What’s (Still) Wrong with Credit Ratings

Frank Partnoy is George E. Barrett Professor of Law and Finance and Director of the Center for Corporate and Securities Law at University of San Diego School of Law. This post is based on his recent article, forthcoming in the Washington Law Review.

Scholars and regulators generally agree that credit rating agency failures were at the center of the 2007-08 global financial crisis. Government investigations found that the credit rating agencies, particularly Moody’s and S&P, were central villains and that the crisis could not have happened without their misconduct. The Financial Crisis Inquiry Commission called the ratings agencies “key enablers of the financial meltdown.” The U.S. Senate Permanent Subcommittee on Investigations concluded: “Inaccurate AAA credit ratings introduced risk into the U.S. financial system and constituted a key cause of the financial crisis.” The Securities and Exchange Commission and the President’s Working Group on Financial Markets reached similar conclusions.

In 2010, Congress passed the Dodd-Frank Act, which required federal agencies to replace regulatory references to credit ratings with “appropriate” substitutes. Dodd-Frank amended the securities laws to enhance the accountability and transparency of credit rating agencies and to create a new Office of Credit Ratings within the SEC to oversee them. In addition, federal and state prosecutors settled cases against S&P and Moody’s, and there were a handful of private investor lawsuits.

My overarching point in What’s (Still) Wrong with Credit Rating Agencies is that these reforms have had little or no impact, and that therefore the same credit rating-related dangers, market distortions, and inefficient allocations of capital that led to the crisis potentially remain. The major credit rating agencies are still among the most powerful and profitable institutions in the world. The market for credit ratings continues to be a large and impenetrable oligopoly dominated by two firms: Moody’s and S&P. And yet credit ratings are still as uninformative as they were before the financial crisis. Simply put, credit ratings remain enormously important but have little or no informational value.

In this article, I document four main points. First, although Congress attempted to remove credit rating agency “regulatory licenses,” the references to ratings in various statutes and rules, regulatory reliance on ratings remains pervasive. Regulated institutions continue to rely mechanistically on ratings, and regulations continue to reference ratings, notwithstanding the Congressional mandate to remove such references.

Second, although Congress authorized new oversight measures in Dodd-Frank, that oversight has been ineffective. Annual investigations by the Office of Credit Ratings have uncovered numerous failures, many in the same mortgage-related areas that precipitated the financial crisis, but regulators have imposed minimal discipline on violators. Moreover, because regulators refuse to identify particular rating agencies in their reports, wrongdoers do not suffer reputational costs.

Third, although Congress authorized new accountability measures, particularly removing rating agencies’ exemptions from Section 11 liability and Regulation FD, the Securities and Exchange Commission has gutted both of those provisions. The SEC performed an end-run around Dodd-Frank’s explicit requirements, reversing the express will of Congress. Litigation has not been effective as an accountability measure, either, in part because rating agencies continue to assert the dubious argument that ratings are protected speech. I argue that the SEC should reverse course and implement Congress’s intent, including encouraging private litigation.

Fourth, given the ongoing problems in these three areas, it is no surprise that credit rating agency methodologies remain unreliable. I show in detail how current methodologies are weak and nonsensical, particular in the treatment of diversification and investment holding companies. Neither regulators nor investors should rely on such crude and uninformative methodologies.

In sum, both regulators and investors should reduce reliance on credit ratings, and regulators should implement Congress’s will with respect to rating agency oversight and accountability. Credit rating agencies are a cautionary example of regulatory stickiness: reliance on ratings has proven difficult to undo. More generally, the stickiness of regulatory licenses is a warning for policymakers who are considering deferring to private entities for regulatory purposes in other areas.

Leading institutional investors and analysts of corporate bond credit risk have long employed far more subtle and sophisticated methods than those reflected in the credit rating agencies’ methodologies. A modern sophisticated assessment of corporate bond credit risk could include not only analysis of market prices and related variables, but also option-adjusted valuation and risk assessment, simulations of income statement variables, stress tests of risk factors, and detailed consideration of recovery rates. Market participants should rely less on credit ratings and more on fundamental factors, such as market measures of credit risk, financial measures of leverage and profitability, accounting measures of earnings and cash flow, and worst-case scenario analysis with respect to both individual credits and portfolios.

Letter ratings are a crude mechanism for information intermediation. Letter ratings obscure the analysis of the key variables that matter in the analysis of credit: probability of default, expected recovery in the event of default, and the correlation of defaults. The methodologies I critique in this article are disconnected from that analysis. If the markets experience another crisis related to credit ratings, and ratings prove again to have been “garbage out,” then during the next regulatory response it will be important to understand more clearly the role of the “garbage in” (i.e., rating agency methodology).

Enough time has passed since the financial crisis and the resulting legal reforms to assess how much the credit rating industry has changed. The answer: not much. The major credit rating agencies continue to generate little informational value, and yet be rewarded handsomely for their ratings. They continue to operate as an oligopoly with special regulatory treatment. Congress should not permit the rating agencies—and the SEC—to flout Dodd-Frank. But even if Congress remains silent, investors should respond by reducing their reliance on credit ratings.

The full article is available for download here.

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