After the Asian crisis during the 1990s and the startling insolvencies of Enron and Parmalat, the recent financial crisis is one the most important trigger to raise doubt concerning the proper work of rating agencies. They are criticized because of their various conflicts of interest and obvious deficits in practicing their rating methods. The rating agencies should be jointly responsible for the emergence of the so-called bubble markets during the last couple of years. Because of these bubbles and their boom and burst effect, private as well as institutional investors lost enormous sums of assets and single countries were thrown into financial turmoil. Because of these facts, the discontent concerning the rating agencies grew. People took additional notice of their market power, which they only obtained because of their influence on the global capital flows and the use of ratings to regulate the financial markets. To particularize the issues, it is helpful to bring up the year 2007, when the delayed payments among the subprime loans became more frequent. This was due to the slower increase of the housing prices and the rising short-termed interest. Consequently, the rating agencies depreciated a lot of these structured financial products, many of which had received the highest seal of quality before (AAA). Those actions both led to a massive loss of confidence on the investors’ side and a remarkable decline of liquidity. The former market of securitization products no longer existed. Influenced by this development and because they were considerable involved in this securitization business, a lot of banks also got into this downstream.
In the first part of this term paper I will present some general facts about the rating agencies including their history of origins. Afterwards I will mention the process of rating and the problems, which led to the misconduct during the crisis. This will also include a discussion concerning the IOSCO Code of Conduct and the deduced implications concerning the malfunction of the rating agencies. Last but not least I will give a conclusion and suggest some essential aspects which should be implemented from the rating agencies.
Table of Contents
1. Introduction
2. Rating Agencies
2.1 Types of Rating
2.2 The “Big Three”
3. The Rating Process
3.1 Procedure of Rating and its Shortcomings
3.2 Usage of the Gauss-Copula-Model
3.3 The IOSCO Code of Conduct
3.3.1 Transparency of the Rating Methodology
3.3.2 Human Resources
3.3.3 Monitoring
3.3.4 Conflict of Interests
4. Conclusion
5. Sources
Research Objectives and Core Topics
This paper aims to analyze the pivotal role and subsequent failure of rating agencies during the global financial crisis. It explores how systemic conflicts of interest, methodological deficits, and the misuse of quantitative models contributed to the mispricing of structured financial products, ultimately leading to a collapse in market confidence and liquidity.
- The historical development and market dominance of the "Big Three" rating agencies.
- Technical shortcomings in rating processes, particularly regarding subprime mortgage-backed securities.
- The impact of the Gaussian Copula model and its role in obscuring systemic risk.
- Governance and regulatory challenges, including the implementation of the IOSCO Code of Conduct.
- Inherent conflicts of interest arising from the issuer-pay business model.
Excerpt from the Book
3.1 Procedure of Rating and its Shortcomings
The main task of rating agencies is the assessment of the creditworthiness of a debtor. A company or country is only allowed to receive a bond on the international capital market after it has been rated by two of the three agencies. One part of the complex rating model is based on specific available business figures. The other part is a well kept secret. After finishing the process of rating the evaluation is published. There are several differences between the leading agencies, but the letter classification (AAA – D) is the same. The solvency of companies is determined by expert opinions and with the help of the long-term “trough the cycle methodology”. But cyclical changes of the failure probability in the short run will not be considered. In contrast to that, the agencies use quantitative models during the rating process of structured financial products like ABS (Asset Backed Securities) or CDOs (Collateralized debt obligations).
But these models have one big disadvantage: the missing consideration of several risk factors. Because of that the rating agencies committed the grave error of maintaining their AAA ratings for the ABS and CDOs during the subprime crisis. If the rise in interest rates and the downswing on the housing market had been considered during the ratings, the decline of solvency would have been recognized earlier. This would have made the radical depreciations of the former AAA products redundant. Without those high ratings a lot less people had requested these papers in 2007. Furthermore, on the consideration of the correlation between housing prices and creditworthiness was not sufficient. This occurred because the agencies overrated the effect of diversification concerning the geographical spread and moreover underrated the common dependence of the national interest rate policy. However, the housing prices declined after the advance in rate by the FED not only in some states of the USA but nationwide. In addition to this, the rating agencies did not well in regarding the information about the lending attitude of the originators, because the failure probabilities of an originator’s loan are correlated among themselves.
Summary of Chapters
1. Introduction: Outlines the significant influence of rating agencies and provides a contextual background on the financial turmoil leading up to the 2007 crisis.
2. Rating Agencies: Defines the function of rating agencies and details the historical origin and market dominance of the "Big Three" firms.
3. The Rating Process: Examines the technical and procedural flaws in rating methodologies, the reliance on flawed risk models, and the regulatory efforts to address institutional misconduct.
4. Conclusion: Summarizes the systemic failures of the rating industry and proposes essential reforms to restore reliability and oversight.
5. Sources: Provides a comprehensive list of literature, reports, and digital resources used for the analysis.
Keywords
Rating Agencies, Financial Crisis, Subprime Crisis, Credit Rating, Big Three, Securitization, Gauss-Copula-Model, IOSCO Code of Conduct, Transparency, Conflicts of Interest, Market Power, Risk Assessment, Mortgage-Backed Securities, CDO, Financial Regulation.
Frequently Asked Questions
What is the primary focus of this paper?
This paper focuses on the role played by international rating agencies in the financial crisis, specifically investigating how their assessments and methodologies contributed to the market collapse.
What are the central themes discussed in the work?
Central themes include the historical power of rating agencies, the complexities of the rating process, the impact of quantitative models like the Gaussian Copula, and the ethical issues regarding conflicts of interest.
What is the core research objective?
The objective is to examine why rating agencies failed to correctly identify the risks associated with structured financial products and to suggest improvements for their future operation and oversight.
Which scientific methods are employed?
The paper utilizes a literature-based analytical approach, reviewing financial reports, regulatory codes (like the IOSCO Code of Conduct), and historical case studies of market failures.
What content is covered in the main body of the work?
The main body covers the history of rating agencies, the step-by-step procedures used in rating securities, technical shortcomings in risk analysis, and discussions on how human resources and governance structures failed during the crisis.
Which keywords best characterize the research?
Key terms include Rating Agencies, Subprime Crisis, Securitization, Conflicts of Interest, and Market Regulation.
How does the author describe the "issuer-pay" model?
The author views the issuer-pay model critically, comparing it to a student paying a professor for a grade, noting that it creates a strong incentive for agencies to provide favorable ratings to maintain business relationships.
What is "rating-shopping" according to the text?
Rating-shopping refers to the practice where an issuer of financial products selects the rating agency that promises the most favorable rating, thereby undermining the independence and objectivity of the process.
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- Constantin Jäkel (Autor:in), 2011, Rating Agencies and their role during the financial crisis, München, GRIN Verlag, https://www.grin.com/document/175078
