The Role of Rating Agencies in Financial Crises

Bachelor Thesis, 2010

45 Pages, Grade: 2.0


Table of Contents

List of Illustrations

List of Abbreviations

1 Introduction

2 Historical Development of the Rating Agencies and Recent Problems
2.1 Years of Foundation
2.2 The Issuer Pays Model
2.3 Nationally Recognized Statistical Rating Organization
2.4 Recent Rating Problems- The Case of Enron

3 The Financial Crisis 2007 - ?
3.1 Reasons
3.1.1 The Subprime Market
3.1.2 Structured Finance
3.2 The Development

4 The Role of the Rating Agencies- A Model trying to explain
4.1 Ratings Shopping and Asset Complexity
4.2 List of Literature
4.3 A Model of an Asset Auction and a Market for Ratings
4.4 Mandatory Disclosure of Shadow Ratings
4.5 Voluntary Disclosure
4.5.1 The Disclosure Decision
4.5.2 The Acquisition Decision
4.6 The Main Results of the Theoretical Model
4.6.1 The complexity of assets raises the incentive to shop for ratings
4.6.2 Complexity affecting ratings bias
4.6.3 Issuer might prefer more complex assets
4.7 An Empirical Dispute

5 Proposed Solutions and Further Perspectives

6 Conclusion

Appendix I: Global CDO Issuance ($millions)
Appendix II: Sample Cash Structured Finance CDO Structure
Appendix III: Numerical Example of Ratings Shopping


List of Illustrations

Figure 1: Sample Subprime MBS Structure

Figure 2: The Waterfall Principle

Figure 3: Typical CDO Contractual Relationships

Figure 4: CDO Issuance by Year

Figure 5: Model Timing

Figure 6: Relationship of Ratings Bias and Asset Complexity

List of Abbreviations

illustration not visible in this excerpt

1 Introduction

“There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.”1

By December 2008, structured finance had a market share in the U.S. bond market of 35%. More than a half of these securities were highly rated with an AAA, the best rating that can be obtained by the credit rating agencies. Shortly after, 36346 tranches were downgraded by Moody’s, one of the biggest rating agency.2 The downgrading of assets had a huge impact on the economy worldwide. It was obvious that the ratings were wrong and had to be corrected afterwards.

Shortly after, Greece was downgraded to the worst asset class, called junk bonds. This had the consequence that the interest rate for Greece lending money rose enormously and led nearly to bankruptcy of the country.

The market behaved the same way as before and trusted the recommendations of the credit rating agencies.

Just a few months ago, people experienced that ratings are not always correct. But when Greece was downgraded, the market reacted the same way as before and nearly caused a huge crash by leading an EU member into near- bankruptcy, which would have had an enormous impact for the whole EURO- zone!

So what do these rating agencies do? They give recommendations about the creditworthiness of assets, to say it simple. They classify assets into several categories from AAA, which is the best, to D, which is the worst.3 I also learned that there are instructions from the rating agencies for the issuers of a rating how to structure an asset to get the best possible rating AAA!4

Frank Partnoy, Professor for Law at the University of San Diego even states that “credit ratings can have great market value but little informational value.”5

My intention of this thesis is not to blame the rating agencies for a bad performance, but to understand why they acted the way they did and to get to know triggers and reasons for this behavior.

Structure of the Thesis

To understand the roots of the capital markets and the rating agencies I want to start with a historical development. With introduction of the Issuer Pays Model and the proclamation of so called NRSROs there is the starting point for a long time discussion within the credit rating industry. Then I want to introduce the case of Enron, a former energy conglomerate which has been wrongly rated by the rating agencies. I want to investigate if there are any parallels to the crisis of 2007. I also want to understand and show the reasons and the structure of the crisis of 2007. So I will introduce the Subprime market and structured finance, as these topics were probably the triggers for the crisis. The main part of my thesis is to find an explanation for the performance of the credit rating agencies. I use a theoretical model which stresses the complexity of assets. The model says that the more complex an asset is, the harder it is to rate for the agencies. In opposite to that I want to compare the results of the theoretical model with an empirical study. I want to investigate if the theoretical model gets the same result as the empirical approach or if there are huge differences. At last I want to introduce some solution proposals by myself and think about further approaches.

2 Historical Development of the Rating Agencies and Recent Problems

Although today’s international stock market mainly takes place in the USA, the origins of modern stock broking lie in Europe.

In 1609, the Dutch East India company invented the common stock to finance their plans of expanding. Shortly after, under the reign of William of Orange, the Dutch Republic had established the most progressive finance system in the world:6 “a strong public credit, stable money, elements of a banking system, a central bank of sorts, and securities markets”7.

The Dutch system was even so successful, that in 1688 the English Empire wanted William of Orange to be king and so he had experienced financiers with him. Shortly after, because of the engagement of the Dutch experts, components of a modern financial system were established in England as well. The Bank of England for example was founded in 1694. After adopting the Dutch financial system, England grew to the leading industrial nation, and consequently was the first nation in the world to experience the Industrial Revolution.

By the end of the18th century, the USA adopted a modern financial system along the lines of Europe. Soon they developed public and private bonds, a central bank and a comparatively stable currency.

In contrast to the USA many European countries were deeply in debt due to many wars. They had to cover the high capital demand for the ongoing military engagement by means of government loans. Despite the high debt level, European countries were highly credit worthy, which in combination with the high capital demand lead to a rapid growth in stock broking. So just after the English Empire had out competed the Dutch in economic aspects, within a century the USA took over the leadership as the “world’s pre-eminent national economy”.8

2.1 Years of Foundation

“Somebody sooner or later will bring out and industrial statistical manual. And when it comes, it will be a gold mine.”9

During the 17th and 18th century, importers in the USA extended their credit period to retailers and shopkeepers to more than a year. The payback of these credits often was late and not steady, the need of information about credit worthiness became more important. Letters of recommendation were faked, detailed financial information was not available. Obviously there was a requirement for collecting information about the credit worthiness of investors, companies and retailers systematically. The idea of rating agencies as informational intermediaries was born.

In the financial crisis of 1837 Lewis Tappan and his brother, who operated in the silk business, went bankrupt. Luckily they had gathered detailed credit information about their customers, among them large enterprises. This was valuable information at the time, so Tappan founded the first credit rating agency, The Mercantile Agency.10 In the late 19th century, the USA was a fast growing economy on continental scale. Especially the building of infrastructure, namely railroad tracks, needed a lot of money. Most railroads were built by private corporations, who developed a dramatically rising demand for capital. After 1850 these corporations expanded westwards into unsettled areas and could not find any banks financing their projects, because the banks doubted the credit worthiness of the companies.11

John Moody, a Wall Street analyst in the late 1800s, followed the success of Tappan’s The Mercantile Agency and founded his rating agency Moody’s in 1909, expanding the business to railroad bonds as there was a high demand for ratings.

Soon Poor’s Publishing Company entered the market (1916), followed by Standard Statistics Company in 1922 and Fitch Publishing Company in 1924. The number of rating agencies diminished to three, when Standard Statistics and Poor’s Publishing Company incorporated to Standard and Poor’s (S&P) in 1941.12

These firm’s ratings were sold to investors in thick manuals.13 “In the language of modern corporate strategy, their ‘business model’ was one of ‘investor pays’.”14

2.2 The Issuer Pays Model

Agencies provided information about investments and bonds, selling that information to investors, but letting issuers free of charge. Those publications were easily copied, especially due to the fact that the photocopier was marketed in those times. So the publications did not derive high enough profit to satisfy the rising demand for fast and extensive ratings. The agencies began to charge issuers to pay for the ratings. The security paper market grew quickly in the 1960’s with little attention to the credit quality. The bankruptcy of Penn Central15, a former US American railroad company16, was a turning point in the development of the issuer pays model. With a default of 82$ Million, the insolvency of Penn Central made many investors doubt the solvency of other companies and refuse to roll over credits. To calm down the contributors of capital, many companies requested ratings. The issuer pays model was born.

Fitch and Moody’s started that payment system in 1970, followed by Standard & Poor’s a few years later.17

This change of paradigm lead to a discussion which is even now up to date. I want to stick to this point later in my thesis as well.

2.3 Nationally Recognized Statistical Rating Organization

Another major change for the credit rating agencies (CRA)18 was accomplished in 1975. The U.S. Securities and Exchange Commission (SEC) decided to set a minimum capital requirement for broker dealers (e.g. bond firms). Following the model of other financial regulators, the SEC wanted these capital requirements to consider the riskiness of the broker dealer’s portfolio and wanted to use ratings as an indicator of risk. The supervisors were afraid of fraudulent rating agencies to enter the market, promising “AAA” ratings to companies who normally would get a “D” rating. To cope with this problem, the SEC decided to create a new category within the CRA. They created the “nationally recognized statistical rating organization” (NRSRO). Straightaway the three big agencies, Moody’s, S&P and Fitch were declared to be NRSROs. The SEC announced that from now on only ratings from a NRSRO should be valid for the regulation of the capital requirements of broker dealers.19

Until 2000 there were only four additional companies announced to be NRSROs 20, but fusions within the CRA let the number of NRSROs fall back to the original three. Most importantly, the SEC built up an entry barrier to become part of the CRA, especially as the institution did not establish criteria defining how to become a NRSRO. Not being a NRSRO, “any would-be bond rater would likely be ignored by most financial institutions; and, since the financial institutions would ignore the would-be bond rater, so would bond issuers.”21

Most literature - as for example White22 - states, that qualifications for admission as a NRSRO are not clearly defined. There is merely an application form on the website of the SEC.23

2.4 Recent Rating Problems- The Case of Enron

I see Enron as a kind of pre- stage of rating failure compared to the misrated structured finance I will describe in the next chapter. As financial instruments like collateralized debt obligations, Enron was an asset to rate for the CRA that was not structured like ordinary assets. Enron dazzled the market players by its complexity and innovation and led to an unusual high growing boom. In this chapter I want to describe the development of Enron and outline the complexity of business Enron dealt with.


Kenneth Lay founded Enron in 1985 by merging the two gas pipeline companies Houston Natural Gas and Internorth.

The new company owned the largest network of interstate gas pipelines and profited from the deregulation of the gas market in the 1980s. To gain higher profits, Enron diversified its business and became “financial trader and market maker in electric power coal, steel, paper and pulp, water, and broadband fiber optic cable capacity. It undertook international projects involving construction and management of energy facilities. By 2001, Enron had become a conglomerate that”24 depicted a broad spectrum of business and services.25

This enormous expansion amazed a lot of capital market players, so no one seriously questioned Enron`s strategy.

The Development

Jeff Skilling, who became CEO of Enron in August 2001, invented the so-called gas bank while he worked for Enron with McKinsey. The gas bank works like a financial bank, with the difference that it intermediates between suppliers and buyers of gas. This new trading model should help both, buyer and seller, to manage their risk. To secure the business, Enron used complex financial instruments like swaps, futures and other financial vehicles. In 1999 EnronOnline was launched, a software which enabled the company to develop and manage those financial instruments more efficiently.

In the 1990s Enron wanted to enter other areas than the gas market. The aims were markets with complex attributes. Pricing should be unintelligible, the distribution channels sophisticated. So it happened that Enron launched its business model to other markets, like electric power and broadband assets.

The aspiring company not only expanded its business to other scopes, but also beyond the U.S. borders. The first international project started in 1993. Enron operated the Teesside power plant in the United Kingdom and also had other projects all over the world, e.g. in Africa, Eastern Europe and Asia. Every project meant a significant investment in the respective economy. With international diversification there are always big risks inherent. Especially in India and China, Enron had opponents on the political level.

Financial Reporting

“Enron’s complex business model - reaching across many products, including physical assets and trading operations, and crossing national borders - stretched the limits of accounting.”26 Two issues seemed to be especially problematic. Firstly, under the circumstances obtaining at the time the accounting rules could not cope with Enron’s trading business. Secondly, especially the extensive use of structured finance transactions was not common practice for accounting makers at that time.27

The Downfall

Enron’s gas trading idea was a smart move in a time of deregulation, nevertheless international expansions turned out to be unsuccessful.28

On October 16, 2001, Enron published a $1.01 billion “’non-recurring charge’ related to ‘losses associated with certain investments … and early termination during the third quarter of certain structured finance arrangements with a previously disclosed entity’”.29 Nevertheless CEO Ken Lay restored confidence in the power of Enron. Despite these protestations, write- offs produced a loss of more than $600 million in the third quarter and took Wall Street heavily by surprise. Thereupon stock price declined from mid-$30s to the low-$20s and caused a serious crisis in the company.30 Enron desperately sought a solution and wanted to merge with its smaller rival Dynergy. But on November 28, Enron’s creditworthiness was downgraded to junk bond status and Dynergy removed the offer of acquisition. On December 2, 2001, with its stock price at $0.26, Enron filed for bankruptcy.31

The particular Importance of Enron

Until four days before Enron filed for bankruptcy, Moody’s, S&P and Fitch had rated the company by investment grade.

How could this happen? The simple version: Enron was highly complex in its business strategy and diversification.32 “-some of its executives were among the most sophisticated of the ‘rocket scientists’, developing transaction structures dazzling in their intricacy.”33 In the special case of Enron, the complexity of business is not sufficient, but necessary to explain the cause. Another cause of the wrong rating of Enron is the fact, that the managers practiced immense accounting fraud. 34 Yet Senator Joseph Lieberman, whose Senate committee held the first hearings on Enron blamed the rating agencies: “The credit- rating agencies were dismally lax in their coverage of Enron. They didn’t ask probing questions and generally accepted at face value whatever Enron’s officials chose to tell them. And while they claim to rely primarily on public filings with the SEC, analysts from Standard and Poor’s not only did not read Enron`s proxy statement, they didn’t even know what information it might contain.”35

3 The Financial Crisis 2007 - ?

In this chapter I want to strongly stress the characteristics, reasons and the development of the financial crisis of 2007. I want to emphasize the pitfall of the Subprime market. But the most important argument of this chapter is the structure and character of structured finance. I want to outline the complexity of those financial instruments, on which I will refer to in chapter 5. It is not only important to see the success of structured finance but also to understand the unusualness.

3.1 Reasons

The crisis of 2007 was in a way born out of many crises that swept around the world in the late 1990’s. The Asian economy tumbled, Russia was in default, Argentina, Brazil and Turkey faltered. Subsequently a lot of emerging countries were cautious about borrowing money from abroad. Their enterprises, government and households reduced investments and consumption. Some of them became suppliers of financial capital themselves - instead of demanders. The savings in one part of the world of course led to deficits elsewhere. Industrial country enterprises started to expand to other investments, especially in information technology. But due to the IT bubble in the 1990’s investments were cut back sharply in this field of business as well.

By providing cash, the monetary policy of the world’s central banks, especially the Federal Reserve, assured that the world did not have to suffer a global recession. Because there was a lot of new money circulating in the world, interest rates in a number of countries decreased. This was the starting point for a growing housing demand and the prices for houses increased.36

3.1.1 The Subprime Market

Home ownership for the low income population was a long time national goal in the USA.37 The main problem that has to be faced in providing mortgage finance to Subprime borrowers is that these borrowers are riskier. Even if this risk is priced, there must be restrictions in providing mortgage for this segment of borrowers. And there are further problems related to Subprime borrowers.38 These clients are often not able to save enough money to provide deposit. Most borrowers in the Subprime segment are not credit-worthy and do not have documented income. They are often not familiar with the home- buying process and do not know how much house they can afford.39

So there was to find a way to lend to such borrowers. The basic idea of Subprime lending is the fact, that the dominant form of wealth of low- income households is their home equity.40 “If borrowers can lend to these households for a short time period, two or three years, at a high, but affordable interest rate, and equity is built up in their homes, the mortgage can be refinanced with a lower loan-to-value ratio, reflecting the embedded price appreciation.”41 After a period of two or three years borrowers have to refinance and the lender has the option to offer new mortgage or not, depending on whether the house price has increased or not.42

Design and Complexity of Subprime Residential Mortgage- Backed Securities How can Subprime mortgages be financed? The answer was Subprime RMBS. Subprime RMBS are different from other securitizations.

Subprime RMBS bonds differ by seniority. This aspect is similar to other securitizations. Unlike other securitizations, the credit enhancement and the size of each tranche depends on the cash flow coming into the deal. The prepayment of the underlying mortgages delivers the cash flow through refinancing. Certain triggers, which measure the performance of the underlying pool, decide what happens to the cash flow. This can eventually lead to a leakage of protection for higher rated tranches.43

“Time tranching in Subprime transactions is contingent on these triggers.”44 The figure below shows the typical structure of a RMBS transaction.

illustration not visible in this excerpt

Figure 1: Sample Subprime MBS Structure

Source: Kevin Kendra (2007).

There are several individual mortgages. The Mortgage Pool contains several Hybrid adjustible- rate mortgages. Multiple Mortgages are pooled into either a Hybrid ARM Mortgage Pool or a Fixed Rate Mortgage Pool. By using a Special Purpose Vehicle the mortgages are classified into different qualities of Bonds.

Prime RMBS and Subprime RMBS both have credit risk as the primary risk facture. But Subprime RMBS differentiate from Prime RMBS by having different structure and having an additional layer that supports the bonds with for example an interest spread. Another important feature is overcollateralization, which means that there are initially more assets than liabilities.45

The RMBS structure is very complicated and has a lot of details which have to be explained. As the most important feature I want to stress the waterfall principle. This means that there is a sequential pay within the RMBS.


1 The News Hour with Jim Lehrer: Interview with Thomas L. Friedman (PBS television broadcast, Feb. 13, 1996).

2 Cp. Benmelech & Dlugosz (2009)

3 There are little differences within the rating agencies, but this is the principle.

4, last visited on August 14th 2010.

5 Partnoy (2001), p. 2.

6 Cp. Sylla (2001), p. 2.

7 Cp. Neal (1990)

8 Cp. Sylla (2001), pp. 3.

9 Cp. MacDonald Wakemann (1984).

10 Cp. Partnoy (1999), p. 636.

11 Cp. Sylla (2002), p. 6.

12 Cp. Cantor & Packer (1994), p. 2.

13 Cp. White (2009), p. 3.

14 Cp. Id., p. 3.

15 Cp. Cantor & Packer (1994), p. 4.

16 Cp.

17 Cp. Cantor & Packer (1994), p. 4.

18 From now on CRA.

19 Cp. White (2007), p. 49.

20 Duff & Phelps (1982), McCarthy, Crisanti & Maffei (1983), IBCA (1991), Thomson Bank Watch (1992); Cp. White (2009).

21 Cp. White (2009), p. 5.

22 Cp. White (2009).

23, last visited on 14.06.2010.

24 Cp. Palepu & Healy (2003), p. 4.

25 Cp. Id. (2003), p. 4.

26 Cp. Id., p. 10.

27 Cp. Palepu & Healy (2003), p. 2.

28 Cp. Id., p. 15.

29 Cp. Gordon (2002), p. 3.

30 Cp. Id., p. 3.

31 Cp. Palepu & Healy (2003), p. 15.

32 Cp. Hill (2009), pp. 283.

33 Cp. Id., p. 284.

34 Cp. Id., p. 284.

35 Senate Committee on Governmental Affairs, press release, Financial Oversight of Enron: The SEC and Private- Sector Watchdogs (October 8, 2002).

36 Cp. Diamond & Rajan (2009), p. 2.

37 Cp. Gorton (2008), p. 5; Cp. Atif, Sufi & Trebbi (2010), p. 3.

38 Cp. Gorton (2008), p. 6.

39 Cp. Listokin et al. (2000), p. 98.

40 Cp. Gorton (2008), p. 7.

41 Cp. Id., p. 7.

42 Cp. Id., p. 7.

43 Cp. Gorton (2008), p. 20.

44 Cp. Id., p. 20.

45 Cp. Id., p. 21.

Excerpt out of 45 pages


The Role of Rating Agencies in Financial Crises
University of Osnabrück
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ISBN (eBook)
ISBN (Book)
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Rating Agency, Financial Crisis, Microeconomics, Enron
Quote paper
Malte Henrik Klein (Author), 2010, The Role of Rating Agencies in Financial Crises, Munich, GRIN Verlag,


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