Vol. III - Penn State Abington

powerful forces in the financial market, there was little regulation of these credit rating agencies
for a long time.
Failure of Accommodating to the New Financial Derivatives
In an economic boom, the earnings from structured finance products based on the
subprime mortgage can be comparatively stable, because of the combination of financial pools
with different risks. But in an economic downturn as we have now, the funds from the subprime
mortgage to these products will shrink sharply, as there is a high correlation among these
mortgages (Strier, 2008:533-53). Thus these structured financial products are more sensitive to
the economic environment than traditional corporate or municipal bonds.
So if the CRAs go ahead and rate these novel instruments which no one has ever known
how to rate, it’s difficult to estimate to what extend the CRAs are risking their reputation to
benefit from these ratings. Their failure to forecast the risk for structured finance does not show
that their ratings on traditional corporate and municipal bonds are unreliable. Accordingly,
issuers and investors are not likely to cast doubt on the CRAs’ traditional ratings after their
failure in novel instruments. From the Chart above, Moody’s loss after the subprime mortgage
crisis was derived mainly from the structured finance products, while its revenue from traditional
ratings has not been affected. This was also illustrated by the continual prosperity of the CRAs
after the Enron Scandal. However, there is a risk here that the CRAs may take no actions to
adjust their methodologies or criteria catering to novel financial instruments if they know no one
will really look into their responsibility.
Possible Solutions
1) Information Disclosure
When the U.S. government noticed potential conflicts of interest with the relationships of
bond issuers, CRAs and investors, it tried to solve this problem by strengthening information
disclosure. The Credit Agency Reform Act passed in September 2006 intended to protect
investors. NRSRO’s obligation to expose information to the public was stressed (Credit Rating
Agency Reform Act, 2006). In July 2008 after the subprime mortgage crisis emerged, the SEC
published a report on the big three CRAs. This report stated that significant aspects of the rating
process and the underlying data based on which ratings are made should be sufficiently
documented and disclosed (U.S. Securities and Exchange Commission, 2008:13).
Of course, information disclosure is an important part of the solution, because it allows
for regulation by government and competitors, and the assessments of investors. The regulators
have emphasized the importance of transparency of methodologies, models and weighting of key
parameters of the CRAs. However, there’s a question if complete information disclosure will
improve the competition of the credit rating market as well as the quality of rating reports. One
problem is that different credit rating agencies have their own methodologies, model
consumptions, etc, although they may not be totally different (U.S. Securities and Exchange
Commission, 2008:13).
In fact, CRAs consider their methodologies and models unique and part of their
competitive edge. What is worse is that CRA may lose their incentives to innovate new rating
methods and instruments to improve the accuracy of their rating reports, especially when the
THE DIALECTICS ▲ 2009
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