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Anne SIBERT

HOW CAN THE CREDIT RATINGS INDUSTRY BE IMPROVED?

4.1 Getting Rid of Conflicts of Interest, Egregious Bad Behaviour and the Credit- Ratings industry’s Involvement in Creating Structured Investment Products 51

4.2 Solving the Problem of the Over Reliance on Ratings

CB Think? 52 4.4 Should the ECB take the role of an independent provider of sovereign risk ratings?

Should a new independent European Credit Ratings agency? 53

Ratings Agencies

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EXECUTIVE SUMMARY

 Until the early 1970s ratings provided little information to the market. Issuers were rated for free and raters sold books of ratings. This was not especially profitable. The ratings industry escaped regulation, probably because of its lack of importance.  Two things changed the industry. Illiquid markets after the bankruptcy of the Penn

Central Railroad in 1970 caused debt issuers to actively seek out ratings and ratings agencies began to charge issuers. Laws and regulations were made dependent upon the ratings of a small number of firms, making these ratings enormously important.  Although the ratings agencies have been condemned for a number of recent errors in

judgement, some studies show that rating changes do have informational value.  The ratings industry is an oligopoly. However, some industries with few firms remain

highly competitive. If the industry had a large number of small firms, each with its own metrics and standards, it might cause confusion for the users.

 The ratings industry faces conflicts of interest. Agencies are paid by issuers and the fee is a proportion of the issue’s value. Ratings agencies sell consulting services as well as ratings. Their management may sit on the boards of the firms that they rate. Firms rate the sovereign debt of countries that regulate them. US-based firms dominate the industry.

 Following the past decade’s financial boom and bust, credit ratings agencies have not only been charged as incompetent, but have been accused of behaviour that is overtly criminal. In particular it has been alleged that they extort firms that do not pay for ratings by giving them unsolicited ratings that are lower than they deserve.

 It is argued that banks, with the help of the ratings agencies, turned bundles of junk bonds into AAA tranches of CDOs, helping to fuel the growth of this dysfunctional market and thereby playing an important role in propagating the financial crisis.

 Ratings alone are a poor measure of risk, but the financial sector may have a culture of being overly dependent on them. The excessive importance placed on ratings could cause a rating change to make a fear or ebullience-driven market outcome possible. There is little evidence that this has happened in the current sovereign debt crisis.  Credit rating firms should be registered but the NRSRO (Nationally Recognized

Statistical Rating Organisation) designation should be eliminated. Registered firms should only be allowed to rate; they should not be allowed to provide other services or products. A rating agency should not be allowed to offer unsolicited ratings if it also offers ratings paid for by issuers. Senior managers should not sit on the boards of the firms they rate. Issuers should have to rotate raters.

 To help solve the problem of over reliance on ratings, to the extent possible regulation should depend on market-based measures instead of ratings. However, there needs to be flexibility in the case of market dysfunction.

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1.

INTRODUCTION

The three big firms that dominate the credit rating industry have recently been viewed as incompetent, badly behaved and bumbling. They have been condemned for failing to downgrade mortgage-backed securities quickly enough and for not foreseeing the failures of Lehman Brothers and AIG. Their participation in the CDO market is seen as an important factor in worsening the financial crisis. They have been called extortionists who give unsolicited bad ratings to firms that do not employ them. Earlier this month Standard & Poor's accidentally released an erroneous message saying that it was about to downgrade French sovereign debt. In this note I provide a brief historical background of the credit rating industry and describe the two important changes that gave the industry its current business model and importance. I assess the extent of the alleged problems with the industry and suggest solutions. I note the viewpoint of the ECB and consider whether it or a new partially publicly funded entity could provide sovereign credit ratings.

Ratings Agencies

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2.

SOME BACKGROUND ON RATINGS AGENCIES

In this section I describe how the credit ratings industry came to be and the two changes

2.1

The Early Years

ratings agencies were the mercantile credit agencies that

agencies go back to 1860 when Henry Varnum

ugh the early 1970s the ratings agencies constituted a rather

ratings agencies followed the business model of rating companies for that gave it its current shape.1

The ancestors of the modern

rated merchants’ abilities to repay their loans. These began following the Panic of 1837 when Louis Tappan left the silk trading firm that he ran with his brother and established the Mercantile Agency in New York in 1841. It operated by collecting information through a network of agents, including attorneys, bank cashiers, merchants and others and then selling this information to subscribers. In 1859 the agency was acquired by Robert Dun who changed its name to R.G. Dun & Company and published the Dun Book, its first reference book of credit information. A similar agency was formed by John Bradstreet in 1849 and it published a ratings book in 1857. In 1933 the two firms consolidated into Dun & Bradstreets.

The origins of the current big three ratings

Poor published a comprehensive compilation of information about the fiscal state of US railroads. Together with his son Henry William he founded H.V. and H.W. Poor Co. which published annual updates of his compilation. In 1906 Luther Lee Blake founded the Standard Statistics Bureau with a view to providing similar information on non-railroad companies. The two firms merged to become Standard & Poor’s Corporation in 1941.

Meanwhile, in 1900 John Moody & Company published Moody’s Manual of Industrial and Miscellaneous Securities, providing information and data on the stocks and bonds of private firms and government agencies. The manual was a great success, but unfortunately it met its demise in the stock market crash of 1907. In 1909 John Moody rebounded with the idea of rating US railroad bonds and he extended this idea to utility and industrial bonds in 1913. By 1924 his service covered almost all of the US bond market.

The last of the current big three agencies to arise was Fitch. In 1913 John Knowles Fitch founded the Fitch Publishing Company. In 1924 it introduced its familiar AAA through D rating system.

From the 1950s thro

uninteresting industry. It appears that their ratings provided little information to the market. According to a study of 207 corporate bond rating changes from 1950 to 1972, credit rating changes generated information of little or no value. Instead they merely reflected information that had already been incorporated into market prices.2 This was hardly surprising as most of the information that the ratings agencies used was publicly available.

Up until the 1970s the

free and then publishing thick volumes detailing their results. These volumes were sold to investors. However this information could be easily copied and the ratings business was not a terribly profitable one. The ratings industry escaped regulation, probably because it was

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