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Institute of Law
FOCOFIMA lecture
The Credit Rating Agencies (CRAs)


Private entities assessing the creditworthiness of borrowers and the risks associated with the full and timely payment of debt securities Issuing credit ratings: Corporate ratings Sovereign ratings Structured finance ratings Assessing credit risk – Components of credit risk: Probability of default Recovery in the case of default Correlation of defaults (for investments with multiple assets)
Investment grade
BB
B CCC CC C D
Non-investment grade – Speculative
Highly speculative Extremely speculative In default with little prospect for recovery In default with little prospect for recovery In default Non-investment – Speculative grade
Introduction



Subprime Mortgage Crisis “Rating agencies continue to create an even bigger monster – the CDO market. Let‟s hope we are all wealthy and retired by the time this house of cards falters” (a Standard & Poor‟s employee). European Debt Crisis The leading credit rating agencies were accused of exacerbating the Greek debt crisis by downgrading Greek bonds just as European officials were about to unveil a support plan. Downgrade of Danish banks “Today‟s rating actions reflect a reduction in Moody‟s systemic support assumptions for Danish banks” (Oscar Heemskerk, Moody‟s vice president).
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Institute of Law
FOCOFIMA lecture
CRA Reforms: Symbology


Dodd-Frank Act: Sec. 938 « … apply any symbol … in a manner that is consistent for all types of securities … for which the symbol is used » « Nothing … shall prohibit a NRSRO from using distinct sets of symbols to denote credit ratings for different types of securities… » EU Regulation on CRAs: Art. 10 « When a CRA issues credit ratings for structured finance instruments, it shall ensure that rating categories that are attributed to structured finance instruments are clearly differentiated using an additional symbol which distinguishes them from rating categories used for any other entities, financial instruments or financial obligations »
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Institute of Law
FOCOFIMA lecture
The CRA Oligopoly

Highly concentrated industry: Three leaders: Moody„s, Standard & Poor„s and Fitch - 98 % of all outstanding ratings - 90 % of the total rating revenues Approximately 150 other smaller CRAs in the world
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Institute of Law
FOCOFIMA lecture
Recent Rating Failures and Devastating Effects of Credit Rating Downgrades



Enron: Nov./Dec. 2001: Downgrade to junk status 4 days prior to bankruptcy Financial Crisis: July 2007: Massive downgrades of mortgage-related securities Sept. 2008: Lehman Brothers: Downgrade to junk status just a few days prior to bankruptcy European Debt Crisis: Apr./May 2010: Interest rates of Greek debt rose sharply when Greek bonds were downgraded by Standard & Poor„s and Fitch Irish debt: Leading CRAs remain prudent; in Feb. 2011, Standard & Poor„s cut Ireland„s rating from A to A- while Moody„s and Fitch had cut it to BBB in Dec. 2010 (i.e. still investment grade)
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Institute of Law
FOCOFIMA lecture
Danske Bank‘s Long-Term Rating History
Source:
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Institute of Law
FOCOFIMA lecture
Evolution of the Credit Rating Industry

EU:


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Institute of Law
FOCOFIMA lecture
CRA Reforms: Supervisory Sanctions


Dodd-Frank Act: Sec. 932 Ability of the SEC to bar NRSROs Suspension or revocation of the NRSRO registration for particular class of securities (if the CRA does not have adequate financial and managerial resources to consistently produce credit ratings with integrity) European Regulation on CRAs: Art. 20 Withdrawal of registration (e.g. if the CRA no longer meets the conditions; if serious or repeated infringement of the regulation)
EU:

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Institute of Law
FOCOFIMA lecture
CRA Reforms: Oversight

US:

Creation of an Office of Credit Ratings within the SEC Regulation on CRAs of 2009: - Registration process - Supervision through a college of supervisors - CESR guidance - Art. 5: Equivalence and certification - Art. 4 para 3: Endorsement regime (of credit ratings issued in third countries): if compliance with requirements that are as stringent as those provided for in the EU Regulation June 2010 Amendment Proposal: - Supervision through a centralized authority: ESMA