Rating Agencies and their role during the financial crisis

Term Paper, 2011
14 Pages, Grade: 1.3


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

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

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.2

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.

2. Rating Agencies

In general, rating agencies are companies that evaluate the different debt instruments of governments or firms. For instance if their clients are willing to issue bonds, a rating agency first has to assign a credit rating to this financial product, which is based on the probability that the debt will be paid back. Rating agencies are also very important for investor decisions during the securitization of mortgage credits. Due to the complexity of the various structured products, many investors, including the institutional ones, do not analyze the creditworthiness on their own.3 Although the agencies often underline that they just publish opinions concerning the quality of the debtor, a lot of investors considered these statements to be a buy recommendation for the several investment products.4

2.1 Types of Rating

There are two main types of rating: the internal rating contains a credit rating of the client who is going to claim a loan. Before a financial institution is ready to hand out a loan, this review is conducted in order to give them a qualitative estimation. The external rating is practiced by independent rating agencies. In this case the principal determines the measure of accuracy of the accomplishment and he also decides on the purpose of the rating outcome.

2.2 The “Big Three”

The origins of the three most popular agencies date back to the 19th Century. It all started with the publication of professional journals by Henry Varnum Poor. They dealt with an infrastructural overview about the USA associated with information about the revenues and profits of the regional railroad companies. Because of the increasing demand from investors who wanted to have a share of the rising state at the end of the century, he was one of the most famous publishers of journals and books dealing with that topic. The name Standard & Poors finally came into being when he merged with the Standard Statistics Company, which had the purpose to collect financial information from US companies.5

Apart from this existing and widespread publication of information no rating system as we know it today existed. The first rating was published by John Moody in 1909. In the same year he established his company Moody’s Investors Service. Like Henry Varnum Poor, he also released investor manuals but with the difference that those did not deal with single companies, but with bonds and stocks of these. He also used the famous literal system (AAA etc.). Besides, he not only offered basic information about the investment projects, but also an additional buying recommendation.6

The smallest of today’s leading rating agencies was founded in 1913. Fitch Publishing Company and its Fitch Bond Book particularly appreciated the analysis of bonds, which were traded in the United States. The Fitch rating played a big role in the 1990s during the internationalization of the rating beyond the US market. The company’s breakthrough came in 1997, when they merged with the IBCA, a British rating company, which was specialized on non-US banks.

Today, there are several rating agencies, although none of them is able to measure up to the leading three. Another important date for the agencies was 1970. Since then they claimed a fee from the bond issuers to pay their ratings. In 1975 the three leading agencies became certified by the government as so-called “Nationally Recognized Statistical Rating Organizations” (NRSRO). After this act, the plentitude of power was further increased. Standard & Poors and Moodys both have market shares of 40 %, while Fitch has approximately 10-15 %.7,8

3. The Rating Process

The process normally comprises various phases, but there is no strict procedure. The steps are subject to the discretion of the issuer. The following chart shows a schematic process of rating designed by Standard & Poors.9

It all starts with a rating request from the issuer and ends with the publication and the surveillance of the rated issuers and issues. Between these procedures, the agency has to evaluate, analyze and, where appropriate, deal with possible appeals of the client.

illustration not visible in this excerpt

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.10


1 Thomas Friedman, 1996.

2 Rosenbaum, Jens , Der politische Einfluss von Rating-Agenturen, 2009, pp. 5, 11-12.

3 Rom, Mark Carl, The Credit Rating Agencies and the Subprime Mess: Greedy, Ignorant, and Stressed?, 2009, 640-641.

4 http://www.versicherungsmagazin.de/Aktuell/Nachrichten/195/12632/Rating-nur-als-Meinungen- und-nicht-als-Empfehlung-werten.html. (date of access 22 Feb 2011)

5 http://www.standardandpoors.com/about-sp/timeline/en/us/ (date of access 22 Feb 2011)

6 http://www.moodys.com/Pages/atc001.aspx (date of access 22 Feb 2011)

7 http://www.fitchratings.com/jsp/creditdesk/AboutFitch.faces?context=1&detail=3 (date of access 22 Feb 2011)

8 Wieben, Hans-Jürgen, Credit Rating und Risikomanagement, 2004, 9-10

9 http://www2.standardandpoors.com/aboutcreditratings/Images/SP_RatingsProcess_large.gif (date of access 22 Feb 2011)

10 Altman E., Rijken, H.A., The effects of rating through the cycle on rating stability [..], 2005, 4-5.

Excerpt out of 14 pages


Rating Agencies and their role during the financial crisis
Berlin School of Economics and Law
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
438 KB
Moodys, S&P, Standard and Poors, Fitch, Big Three, Rating, Agencies, Gauss Copula, IOSCO, Transparency
Quote paper
Constantin Jäkel (Author), 2011, Rating Agencies and their role during the financial crisis, Munich, GRIN Verlag, https://www.grin.com/document/175078


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