................................................... 118 REFERENCES ................................................................................................................. 124 APPENDIXES .................................................................................................................. 144 Appendix 1. February 4, 2103, US Department of Justice files $5 billion lawsuit against Standard & Poor's ........................................................................................................... 144 Appendix 2. Interview with former Executive Managing Director of S&P .................. 146 Appendix 3. History of growth of CRA industry ........................................................... 162 Appendix 4. Analyst e-mails .......................................................................................... 162 Appendix 5. "Subtitle C—Improvements to the Regulation of Credit Rating Agencies 164 Appendix 6. Table of the efforts over the last 10 years made by the EU to address the credit rating agencies ...................................................................................................... 165 Appendix 7. Resume David P. Jacob (Executive Managing DirectorS&P)................... 166 KOKKUVÕTE ................................................................................................................. 169 4 INTRODUCTION Credit Rating Agencies (CRA) have been issuing credit opinions on bonds for over 100 years. As of 2008, there are estimated to be about 150 domestic and international credit rating agencies throughout the world (Langohr and Langhor, p 384, 2008). "More than 745,000 securities from over 42,000 issuers, and representing at least $30 trillion are rated..." (Ibid. page 23). Credit ratings are used by bond issuers, investors, and regulators all over the world as a measure of the likelihood of default. The ratings are relied upon by some for making investment decisions and for assessing risk, and by others to satisfy regulatory requirements. Over the years, they have become a ubiquitous statistic and presumably indispensable in the investment and trading of government, corporate, and structured finance bonds. Since so many market participants use the credit ratings, there is a tremendous potential for damage if the credit ratings are incorrect. Financial institutions and regulators have essentially outsourced their credit work to the CRAs and thus, have created tremendous systemic risk for the capital markets. Because of the prominence of credit ratings in the capital markets, the CRAs wield tremendous power. They can affect a company‘s or a country‘s cost of capital by the credit rating that they assign. If credit ratings are properly performing their function, then a higher credit rating will generally lead to a lower cost of capital. If they are not properly performing their function they are masking the true risk of the securities. The proper functioning of the CRAs is an important topic for financial regulators all over the world, because ultimately they are responsible for the safety of the financial system, and until now the regulators have relied on credit ratings from the CRAs as an important measure of credit risk. The quality and reliability of credit ratings is also a very important topic for investors as some of them still continue to rely on the credit ratings for information. The topic of effectively controlling the CRAs, continues to discussed by regulators, academics, and investors. The most recent crisis shook the global economy to its very foundation. According to the IMF, ―Including assets originated in other mature market economies, total write downs could reach $4 trillion over the next two years, approximately two-thirds of which may be taken by banks‖ (World economic outlook 2009). The magnitude of this loss and the role of the CRAs makes the topic of CRA regulation and reform critical for the future stability of the global financial system. Given the critical role and perhaps indispensable role of the Credit Rating Agencies (CRAs) in the capital markets, and given their recent spectacular failure, and other past failures, new regulations continue to be put in place to control and improve the CRA function. The goal of this thesis is to analyze whether or not the regulations and guidelines that have been implemented thus far are working to control the CRAs, and to prevent them from again damaging the financial markets. If the research shows that the regulations are not effective, then further work has to focus on why the regulations continue to fail, and what needs to be done to improve them, or change the framework in which the CRAs operate. Following every crisis, new regulations are put into place, to try control the CRAs, and to establish a framework for them to properly perform their function. Nevertheless, the failures continue, and the CRAs continue to be at the center of financial controversy. In July 2010, the US Congress passed comprehensive financial reform, commonly known as the Dodd-Frank Act. Included in this legislation are new rules directed at the CRAs (An executive summary… 2010). 6 This research will focus on the efficacy of the following regulatory initiatives: 1. Code of Conduct adopted by IOSCO in 2004, 2. CRA Reform Act of 2006, and 3. Dodd-Frank regulations of 2010 It is difficult to directly prove that the regulations are or are not working to prevent another crisis, until the next crisis occurs. But, examining how the regulations are currently affecting CRA behavior, and how the courts are ruling, and on which regulations they are basing their decisions, provides insight into the efficacy of the new rules and guidelines. The approach of this thesis is to track the evolution of the regulatory efforts and to analyze how they are performing. The method used to prove this thesis is to examine the main guidelines and regulations that have been adopted since 2004-2010. Then to juxtapose against these regulations a documentation of the continuing failures of the CRAs, the continuing bad behavior of the CRAs , the inability of investors and the government to hold the CRAs liable for their errors. Specific court cases are cited, analyst emails are cited, and specific instances of regulations being ineffective are noted as evidence to support this thesis. Finally, in the most recent 2013 set of lawsuits brought by the US Department of Justice and 16 States against one of the CRAs,

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