The Role of Rating Agencies in Structured Finance

Table of Contents

List of Abbreviations

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

List of Appendixes

Appendix

List of Abbreviations

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1 Introduction

“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). More­over, 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.

1.1 Course of the Investigation

In the remainder of this paper, the core functions and characteristics of CRAs are initially analysed in the following chapter. Moreover, a look is taken into the credit rating market and how business models of CRAs have changed over time, as well as the growth of global structured finance. The main focus in chapter three lays on the general role of CRAs with specific regard to the mechanism of securitization and the rating process and its iterative characteristics. Furthermore, this section answers questions as to the importance of struc­tured finance ratings and the interdependencies between CRAs, issuers, investors and regu­lators. In the fourth part of this essay, particularities and challenges of CRAs are outlined addressing issues concerning the nature of the rating process, the structured finance market, as well as the market of CRAs. The concluding chapter six subsumes all relevant findings and presents an outlook of potential future developments.

2 Introduction to Credit Rating Agencies

Prior to analyzing the specific role of CRAs within the context of structured finance, it is necessary to gain an understanding of the general functions of CRAs as well as of their market environment. According to Heakal’s very broad definition, a CRA’s main function is measuring “the ability of an entity – this can be a person, a corporation, a security or even a country – to meet its obligations”. Subsequently, the origin and history of today’s CRAs will be briefly discussed because, to some extent, it shaped the functions and tasks CRAs fulfill nowadays. The predecessors of CRAs can be identified as mercantile credit agencies which existed in the 19th century. During that time, these mercantile credit agen­cies measured a merchant’s ability to pay his financial obligations (Credit Reporting Sys­tem, n.d.). The modern credit rating industry was created by John Moody in 1909, when Moody’s Investors Services began offering ratings to investors which assessed credit risks of dynamic institution to meet its financial obligations. Another major player of today’s CRA market, Poor's Publishing Company, issued its first ratings in 1916; Standard Statis­tics Company was founded and published its first ratings in 1922. The smallest of today’s big three CRAs, Fitch Publishing Company, was founded in 1924. Standard and Poor's (S&P) as it is in existence today, was created through a merger of Standard Statistics Com­pany and Poor’s Publishing Company in 1941 (Mason & Rosner, 2007, p. 8).

Nowadays, S&P and Moody’s are the undisputed market leaders of the credit rating market with both having a market share of 40% each. Only Fitch is capable of competing at eye level with these two rating heavyweights by claiming a market share of about 15%. While controlling about 95% of the total market, S&P, Moody’s and Fitch are considered as the ‘big three’ in this truly oligopolistic market with extremely high barriers to entry.

In the following, the business model of CRAs is illustrated, including the decisive change it has undergone decades ago. The main objective of CRAs traditionally was to provide in­vestors with information relating to the creditworthiness of an entity. Therefore, it is logical that the CRAs’ customers were the investors seeking this information. Consequently, the CRAs’ revenues were originally generated from subscription fees that investors paid, im­plying that initially, CRA were financially dependent on the mandates of the potential in­vestors. As thus, the initial business model resulted in an independency of the ratings from the issuing entities.

However, from the 1970s onwards, a shift in the business model took place. This shift can generally be attributed to two main reasons. First, issuing entities realized that it was very important for them to be rated and more so in a favorable way to gain the confidence and trust of potential investors. The issuing entities became aware of the fact that many inves­tors were relying heavily on the ratings published by the CRAs. This led to a high demand for ratings by issuing entities, and soon, ratings were regarded as a seal of approval (Cantor & Packer, 1994, p. 4). The second fact, which further accelerated the above mentioned ten­dency, can be contributed to the declining revenues from CRAs’ original business model. In order to find an explanation for this phenomenon one must examine the means of how ratings were delivered and distributed to potential investors. Initially, ratings were compiled into books, which would then be purchased by investors. However, it did not take long until pages of the rating books were merely copied and distributed, without generating revenues for the CRAs (Smith & Walter, 2001, p. 6). Combining these two reasons, it becomes ob­vious that the original business model was only capable of delivering poor revenues to the CRAs. Hence, the prospect of the issuing entities paying high fees for the rating of their instruments, presented itself as a very profitable alternative. Especially the emerging struc- tured finance market held the promise of increasing revenues and growth potential. It is not surprising that CRAs could not resist these opportunities and hence entered the structured finance market on a wide scale (Mason & Rosner, 2007, p. 10).

Looking at the rapid increase of structured finance issuance between 2002 and 2006 at an annual compound growth rate of incredible 27%, CRAs seized the chance of this enormous growth potential by concentrating on this promising revenue source (cf. Figure 1). The enormous upsurge in the structured finance issuance is mainly driven by the fact that, on the one hand, there has been an ongo]ing search for alternative investments with promising return structures and on the other hand the banks have recently urged to remove illiquid assets from their balance sheets. Considering the current financial crisis, however, growth rates of structured finance are very likely to decrease significantly again.

CRAs have continuously been engaged in a process of developing and adapting to metho­dologies to rate structured finance instruments. Over the years, these mandates became an increasingly substantial component of their revenue and thus, in 2006, structured finance ratings represented on average 50% or more of the four biggest CRAs’ revenues (CESR, 2008, p. 8). As depicted in Figure 2, revenues generated the in the field of structured finance have been considerably higher than the revenues attributed to other fields of action. In addition, the field of structured finance was the only sector experiencing a rapid growth between 2002 and 2006, which eventually resulted in the record quarterly revenue of 275 million dollars in 2006. One of the main reasons for the large increase of the revenues gen­erated in the structured finance market lies in the higher fees as a percentage of the nominal value of the transaction that can be won in rating structured finance instruments. Estimation range from two to three times higher fees in the rating of structured finance instruments in comparison to conventional ratings.

The main objective of CRAs was traditionally to provide investors with information relat­ing to the creditworthiness of an entity. Therefore, it is logical that the CRAs’ customers were the investors seeking this information. Consequently, the CRAs’ revenues were origi­nally generated from subscription fees that investors paid, implying that initially, CRA were financially dependent on the mandates of the potential investors. As thus, the initial business model resulted in an independency of the ratings from the issuing entities.

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