“There are two superpowers in the world […] the United States and Moody’s Bond Rating Service” – Thomas L. Friedman, NY Times
The above statement by Thomas L. Friedman accentuates the importance of credit rating agencies (CRAs) in modern financial markets. As the past months have shown, Friedman’s statement has held especially true for the role of CRAs in the structured finance market, where CRAs are currently being made responsible for playing an integral role in the emergence of one of the biggest financial crises of mankind: the subprime crisis. The role and the importance of CRAs in the structured finance market is the central topic of the following paper. To fully understand the impact of this issue on the worldwide financial markets, it is interesting to shed some light onto the dimensions of the structured finance market. The market is of considerable size given that outstanding structured finance securities in the United States amounted to 7.3 trillion US dollars in 2005 (Nomura, 2005) and have now grown to 9 trillion US dollars, which is more than two thirds of the United States GDP of 13.1 trillion US dollars in 2007 (U.S. Bureau of Economic Analysis, BEA, 2007). More-over, these outstanding structured finance securities represent more than 30% of the total outstandings in the U.S. bond markets (Nomura, 2005). As these figure reveal, it is not surprising that complications in the core of the huge market of structured finance could potentially lead to a major destabilisation of the entire worldwide financial markets; a risk that was obviously underestimated for a long time and finally lead to the genesis of the sub-prime crisis.
The role of CRAs in the structured finance market has long been debated and the current financial turmoil has brought about concerns regarding such questions as to whether these credit ratings were based on wrong information and faulty or dated models, thereby questioning the significance of the system of CRAs. To enable a better insight into the functioning of CRAs and a justified testimony as to their performance, the following paper will dig deeply into the ambiguity of the rating process and the role of CRAs in structured finance.
Table of Contents
1 Introduction
1.1 Course of the Investigation
2 Introduction to Credit Rating Agencies
3 The Role of CRAs in Structured Finance
3.1 Mechanism of Securitization
3.2 Rating Process
3.3 Interdependencies
3.4 Importance of Structured Finance Ratings
4 Particularities and Challenges of the Rating Process
4.1 Introduction to the Major Problem Areas of CRA
4.2 Particularities of the Rating Process
4.3 Particularities of the Market of CRA
4.4 Particularities of the Structured Finance Market
5 Conclusion
6 Reference List
Objectives and Core Themes
This paper examines the pivotal role of Credit Rating Agencies (CRAs) within the structured finance market and investigates the systemic factors that contributed to their perceived failure during the subprime mortgage crisis. It seeks to clarify the functional interdependencies between issuers, investors, and rating agencies, while analyzing whether the inherent nature of the rating process and market structure create unavoidable conflicts of interest.
- The business model evolution of CRAs from subscription-based to issuer-paid services.
- The interactive and iterative nature of the rating process in structured finance.
- Systemic conflicts of interest and the impact of the CRA oligopoly.
- Challenges related to market opacity, complexity, and information asymmetries.
Excerpt from the Book
3.2 Rating Process
In the following paragraph, the rating process will be described in order to illustrate how CRAs finally arrive at a certain rating. Before a rating process begins, preliminary informal discussions between the CRA and the issuer take place, generally initiated by the latter (Mason & Rosner, 2007, p. 17). These discussions can result in a rating mandate for the CRA given the fact that both parties arrive at an agreement regarding the details of the contract. However, it is not said that the issuing entity can only sign up a single CRA for a specific mandate. Often an issuer hires more than just one CRA to prepare a rating for the same structured finance instrument. After being mandated, the first step of the CRA in the rating process is to familiarize itself with the characteristics of the issuer, thereby reducing the information asymmetries by conducting in-depth discussions with the management of the issuer (Mason & Rosner, 2007, p. 17). Moreover, CRAs try to gather information on the underlying asset pool and further aspects relevant for the final rating decision. Often, CRAs receive all information exclusively from the issuer without even verifying it, a problem that will be discussed in more depth in the following chapter (Mason & Rosner, 2007, p. 13).
The core of the rating process is basically a two-step rating approach composed of a credit risk modeling part and a structural analysis part which is employed by most of the CRAs (Bank for International Settlements [BIS] Report, 2005, p. 16). The first part of the analysis, namely the credit risk modeling, focuses on the underlying asset pool with respect to probabilities of default of the individual obligors in the pool, recovery rates or losses-given default, and default correlations within the pool (BIS Report, 2005, p. 17). Important determinants of assessing the credit risk are loss volatility, obligor concentration, and default correlation.
Summary of Chapters
1 Introduction: Provides an overview of the global structured finance market and defines the central role of CRAs in the context of the subprime crisis.
2 Introduction to Credit Rating Agencies: Details the historical development and traditional business models of credit rating agencies.
3 The Role of CRAs in Structured Finance: Analyzes the mechanism of securitization, the two-step rating approach, and the interdependencies between market stakeholders.
4 Particularities and Challenges of the Rating Process: Discusses the major problem areas, including conflict of interest, market oligopolies, and the inherent complexity of structured finance instruments.
5 Conclusion: Summarizes the findings and emphasizes the collective responsibility of all stakeholders in preventing future financial catastrophes.
6 Reference List: Compiles the academic and professional sources utilized throughout the essay.
Keywords
Credit Rating Agencies, CRAs, Structured Finance, Securitization, Subprime Crisis, Financial Markets, Credit Risk, Rating Process, Conflict of Interest, Oligopoly, Information Asymmetry, Issuing Entities, Investors, Basel II, Financial Stability
Frequently Asked Questions
What is the primary focus of this paper?
This paper explores the role of Credit Rating Agencies within the structured finance market and investigates why these entities are considered to have played a significant role in the emergence of the subprime financial crisis.
What are the central thematic fields covered?
The core themes include the historical background of rating agencies, their evolving business models, the technical rating process in securitization, and the systemic challenges involving conflicts of interest and market transparency.
What is the primary research objective?
The goal is to provide a critical analysis of the rating system, examining if the inherent structure of the industry and the dependency on issuers make it difficult for CRAs to maintain objectivity.
Which scientific methodology is applied?
The study utilizes a literature-based analysis, synthesizing information from industry reports (e.g., BIS, IOSCO), academic papers, and financial market data to evaluate the performance and structure of rating agencies.
What does the main body address?
The main body breaks down the mechanism of securitization, describes the two-step rating approach (credit risk and structural analysis), and details the specific challenges caused by market complexity and oligopolistic competition.
Which keywords characterize this work?
Key terms include Credit Rating Agencies, Structured Finance, Securitization, Subprime Crisis, Conflicts of Interest, and Information Asymmetry.
Why do issuers often hire more than one rating agency?
Issuers often engage multiple agencies to secure favorable ratings or to comply with specific market requirements, though this practice can lead to a "shopping" for the most lenient or desired rating.
How does the "issuer-pay" model affect the rating quality?
The "issuer-pay" model creates a potential conflict of interest where agencies may fear losing future business if they provide an unfavorable rating, potentially compromising their independence and the quality of their assessment.
What are the specific difficulties in rating structured finance?
The primary challenges include extreme complexity, lack of historical performance data for new instruments, and a heavy reliance on data provided exclusively by the issuer without independent verification.
- Quote paper
- Anonym (Author), 2008, The Role of Rating Agencies in Structured Finance, Munich, GRIN Verlag, https://www.grin.com/document/129297
