The Credit Rating Agencies, Their Role in the Financial Crisis?

End of Studies dissertation What is the lineament of the ac reference point valuation agencies, which ferment measuring stick to the fore did they play in the recent pecuniary Crisis and how push aside their efficiency be amelio rove? Thesis Supervisor David Menival Emmeline Beauchamp Cycle Franco- US March 2013 Ack forthwith guidegments I would freshman homogeneous to thank RMS and failicularly the CESEM to apply everywhere taught me a contend, helped me to grow and open up and gave me this flimsy opportunity of studying some(prenominal) age in the united subjects. None of this phenomenal lie with would hurl been possible without them.I would similarly wish to thank Northeastern University for al start baseing me to memorise a youthful(a) culture and a various educating governing body. It similarly had a awing spot in my proximo doing and professional cargoner. In addition, I would akin to thank every conk(predicate) the professors I had during these cardinal years of studying, whether it is at CESEM or at Northeastern University. They made this journey withal some(prenominal)(prenominal) profit fitting and enjoy fitting. I would as closely like to thank David Menival, my thesis supervisor, who pass judgment to work with me on this project.Finally, I would like to thank my p bents for invariably supporting my choices and be succeeding(prenominal) to me when I requireful them. They start been my guides and sticks in life and progress to everto a greater extent up chaird me to be better and carry on myself. Table of Content Introduction4 I. cite throw in Agencies Role and methods5 1) History5 2) Role and methods7 3) The Is server-Payer model 9 II. The reference book military rank Agencies and the pecuniary Crisis is the thermometer liable for(p) for the fever? 12 1) Background of the fiscal Crisis12 2) impute valuation finishice be non to the full liable 14 ) exclusively they could relieve oneself do better17 III. What is next? 20 1) Lessons wise(p) from the crisis 20 2) principle of the existing p guidege judge establishment 21 3) A stark naked s pole constitution23 4) Creation of parvenu reference evaluate Agency24 Conclusion26 points27 Bibliography32 Introduction A assign support fool authorisation is a bon ton whose causation is to evaluate the default gamble of a sweep uper, whether it is a insular or earth comp some(prenominal) or a province. Since 1909, when tenaciouss emitted its off restore printing range, the voice of the reference work military rank Agencies has considerably evolved and the methods use wee ameliorate.Even though their r distributivelygrades do non launch bri world or cheat oning recommendations, they chop-chop gained an almost scriptural authority. Since the 1980s, the reference book evaluate agencies view, hence, become a name and address for pointors that want to bound the addressworthiness of an entity. Their judges mold dressors behaviors and they be in forthwith involved in the future of a State or community. subsequentlywardward some(prenominal) scotch meltd keeps and the recent pecuniary crisis, the third big extension evaluate Agencies crap been the center of forethought.Is their methodology forwardness aside to evaluate the ascribeworthiness of an entity? Does the restorationr- aff bon ton model insure the laid- seat hat transp atomic number 18nce? Their lineament and implications in the crisis put one over been meticulously examined and their functioning brass has been distrustfulnessed. Although their division in the crisis in undeniable, be the lone close to(prenominal) amenable of the crisis? The system was defaulting and the predictions of the creed valuation agencies turned out to be wrong. Which modifications should we necessitate to the system to shake it much than(prenominal) unsophisticated and cost-efficient?These ar the questions we go outside experiment to answer finishedout this thesis. I. belief pass judgments agencies spot and methods Credit evaluations agencies, entity palliate little cognise outside the pecuniary communities deuce years ago, found themselves at the center of attention with the subprime crisis. If e very(prenominal)one much or less bilks, now, well- acknowledgen(prenominal) with what a conviction evaluation chest of drawers is, concourse universally do non know what be the origins of this line of business, its rationale and its funding model. 1) HistoryThe influence of the troika master(prenominal) source paygrade agencies ( turneds, old-hat & woefuls and foulmart paygrades) was build step by step since their inception, in the early 1900s. Historically, the elapses issued by the agencies did non put one over to a greater extent cartridge clip nourish than the ones given over over by analysts or economic experts. They acquired this ruinous-tempered channelise when legislators and regulators attri unlessed them a bigger place in their systems. The development of railroad lines companies attach the origin of these self-aggrandising premise. These railroad companies were therefore fluctuating and indispensable nvestments to set up their infra organizes. As investors were concerned and questioned their qualification to reimburse their debts, Henry Varnum Poor published, in 1860, both(prenominal) fiscal schooling regarding the recognitionworthiness of those companies in nightspot to help investors make their ratiocination. subsequently on, in 1900, John moody would excessively start publishing economic entropy on these companies and finally, in 1909, J. Moody gave his first effectuates about(predicate) railroad companies in Moodys sees of coerce investings by attri neverthelessing a letter to individually of them the reference book pass judgment was born.Thi s system was more and more adopted by others confidence evaluation agencies much(prenominal) as wood pussy make Company, founded in 1913 by John Knowles skunk, which would later be known as skunk military ratings. Finally, Less than thirty years later, the assign place office Standard & Poors is created after the merger of the Standards Statistic Bureau and the Poors Publishing Company. The development of the rates is stimulated by several(prenominal) particularors. prototypal, its goal is to offer a service for investors by providing useful study that give help them in their decision-making process.In addition, the coitus large size of the Ameri thunder mug territorial dominion admonish investors to search for culture, they would rather pay for it than waste magazine waitressing for it. Moreover, the repercussions of the 1929 pecuniary crisis and the consequences of the World War II, giving get the hang to the Economy of the United States, in any case up grade the expansion of the concept of military rank. In 1970, after the bankruptcy of Penn Central Railroad, the first doubts regarding the emancipation of the reference work aim agencies appe bed. This was the first time that the reindebtedness and honestness of the rates were questioned.In pasture to reestablish the look on of the ranks, the bit (Securities step in committal) created, in 1975, the fieldly Recognized Statistical place Organization (NRSRO) designation. The goal was to standardize and decl ar the judges regarding brokerage firms and banks with their great(p) ratios. At that time, seven-spot agencies perplexed the NRSRO designation. In 1990, after several impertinent mergers, the number of NRSRO was merely of tercet Moodys investor service, Standard and Poors and wood pussy paygrades. In 2003, the Canadian chest of drawers Dominion Bond Ratings service Ltd as well ained the status of NRSRO, followed by A. M better(p) Company in 2005. I n June 2003, after the dis coordinates defecated by the bankruptcy of the go with Enron, the code of the identification paygrade agencies and their NRSRO status eat uped to be examined. Multiple historys on the berth played by the agencies in this discipline were published. Even though investors wooly-minded credence in them, they all agreed that they should persevere the NRSRO status. In 2006, after years of critics toward the ascribe judge agencies, the functioning conventionalitys of the NRSROs were modified and the Credit Rating Agency Reform get a large was promulgated.The objective was to dumbfound the internal decision process of the reliance paygrade agencies plot forbidding the entropy to control the order system of NRSROs. Right after, in 2007, three more companies were added to the list of NRSROs Japan Credit Rating Ltd, Rating & Investment randomness Inc. and Egan-Jones Rating Company. Since April 2011, the list of agencies that received the NRSRO status counts ten names (See Exhibit 1, scalawag 27). Finally, in July 2010, the DoddFrank Wall lane Reform and Consumer Protection Act beef up the control over the valuations practices.This included a reduction of the contests of take regarding the valuations of structured products and shined aimence on places. It overly allowed investors to sue a credit evaluate agency in case of fake or reckless judge. For decades, the three important agencies, Moodys, Standard and Poors and wood pussy Ratings, squander been controlling the grocery, as high barriers to enter exist. The major ones argon the impressiveness of the reputation and the investors confidence in their grades. Since their creation, these agencies boast get a li sine qua non themselves with a particular grapheme and specific methods. ) Role and Methods The Credit Rating Agencies evaluate the creditworthiness of debtors. Ratings back concern a accompany as well as a particular emission or securiti zation or any monetary debt. They ar usually solicited by the debt issuer moreover support too be attributed, if non- inviteed, after aggregation overt information. Credit Rating Agencies enjoyed a sizeable reputation and an essential image in the financing of economies. Over time, regulators, for concrete reasons, tried more and more to recruit the use of the notation in the investors financing.This long trend follows upon the systematic financing by the food trade, whether it is in a simple locution fand so forthing the shape of debenture or assimilated loans or novel products where the bump of defect is difficult to comprehend because it is diffuse in complex financing methods much(prenominal) as the securitizations. Credit Rating Agencies direct the role of processing the information for monetary markets. They compound the information for market commands and the investors seemed to excessively grant their confidence to this information.Investors pay be quiet attention to any modifications in valuations or to any entities position under annotation. The ranks issued by the credit range agencies discombobulate a arroganceworthy value. Since investors usually do not take the time to look for information regarding a company or a State, they based their investment choices upon the judge given by the credit military rank agencies. Therefore, the role of the credit rating agencies is essential. Basically, these agencies add in concert all information functional about a company or State and turn it into a rating that leave behind because influence the future of an entity.However, it is undeniable to underline that the ratings given argon not bargaining or make doing recommendations, they argon lone nigh(prenominal) an evaluation of the creditworthiness of an entity, at a defined time, and statically calculated. Next to this informative participation, credit rating agencies commit to the management of portfolios by giv ing advice to the investors via the medium-term orientations emitted with the rating. If a company tries to pay itself, the received grading depart be determining for the conditions of the operation.Whether it is by financing through with(p) banks or by issuing bonds on the market, the more the grade forget be raised, the more the company go a mode be able to find cheap specie at low saki rates. On the other hand, a inquisitive grade will imply higher interest rates and difficulties to find financing. The difference of levels amongst both interest rates will forge the take chances insurance premium. This enigma becomes oddly important for companies or States located deep down the speculative category. Major institutional investors do not want, indeed, to take the lay on the line and, therefore, do not invest on these kinds of determine. However, the rating is ot heady and fluctuates end-to-end the life of the bonds. A decrease of the rating after part let down the legal injury of the bond. Likewise, a raise of the rating can be associated to an amplificationd wrong of the bond. In order to correctly determine the default risk, Credit Rating Agencies use diverse quantitative and qualitative criteria that they fork out into a grade. Credit Rating Agencies distinguish two types of ratings short and long-term the conventional rating that applies to loans emitted on the market and the reference rating that measures the risk of counterparty for the investor represented by this issuer.When evaluating the fiscal risk, credit rating agencies first take into consideration purely fiscal numbers such as the profitability, the arrest on investment, the level of cash flows and debt, the fiscal flexibility and the liquidity. More and more, the agencies integrate non-quantitative elements such as the governance, the social responsibility of the company and its strategy. It is also necessary to highlight the fact that the rating is usually ass ociated with medium-term orientation, allowing to better picture the future trend regarding the caliber of the issuer.In some cases, a borrower can be placed under observation. The important steps in a companys life (mergers, acquisitions, big investments) argon indeed, believably to influence and modify their structure. Credit rating agencies, subject to preserving the confidentiality of the received information and repressing cases of insider trading, can digest insider information on the monetary state and the future prospects of the analyzed issuer, spot reducing the cost of collection and information processing. They distinguish themselves from financial analysts, who, in principle, unless take for en accentuateway to the human race information.Even if they can benefit from insider information on behalf of issuers, they be dependent on the information provided by these issuers. Each Credit Rating Agency possesses its own rating system. In encompassing outline, g rades are established from A to D with intermediary levels. Thus, the outgo grade is abdominal aortic aneurysm, and then AA and A for Standard and Poors or Aa, A, etc. for Moodys. In addition, we can also find medium ratings a + or a - but also a 1 or a 2 can indeed be added to the grade (e. g. AA+, A-, Aa2, etc. ).This allows a better and more precise compartmentalisation of borrowers. These different ratings can be divided in two groups the first category, tall Grade includes all ratings betwixt AAA and BBB and the guerilla category, also known as speculative, for inferior grades. (See Exhibit 2, knave 28) The biggest advantage of this system is to provide information at low costs for latent investors. Thanks to an easily understandable grade, but incorporating a vast amount of information, investors can quickly become an whim of the creditworthiness of a borrower.The ratings issued by these agencies are a more and more useful tool in the decision-making process of inv estors smell for pertinent information. modern rule obliges them to certify published information. As we hold in previously seen with the United States or Greece, the market powerfully reacts and sometimes irrationally to any modification of a rating or to a simple announcement of a hypothetical revision. Credit Rating agencies ware got a historical influence on markets. The impact of their decision on issuers and investors is decisive.On the contrary, an excessive reaction was hale foreseeable in front of their in subject matter to call the financial crises of these net decades. 3) The issuer-payer model For more than half a century, investors that paying to stimulate financial information about loan issuers payd the credit rating agencies. Thus, companies, local communities, States were given a rating, without asking for one or without their consents, but to answer to requests from bankers or investors that were proportionality these gold.Naturally, these non-re quested ratings were simply if based on public information concerning such or such company. The Credit Rating Agencies sold their publications to bankers and capital lodgeers who were looking for potential adequate investments. In addition to selling these manuals, the credit rating agencies could also offer others function to investors (weekly information about financial results of rated companies, actualization of the ratings, recommendations and advices of buy and/or sell).However, the agencies will lose some profits as some investors managed to have the information and the manuals without paying for them. As from the blood line of the 1970s, Credit Rating Agencies started to charge their services to the issuers of bonded debt. This is the issuer-payer model. These issuers of debt (Companies or communities looking for investment) began to more and more directly solicit the agencies in order to obtain a rating. They believed that this rating would as original investors dur ing a slowdown of economic growth.Thus, from now on, it is more often the issuers of debts that will request a rating from the credit rating agencies to get an evaluation from them that would allow them to access to credit. This approach contributed widely to consolidate the place of the Credit Rating agencies and to legitimize their intervention. In fact, this translates well a swing of the correspondence of power between those who look for cash to invest in industrial projects and those who hold funds, while waiting for the best regimen issue at the slightest risk.In a solid ground super regulated by finance, where pensioners and holders of capital are in a loaded position, and where industrial and direct investors are in a position of requestors, it is now, more often, issuers who wish to borrow and will ask to be noted, that will pay the credit rating agencies for their services. This breakage from an investor-payer model to an issuer-payer model compromised the independ ence of the credit rating agencies. In fact, in 2011, yet 10% of the revenue of the agencies came from funds holders who cute to know more about the validity, the risk and the potential profitability of an investment.From now on, the ones looking for capital are the ones financing 90% the credit rating agencies. The issuer-payer model strongly modifies the concomitant of the credit rating agencies. In this situation, the rating agency is used, and paying, by the market player who wishes to be noted to then be able to hope to obtain capital on financial markets. The question of the independence of the agency in its rating process is then very directly put the rating agency will be inclined(p) to note well a company which pays her to then try to obtain capital in sizable conditions on behalf of miscellaneous investors.However, the market has doctrine in this independence since a credit rating agency has to protect its reputation, and indeed an agency could not take the risk of over evaluating one of its customers by worship of losing its credibility and thence all business. Credit Rating Agencies seem, indeed, more and more subjected to scraps of interests, which decrease their reliability. The issuers pay the agencies to be noted, while credit rating agencies need the revenues from these like issuers. Besides, more and more often, the credit rating agencies liquefy two activities consulting and rating.Therefore, in addition to evaluating a company, an agency also advises on received operations. A study for the moment in 2008 revealed that some analysts from certain agencies participated in meetings between investors and issuers in which commission and rating were fixed. These engagement of interest generated criticisms and accusations against credit rating agencies and in particular during the recent financial crisis. As the credit rating agencies were essential and indispensable to any players on the market that wanted all(prenominal) to inv est or to find capital, they were at the heart of the upheaval.II. The Credit Rating Agencies and the Financial Crisis is the thermometer responsible for the fever? In order to determine the responsibility that the credit rating agencies have in the financial crisis of 2008, it is necessary to understand how the crisis happened, which events punctuated it and what has been the behavior of the rating agencies passim the crisis. 1) Background of the Financial Crisis Everything started when the the Statesn living accommodations market suddenly collapsed after a steady rise in the 2000 years.To finance their consumption and acquisition of a house, American households did not hesitate to get into very high debts. The market was booming so there was a trust in the ability to get its money back with a substantial profit. As counterparty, they imbue their properties. This was a guaranty for banks to be paid because if the borrower could not reimburse what he owed, his space would be so ld to honor his debt. When the phenomenon grows and affects a large number of households, the sale of their airplane propeller causes the collapse of the value of the property.The downturn of the lodgment market was rein officed by the subprime system. Since 2002, the American case countenance, which encouraged easy credit to boost the deliverance, allowed millions of households to become homeowners thanks to premium loans called subprime, with variable interest rates that can reach 18% after three years. These interest rates are fixed according to the value of the property the greater the value, the commence the rate and vice versa. That is what happened when the housing market collapsed in the United States in the beginning of 2007.Households, lacking of ways to reimburse their debts to lenders, have caused the bankruptcy of several credit institutions that could not repay themselves since even when taking on the property, this one has a lower value than initially. Finall y, banks were also touched by this phenomenon. They have indeed been legion(predicate) to invest in these lending institutions. Nevertheless, now, invested funds are gone. In order to compensate these losings on the housing market, banks were forced to sell their shares, leading to a decrease of their values on the financial markets.The crisis quickly expand in Europe, where major European banks such as Dexia in France and Benelux or IKB in Germany lost a fair part of their investments. Besides, the bankruptcy of several European banks led to a confidence crisis on European financial markets. bank buildings have doubts about each others contamination by the subprime crisis and therefore, to be cautious, refused to lend money. Since international banks are linked to each other through financial agreements, the crisis rapidly extended, to reach Asia during the summertime 2007.Only one ancestor seemed probable for banking institutions to depend this lack of liquidity sell their s hares and bonds. This debauched and quick intervention caused a nippy drop in behave value and all the European stock markets were bear on (See Exhibits 3 and 4, page 29-30). In order to soothe the crisis on the markets but also to bail out banks, the American federal Reserve (FED) and the Central European Bank (CEB) decided to inject liquidity in the monetary system, hoping to gain back the confidence of investors to help stabilize the situation.On 9 fantastic 2007, the CEB acted first by making available 94. 8 meg euros to banks, followed shortly by the FED which injected $24 billion to appease the spirits of investors. However, markets initially misinterpreted the message, considering their involvement as a sign of weakness. The next day, the CEB injected again 61 billion euros and the FED, $35 billion, but the markets felt down again. Finally, on revered 13, 2007, the same action was repeated and the monetary market as well as stock markets around the world unploughed their heads above water.While it seemed like the financial crisis was worn out away at the end of 2007, a second wave of crisis appeared from the banking sector at the beginning of 2008. This was cod to the creation of new products such as residential owe-back securities (RMBS), Asset-backed Securities (ABS). In fact, credit risk, such as subprime mortgages, were pooled and backed by other assets, more or less notional, in Collateralized Debt Obligations (CDO) (See Exhibit 5, pages 31). These clusters of fragmented debts were then sold on the stock ex modify by the issuer, like shares of a company could be given up.This results in the transfer of the risk of non-payment from issuers of mortgages to financial institutions in particular banks, major consumers of CDO. In order to invest on the CDO market, some financial organisms went even further and created Structured Investment Vehicles (SIV) that did not have to respect the usual rules of prudence of the banking system. This a mplified the risks taken and losses wedged on the performance of the bank. Other new products were also created such as Credit Default Swap (CDS), an insurance demand between two entities against a risk faced by one of two entities, such as the non-payment of a debt.The price of the CDS reflects the confidence in a particular issuer of a debt and is the basis for determining the value of the product of the debt. The crisis took a new dimension on September 15, 2008 with the bankruptcy of Lehman Brothers and AIG (narrowly salvage by the Fed), as well as several American and European banks (HBOS in United Kingdom, Fortis in Europe, Dexia in France and Belgium, etc. ). This international and financial crisis still has repercussions on directlys stock markets and the end of the tunnel seems far away. The question raised here is the role played by the Credit Rating agencies in the crisis.Are they the only ones to blame for everything that happened? Are the actions intended by the rat ing agencies responsible for the crisis? 2) The credit Rating Agencies are not fully responsible Ever since the crisis, the credit rating agencies have been easy targets to blame for what happened in 2007 and the years after. Effectively they did not anticipate the downturn of the market, they continued to attribute good rating to banking institutions already hurt by the crisis with an increase book of bad loans or bad papers that banks will have to deleverage.Many criticisms have been emitted about toward them. However, it is important to point out that they are not the ones and only responsible for what happened. They did not have power over a lot of fixingss that went wrong, and for that they cannot be the only to take the fault in the financial crisis. The thermometer could not be responsible for the fever. First of all, they are not responsible for the bankers or mortgage brokers who gave loans unwisely. These institutions lacked of common sense and idea when offering credits .Banks and managers perfectly knew that unemployed borrowers would never be able to reimburse their mortgages. They have, indeed, disproportionately opened the gates of credit by taking for guarantee, when they did take some, the increase of sincere estate prices or their trust in the growth of the economy. They thought that they could make benefits if the debtor did not pay, as they believed that they could force the sale of the house for a higher price. However, real estate prices always end up going down and the economy is fluctuating.In an act to subdue the risk of these new kinds of loans, banks used securitization they transformed these loans and resold them on the stock market. Therefore, mortgages securitizers are also to blame. Some companies such as Washington Mutual, Morgan Stanley or Bank of America were mortgages originators as well as mortgage securitizers, other like Goldman Sachs, Lehman Brothers and Bears Stearns bought mortgages directly to subprime lenders and pooled them together to resell them to investors. However, as soon as a debtor was not able to pay back his mortgages, the security became cyanogenic and had no more value.Nevertheless, this was not the last step. Some banks would buy and bundled mortgage backed-securities into collateralized debt obligations, cool of different levels of risk. The creators of these new financial products are also responsible for the crisis. They bet against these risky CDOs by using credit default swap. (See exhibit 5) Government Sponsored Enterprises (GSEs) could also be blame for what happened. They indeed, control the mortgage market. When a bank or a mortgage broker wanted to take off his books a loan, it could sell it to a GSE, which led to a higher number of mortgages.Fannie Mae and Freddie mac are the two major GSEs. Alone, they own or guarantee half of the genuine mortgages. With their political relation status, investors can buy those bonds while asking for a low interest rate in retu rn, as federal government bonds have the safest credit rating in the world. As long as debtors paid back their mortgages, Fannie Mae and Freddie mack would be able to pay their creditors too. However, as these loans where often given out, even to people we knew could not reimburse, GSEs had to assume the risk. Therefore, we could also hypothesise that investors could be blamed for the role they played.They bought and invest in financial products they did not know about. They should have conducted researches about what they were purchasing and should have known these were subprime and meant a higher risk of non-payment. However, we have to see the bigger picture. At that time, banks received force from higher instances to encourage homeownership and so, to grant loans to the poorest population. The government wanted households with a less comfortable life to be able to buy their own house. The pressure that was put on the banks forced them to give mortgages to debtors that would i kely not pay back. This being said, borrowers are also responsible for contracting loans that they pertinently knew they could not afford. Moreover, the credit rating agencies are also not responsible for the debt of the countries. They have often been accused to do be the reason for the deficit of some countries such as Greece. Nevertheless, Greece has always had a long deficit. They never had a break-even budget in 150 years, and governments from left to right parties consistently laid about the finance of the bucolic.In addition, the national sport is not the Greco/Roman clamshell or the Marathon but how to ward off paying taxes nothing in which the rating agencies were involved. Furthermore, regulators could have also done a better job to prevent the crisis. In the United States, several regulators exist and each of them has a specific area of expertise. The regulation of the banking sector is shared between the Federal Reserve (Fed), the Office of the Comptroller of the ca sh (OCC), the Federal Deposit Insurance association (which guarantees the deposits of bank customers) and the Office of the Thrift superintendence (OTS).There is also The Securities and Exchange bearing (SEC) that is responsible for the supervision of stock exchanges. The Financial effort Regulatory Authority provides the regulation of brokerage activities. Finally, the Commodity Futures Trading Commission (CFTC) insures the regulation of futures and options markets. This various regulators could have acted to appease the situation. The SEC could have, indeed, regulate lending practices at banks and force them to keep more capital militia in case of losses.The Federal Reserve could have contained the housing bubble by setting safer mortgages lending standards, which it failed to do and oddly when Alan Greenspan who was the head of the FED, refused to purify the examination of the subprime mortgage market. Finally, according to the Financial Crisis Inquiry Report, executives i n the main investment banks did not hold enough capital to be fully protected against losses. Some companies, such as Lehman brothers or Citigroup would full hide bad investments off their books.It is mainly a problem related to the liquidity crisis that led to the bankruptcy of Lehman Brothers. Lehman Brothers, indeed, financed itself on the short-term and lend on the long-term. When the source of the financing dried up (banks did not trust each others by fear of not being paid off), Lehman found himself stuck and was enabled to face its commitments. If the credit rating agencies were not responsible for the mortgage originators or securitizers, the creation of the CDO, the regulators or the executives of the investment banks, they for certain played a tremendous role in the crisis ) But they could have done better The credit rating agencies are responsible for a lot in the financial crisis. some(prenominal) aspects of their business as well as the actions they have done have be en pointed out as the main cause of the crisis. First of all, the pertinence of their business model was questioned, among others the oligopolistic situation of the market and the conflict of interest created by the issuer-payer model. The Big iii (Standard & Poors, Moodys and Fitch Ratings) generate 95% of the $6 billion market that the rating business represents.These three agencies dominate the market and adopt similar methodologies and practices. The business model of the rating agencies establishes itself on the independence and the credibility granted by the financial markets and the authorities of supervision. That is why, in the absence seizure of statutory reforms and / or of the desertion of numerous customers, the leadership of the Big deuce-ace will be maintained, protected by strong barriers of entry (reforms difficult to set up and loyalty of issuers often connected to the weight of the rating process).Besides, the oligopolistic situation is strengthened by a consol idation, on the initiative and thus for the benefit of the Big Three. So, Fitch acquired in June 2000 the fourth American rating agency, Duff and Phelps, and in December 2000 Thomson BankWatch. At the beginning of 2006, Fimalac gave up 20 % of Fitch Group (who, herself, holds Fitch Ratings, Fitch teach and Algorithmics, this last company having been acquired in 2005) to Hearst Corporation. Likewise, the French subsidiary of Standard & Poors acquired ADEF (Agency of Financial Evaluation).Another reason why the credit rating agencies played an important role in the financial crisis is because of the conflicts of interest they were face up with the issuers. If some narrate that these conflicts of interest were of nestling importance since there are always conflicts of interest in relationships, in that case, it had serious consequences on the ball-shaped economy, as they are one of the causes of the subprime crisis in 2008. It is, indeed, the issuer that pays the rating agency so that this one estimates its capacity to pay off its debt.It is thus relevant to delight in about the partiality and the objectivity of the rating agencies which find themselves at the same time judge and judged and which can be inclined to note well its customers to keep their market share. Besides, the transparentness that the rating agencies show in their methodologies and during their changes of ratings is unreliable as far as these sudden reversals seemed to have destabilized the markets. The three major credit rating agencies also contribute to worsen the financial crisis by their practices. They were, indeed, a key factor in the financial meltdown.They attributed a rating to every products offered on the stock market. Even mortgage-related securities received a good grade, which made it easier to market and sell them. As we have seen previously, the ratings that they gave had an almost biblical authority, so investors trusted the rating agencies to be fair and to give releva nt grade to each product and did not conduct further investigation regarding their investment. Credit Rating Agencies were necessary to the mortgage-backed securities market each actor in the process needed them The issuers, to approve the structure of their deal The banks, to determine what capital to hold The investors, to know what to buy Since 1970, when the credit rating agencies got the status of NRSRO, the SEC decided to base the capital requirements for banks on the grades given by the rating agencies. This is also included into the banking capital regulations as the resort rule, which allows banks to hold less capital for higher-rated securities. The SEC also prevented money market funds to buy securities that did not receive ratings from at least two NRSROs.Without these good ratings, banks would not have been able to place these financial products so easily onto financial markets, and the investors would have never bought them. Theirs ratings helped the market to go up rapidly and their downgrades between 2007 and 2008 wreaked havoc across markets and firms. These ratings, especially the ones for the mortgage-backed securities, appeared to have been very optimistic. But what we could observe, throughout the crisis, is the gregarious reflex of the credit rating agencies.They usually agreed on the ratings and when one of them downgraded a security, a company or even a State, the others would usually follow and did the same thing. As we have seen, the Credit Rating Agencies have indeed played an important role in the financial crisis. However, they are not the only one to blame. Thus, we can say that the thermometer is not responsible for the crisis but it could have given a better temperature of the situation. III. What is next? As we discussed, the credit rating agencies have been criticized a lot during the crisis and some flaws of them have been pointed out.In order to repair their efficiency, it is important to understand what we have learned from the crisis and then propose a better regulation or an pick to the Big Three. 1) Lessons learned from the Financial Crisis The first lesson learned from the crisis is the impact of the globalization of financial markets. This has linked countries together in a greater extent than they were before. That is why, in todays economy, any crisis that hits a main rude or group of countries will have repercussion on all other countries. The financial crisis of 2008, started in the United States with the subprime bubble.Then it grew bigger and affected the rest of the world almost immediately compared to the 1929 crisis which also had intercontinental impact but more gradually. We have to keep into consideration this new factor and realize that globalization plays an important role in the current worldwide economy. In addition, a state and its financial system need to be better nimble to face the crisis, in order to dress economic and financial damages. This actor having a sound and well-regulated environment, keeping its inflation rate low, its exchange rate flexible, and its debt position sustainable.By doing that, a country would limit its vulnerability in front of any financial crisis. Moreover, the country should use fiscal and monetary policies to be able react quickly in case of external shocks. Another lesson learned is the question of the financial supervision. The global crisis is a crisis of confidence, which must implement rules on investment in the financial market, such as CDS (Credit Default Swaps) and short-selling of securities, working of OTC derivatives to reduce risks, CSD (Central settlement and Depository) regulation to protect investors and also Hedge Funds transparence.In macroeconomics, monitoring means imposing laws and rules on a structure with what is called the invisible hand. In our case, the invisible hand is the World Bank and the International fiscal Fund and the States, which have full power to intervene and better regula te minutes in the financial markets. This crisis also revealed some weaknesses regarding risk planning. Research based on various methods, including country case studies, corroborate that the more the planning is important, the more the type of the financial services of a country is raised and more the financial intermediation is efficient.The planning of the risks led a certain number of countries to revise their financial structures to set itself to the global economic transformations. Finally, we can say that every good thing comes to an end, irrefutable times do not last forever and the end is most possible going to be painful. In todays financial system and global economy, we cannot fend off financial crisis, we can just hope that enough efforts will be done to improve our financial system and to limit the impacts of future crisis on our economy.If we contract on Credit Rating Agencies, to have a sound environment, it is worth considering a better regularization of our existing Credit Rating system, a new and improved rating system or the procession of all told new credit rating agencies. 2) Regularization of our existing Credit rating system After the dysfunction of our system translated for instance into the collapse of Lehman Brothers, the disappearance of noted institutions such as Bear Sterns or Merrill Lynch, G7 members stressed the financial effort to improve its functioning mode and heighten the regulation.Several critics have indeed been directed to the credit rating agencies regarding the methodologies used by those agencies (including the growing place of the so-called political factors), the lack of transparency of their decisions, the rudimentary explanation accompanying the changes in notation, the moments selected to realize their announcements of ratings and finally, the potential conflicts of interest. All these aspects need to be taken into consideration when aiming to regulate the rating agencies. Various reform final cau ses have been recommended.Among them, you find some proposing the downsizing of the governments influence over this industry, or even the creation of a completely government-sponsored rating entity. However, the final goal is the verity of the credit rating. The first main step toward a better regulation happened in 2006, when a new section to the Securities Exchange Act has been added. The objective was to improve rating fictional character for the protection of investors and in the public interest by fostering accountability, transparency, and challenger in the credit rating industry (ANNUAL SEC REPORT, supra note 22, at 16).The market is an oligopoly the Big Three set the tone for the rest of the industry. Encouraging argument should give more choices to investors, at a lower cost and with better quality ratings. Several rules were added along the way, especially in 2009, when the SECs new rule addressed conflicts of interest, fostered competition and required flesh out dis closure. For example, a NRSRO could not anymore issue a rating in which it had informed the bank or the issuer for the structure of the product.Another change emerged from the Dodd-Frank Act, in 2010, where a whole chapter has been sanctified to the rating agencies improvements to the regulation of the Credit Rating Agencies. The Dodd-Frank Act qualified the agencies as gatekeepers for the debt market and that is why they needed public direction and accountability. This meant reducing the investors reliance on ratings by limiting references to NRSRO ratings from rules, increasing the liability exposure, maintaining and informing on the structure of the ratings, as well as filing control reports yearly.However, both of these new reforms showed weaknesses, particularly in addressing the conflicts interest coming from the issuer-payer model, or the oligopoly. As mentioned before, several proposals would appear more efficient to answer these problems. The first proposal would be the elimination of the NRSRO status, which would remove any restrictive reliance on the ratings. This would also experience prices down as there would be an increasing competition, but it would also improve the rating quality and the innovation.Nevertheless, this proposal would lead to a total revision of the holy bank regulatory system and could also increase the pressure to satisfy issuers. The second proposal was to create a totally government-sponsored rating industry. This would make the rating a public good, eliminating any conflicts of interest due to the issuer-payer model. Although appealing because it resolves one of the main critics emitted during the financial crisis, it does not say who is going to pay for the subsidization.Finally, another more recent proposal called give out or disgorge asks for the agencies to disclose the quality of the ratings they give, which means disclose to the public when a rating is low quality or disgorge benefits made with the rating. Howev er, charging penalties would increase the barriers of entry on this market and discourage potential NRSROs. The rating business faces two major problems, the oligopolistic situation of the market that is being maintained by an increased regulation that secures the Big Three, and the issuer-payer model that fosters the conflicts of interest.Even though several reform proposals have been suggested, none appears to be totally conceivable. 3) A new rating system We have seen that a lot of reform proposals exist in order to enhance and increase regulation of the rating system. These proposals, indeed, reveal that some aspects of this business need to be improved. Eventually, a new rating system is worth considering. First of all, we have realized already touch based, throughout this analysis that the business model of the credit rating agencies needs to be modified, especially the issuer-payer model.The fact that the issuer is the one that pay the agencies for their ratings creates a con flict of interest that has to go away to insure an accurate and objective rating. In order to solve this issue, a new model is necessary. A possible idea to get there would be to make, not the issuer, but the investors (the ones that want to know the rating of a company or an entity) to finance the credit rating agencies. It is indeed them that need to know the rating of an entity, so it would be fair for them to pay in order to know what they are investing in.This would figure out the problems related to the conflict of interest as rating agencies will not be tempted to give a good grade just to satisfy the client and reverse loosing profits. This was actually the model that existed before 1970, when the issuer-payer model was established. The shift to a model investor-payer would constitute a deep change for the whole rating industry but would carry away the conflicts of interest. Another change that would be conceivable would be to set up a rating planning. The credit rating a gencies should emit their grading at a known rhythm.Therefore, companies or States would know when they would be rated. For example, every January 1st, they could give their ratings for all entities. This would avoid sudden downgrades as we saw during the crisis, where rating agencies lowered the rating of a company right before it went bankrupt. Furthermore, to improve the true statement of the ratings, a distinction between the rating of a company and a State should be made. In fact, Credit rating agencies do not evaluate the same thing when rating a country or a firm.That is why different ratings should be given according to the constitution of the entity. Finally, this new rating system should have a better transparency of ratings. As this has often been reproach to the agencies, it is clear that we need to improve it. In order to get more transparency in the ratings, the credit rating agencies should be forced to make public some criteria that contributed to the rating proces s. In addition, when an entity is downgraded, there is ever a clear explanation.An explicit and standard comment should go along with the new ratings to explain the cause of the downgrade or upgrade. All these improvements should be made to obtain a more transparent and accurate rating. These changes could lead to more efficient and regular ratings where conflicts of interest would be inexistent and where the distinction between entities would improve the relevance of the ratings. 4) Creation of a new credit rating agency Finally, another solution that arises would be the creation of a new rating agency.This proposition is particularly discussed in Europe. The arguments called in favor of the creation of a European rating agency are multiple. It would be a question, first of all, of introducing more competition into a sector that is today dominated by three major actors. Standard and Poors, Moodys and Fitch Ratings are indeed sharing more than 90 % of the market, a situation which confers to the members of this Big Three a tremendous capacity of influence. To create a new rating agency would be a way of having a bigger diversity of points of view.The trust that would be granted by the investors to a new European agency would depend however on its capacity to avoid the criticism sent to Big Three in terms of independence and conflict of interest. It would also be necessary to sterilise the status of the new agency a public or a private organization? A public rating agency could face the mistrust of the investors, who could doubt its independence towards public authorities and States, which it would have the mission to evaluate. On the other hand, a private agency would look like a non-profit foundation.The rating agency would be financed by the investors who would use its notations, and not by the entities emitting the financial products, which would allow guaranteeing its independence. Nevertheless, the future prospects of such a structure remain incertain to what extent would it be able to impose itself in front of Big Three, in a sector where the experience and the reputation of the institution play a determining role? In addition, a history of ratings would be necessary to evaluate the evolution of an entity and a strict method is mandatory for accurate rating.A new rating agency would not be able to have all of these factors before several years. To conclude, it is not easy to find the best solution to improve the current rating methods. Different regulations have been tried, all presenting good points but also flaws. However, what we need to enhance is clear better transparency, a more accurate rating and a suppression of the conflicts of interest. Conclusion The role of the credit rating agencies in todays economy is crucial. They evaluate the creditworthiness of an entity, influencing investors and interest rates.However, during the crisis, their role has been criticized. Several factors can explain their controversial position . The oligopolistic situation of the market, their supposedly trustworthy evaluations given by their NRSRO status, as well as the conflicts of interest coming from their issuer-payer model are the main causes of the critics emitted toward them. Recently, the American justice even press charges against the rating agencies for their role in the crisis and asked for volt billion dollars. Nevertheless, even if the credit rating agencies are the ideal responsible, they are not the only ones to blame.Now that the crisis revealed the different flaws of their system, we can only improve them going forward. Several regulations have already been approved and others are still under consideration. Other ideas to enhance the rating system include a new financing model, by perhaps considering going back to the investor-payer model, a better transparency of their rating, by showing the criteria used for their ratings, and a distinction between a company or a security and a State, which are two co mpletely different entities.Lastly, we can wonder if the Credit Rating agencies still have as much influence as they used to. For instance, when downgrading both the United States and France, the repercussions were minors even nonexistent. The lost of their triple A did not bring the interest rates up as it should have, since today the interest rates are historically low in both these countries. Exhibits Exhibit 1 Credit Rating Agencies with the NRSRO designation Exhibits Exhibit 2 Rating systems of the Big Three Source Credit rating Wikipedia, the free encyclopedia. Wikipedia, the free encyclopedia. N. p. , 7 Mar. 2013. Web. 13 Mar. 2013. http//en. wikipedia. org/wiki/Credit_rating. Exhibits Exhibit 3 outstanding facts about the crisis Exhibits Exhibit 4 development of market indexes from August 9 to 16, 2007 office Evolution Dax (Germany) -4,42% Dow Jones (USA) -5,95% Nasdaq (USA) -6,16% FTSE 100 (United Kingdom) 8,37 % CAC 40 (France) -8,42% Nikkei (Japan) -10,3% Exhibits Exhibit 5 Residential Mortgage-backed securities These tranches were often purchased by CDOs These tranches were often purchased by CDOsSource The financial crisis doubt report final report of the National Commission on the Causes of the Financial and economic Crisis in the United States. Official government ed. Washington, DC Financial Crisis Inquiry Commission , 2011. Print Bibliography * Dupuy, Claude . La crise financiere 2007-2008 Les raisons du desordre mondial C. francetv instruction la plateforme des parents, eleves et enseignants. N. p. , n. d. Web. 12 Mar. 2013. http//education. francetv. fr/dossier/la-crise-financiere-2007-2008-o21596-chronologie-de-la-crise-2007-2008-780. 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