Deeply and persistently conflicted: credit rating agencies in the current regulatory environment.

• Author: Lynch, Timothy E.

--Let's hope we are all wealthy and retired by the time this house of cards falters.;o). (1)

ABSTRACT

Credit rating agencies have a pervasive and potentially devastating influence on the financial well-being of the public. Yet, despite the recent passage of the Credit Rating Agency Reform Act, credit rating agencies enjoy a relative lack of regulatory oversight. One explanation for this lack of oversight has been the appeal of a self-regulating approach to credit rating agencies that claim to rely deeply on their reputational standing within the financial world. There are strong arguments for doubting this approach, including the conflicting self-interest of credit rating agencies whose profits are gained or lost depending on their ability to lure the business of issuers who will always be seeking the highest rating possible. In recent months, government and press investigations initiated largely in response to the economic turmoil surrounding subprime mortgages have led to additional skepticism about the self-regulating abilities of credit rating agencies' reputational integrity concerns.

This Article argues that the current underlying theories of credit rating regulation may be prone to fail because they leave in place the fundamental conflicts of interest that have been shown to induce profit-seeking credit rating agencies to over-rate securities, indicating to investors a lower amount of default risk than actually exists. If investors were able to fully discount or adjust for this misinformation, a goal of the disclosure requirements of the Credit Rating Agency Reform Act, additional governance may not be required. Unfortunately, there is considerable empirical and anecdotal evidence in business as well as behavioral finance literatures that many investors using credit rating agency ratings are simply not able to perform such adjustments.

This Article develops a governance framework that accounts for the rating agencies' conflicts of interest problem and makes the proposal that public funding augment the current system of evaluating creditworthiness, either through the establishment of a publicly-funded independent credit rating institution, through the hiring of private rating agencies by the government to rate certain securities, or through the use of the tax system to incentivize private rating agencies to issue more accurate ratings. This Article argues that such mechanisms could provide valuable information to investors, could illuminate the reputational compromises credit rating agencies often make in favor of profit-seeking, and, thus, could mitigate a significant amount of the errant information currently produced by private-sector credit rating agencies.

INTRODUCTION I. CREDIT RATING AGENCIES A Credit Rating Agency Fundamentals B. Revenue Model C. Public Effects of the Credit Rating Agencies 1. Role in the Capital Markets and Investment Industry 2. Public Use of Ratings as Regulatory Benchmarks 3. Contact-based Use of Ratings as Benchmarks II. PROBLEMATIC ISSUES PRESENTED BY CREDIT RATING AGENCIES A. Issuer-Pays Conflict of Interest B. Risk of Error Independent of Issuer Bias III. CREDIT RATING AGENCY INTEGRITY DEFENSES A. The Reputation Defense B. Theoretical Responses to the Reputation Defense 1. Marginal Cost, Marginal Benefit Analysis 2. Lack of Market Sensitivity 3. Certain Conflict of Interest Management Mechanisms C. Empirical and Anecdotal Evidence of the Failure of the Reputational Defense 1. Quantitative Evidence of Capture 2. Anecdotal Evidence of Capture 3. Evidence of Error (Independent of Capture) a. Lack of Diligence b. Poor Modeling c. Poor and Inaccurate Disclosure d. Issuer-Pays Conflict Exacerbates Laxity IV. CREDIT RATING AGENCY REFORM ACT OF 2006 V. PROBLEMS WITH THE CURRENT REGULATORY ENVIRONMENT A. Issuer-Pays Conflict of Interest Persists B. Limits to Disclosure 1. The Disclosing Rating Agency 2. Limits of Investor Sophistication and Vigilance a. Coping with Complexity b. Evidence c. Behavioral Finance and Bounded Rationality 3. Other Credit Rating Agencies C. Potential Unintended Consequences of Regulation VI. PUBLICLY FUNDED CREDIT RATINGS A. The Public Agency 1. Basic Description 2. Benefits of the Public Agency 3. Responses to Certain Arguments Against the Establishment of a Public Agency B. Government Paying for Private Rating Services C. Tax Incentives to the Rating Industry CONCLUSION INTRODUCTION

The economy is currently in a period of turmoil. U.S. housing prices have fallen significantly. (2) Foreclosures are up. (3) In order to stabilize the housing market and the economy, the federal government has nationalized Fannie Mac and Freddy Mac. (4) The federal government has taken large ownership interests in several other financial institutions, including one of the world's largest insurance companies. (5) Three of the largest independent Wall Street investment banks have collapsed. (6) Several large commercial banks have collapsed, including the largest to collapse in U.S. history. (7) Equity values have plummeted. (8) There is a worldwide credit crunch. (9) The U.S. economy is in a recession, (10) and the economic downturn is felt globally. (11) In an attempt to halt the economic decline, the federal government has authorized the U.S. Treasury to purchase up to $700 billion of bad mortgage-related debt securities from private entities. (12)

Why has the economy entered such a tumultuous period? A partial answer is that too many institutional investors poured too much money into the U.S. housing market during the housing bubble of the 2000s, (13) and when the housing bubble burst, an ensuing wave of foreclosures drove down the value of these investments, forcing some investors into insolvency. (14) Many institutional investors, in order to meet capital and liquidity requirements, have had to restrict lending (15) while seeking additional capital. (16) This has led to the widespread credit crunch (17) and a general economic slowdown. (18) This problem is exacerbated by the fact that many of the security vehicles used to invest in the housing market--mortgage-backed securities ("MBSs") and collateralized debt obligations ("CDOs") based on MBSs--are often complexly structured, (19) and their underlying assets (thousands of individual mortgages) are often legally distant and largely invisible. (20) This complexity and opacity has resulted in a situation where many security holders do not know the exact nature of the risks they bear, (21) and the markets cannot easily value these securities. (22) As a result, liquidity in these products has shrunk considerably, (23) financial uncertainty is pervasive, (24) and the credit market has constricted considerably. (25)

But such an explanation merely raises additional questions. The most immediate question is why did so many ostensibly sophisticated institutional investors invest so heavily in the U.S. housing markets, especially during a housing bubble (26) and during a time when subpfime mortgages constituted such a large percentage of home loans originated in the U.S. (27) To begin to answer this question, it is worth investigating the role of the many actors who contributed to the creation of the current turmoil. Some culprits are commonly discussed--unethical home loan originators who preyed on unsophisticated homebuyers whose creditworthiness prevented them from taking out traditional home loans; (28) speculators who took advantage of the inexpensive financing to ride the seemingly endless wave of increasing housing values; (29) and irresponsible homebuyers who took out home loans which they did not understand or could not afford to repay. (30) Some culprits, however, are less well known. Three additional ones include: (i) the investment banks who sponsored the creation of many MBSs and the CDOs based on them; (ii) the three large American credit rating agencies, Moody's Investor Service ("Moody's"), Standard and Poor's Rating Services ("S&P"), and Fitch Ratings, Ltd. ("Fitch"), each of which appear to have been recklessly, if not knowingly, rating MBSs and related securities (31) as less risky than they actually were and, consequently, to have fed investor appetites for MBSs and other U.S. real estate financial products; and (iii) the institutional investors themselves, who appear to have been relying too heavily on credit ratings as substitutes for--rather than supplements to--their own internal risk assessments.

This Article addresses the inter-relational dynamics of these last three actors, and, in particular, focuses on the actions and incentives of the credit rating agencies--the actors positioned immediately between the issuing investment banks and institutional investors. It addresses why the credit rating agencies might issue inaccurately high ratings, and why institutional investors might have been encouraged by inaccurately high credit ratings to invest increasingly large sums of money into the U.S. housing market, and then offers a possible framework for addressing these interrelated problems. Such investment fueled the housing bubble (32) and created the conditions that would not only result in the current economic turmoil but would expose both the bad behavior of the credit rating agencies and a certain lack of sophistication on the part of institutional investors.

Part I of this Article briefly describes the credit rating agencies, their operations, and their importance within the capital markets, as well as how their ratings are used in regulating the investments of certain institutional investors. All large American credit rating agencies earn the vast majority of their revenues from securities issuers who contract with credit rating agencies to have their securities rated. (33) Part II examines the conflict of interest inherent in this "issuer-pays" revenue model.

The credit rating agencies have acknowledged the existence of the issuer-pays conflict of interest and the more benign risk of...