Vol. III - Penn State Abington

REFORMING THE CREDIT RATING AGENCIES:
A COMPREHENSIVE SOLUTION
By Yuqing Wu ∗
The George Washington University
Elliott School of International Affairs
When the subprime mortgage crisis broke out in 2007, few people could imagine that
this crisis would evolve into a global financial tsunami. Of course, many institutions, including
government agencies, are responsible for this crisis. Among them, credit rating agencies (CRAs)
have aroused drastic disputes, and not for the first time. After the Enron Scandal and the IT
bubble, CRAs were blamed for their failure to forecast these affairs (U.S. Securities and
Exchange Commission, 2002). Criticism of CRAs has become even fiercer this time around,
because they have played such a central role in the current crisis.
The present financial crisis was mainly triggered by residential mortgage-backed
securities (RMBs) and collateralized debt obligations (CDOs). RMBs are financial products,
usually created by investment banks, that package hundreds or thousands of subprime mortgage
loans into a pool. A trust purchases these pools and becomes entitled to the interest and principal
payments. The trust then issues RMBs to investors in order to finance the purchase (U.S.
Securities and Exchange Commission, 2008:6). In this way, investors receive their interest and
principal payments through the interest and principal payments from the pool. Based on the
RMBs, the CDO is created to ensure the value of the investments to RMBs, making the process
even more complicated (U.S. Securities and Exchange Commission, 2008:9).
Because the debt chain had been largely extended, it was difficult for investors to assess
the risk of these products, even though many of them were managed by financial elites like those
working at AIG. So, investors relied largely on CRA ratings of complicated products such as
RMBs and CDOs. Credit rating agencies showed great optimism for these structured finance
products, especially CDOs. Based on the same mortgage asset pool, 80% of CDOs could get a
Triple A (AAA) rating (Zhao, 2008). Not surprisingly, CRA involvement greatly stimulated the
explosion of structured finance products.
Even worse was the failure of CRAs’ early detection of the deterioration of these
structured finance products, without a gradual regrading. For example, New Century Financial
Corporation, the second largest subprime mortgage company, issued a profit warning on 13th
Feb 2007, but none of the big three CRAs (Moody’s, Standard & Poor’s, and Fitch) reacted to
∗ Yuqing Wu is currently pursuing a Master degree at the Elliott School of
International Affairs, the George Washington University, with concentration in
Economic Affairs and International Development. Previously, she interned as an
administration assistant in the Civil Ministry of Haizhu District Government in
Guangzhou City and at the Freeman Chair in China Studies at the Center for Strategic
and International Studies. Ms. Wu received a B.A. in International Politics from the
Public Administration School of Nanjing University (NJU). Her main interests include
political economy in the Asia-Pacific region, and Sino-U.S. relations. As a native
Chinese, Ms. Wu speaks Cantonese and Mandarin.
THE DIALECTICS ▲ 2009
www.abington.psu.edu/dialectics
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