K.C.

COLLEGE

Credit rating agency

A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.[1] More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries. A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK). A credit ratings agency is a company that assigns credit ratings to institutions that issue debt obligations (i.e. assets backed by receivables on loans, such as mortgage-backed securities. These institutions can be companies, cities, non-profit organizations, or national governments, and the securities they issue can be traded on a secondary market. A credit rating measures credit worthiness, or the ability to pay back a loan. It affects the interest rate applied to loans - interest rates vary depending on the risk of the investment. A low-rated security has a high interest rate, in order to attract buyers to this high-risk investment. Conversely, a highly-rated security (carrying a AAA rating, like a municipal bond which is backed by stable government agencies) has a lower interest rate, because it is a low-risk investment. These low-risk bonds are available to a wide range of investors, whereas high-risk bonds cater to a narrow investing demographic. Companies that issue credit scores for individuals are usually called credit bureaus and are distinct from corporate ratings agencies.

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Purpose of credit rating: A credit rating is a comprehensive tool for assessment of an obligors creditworthiness, of reliability of its debt obligations and for establishing fee for relevant credit risk. It allows the ratings bearer to show potential investors and partners its creditworthiness without divulging any confidential information, and to make relations between obligor and investor highly transparent and efficient. High credit rating enables the obligor to get resources at lower rates, albeit a credit rating itself, whatever level it is, is a benefit for the obligor, since it exhibits information transparency of the entity rated. Benefits of credit ratings:
Credit rating is an important tool for borrowers to gain access to loans and debt. Good credit

ratings allow borrowers to easily borrow money from financial institutions or public debt markets. At the consumer level, banks will usually base the terms of a loan as a function of your credit rating, so the better your credit rating, the better the terms of the loan typically are. If your credit rating is poor, the bank may even reject you for a loan. At the corporate level, it is usually in the best interest of a company to look for a credit rating agency to rate their debt. Investors often times base part of their decision to buy bonds, or even the stock, on the credit rating of the company's debt. Major credit agencies, such as Moody's or Standard and Poor's, perform this rating service for a fee. Usually, investors will look at the credit rating given by these international credit rating agencies as well as ratings given by domestic rating agencies before deciding to invest. Credit ratings are also important at the country level. Many countries rely on foreign investors to purchase their debt, and these investors rely heavily on the credit ratings given by the credit rating agencies. The benefits for a country of a good credit rating include being able to access funds from outside their country, and the possession of a good rating can attract other forms of investment to a country, such as foreign direct investment. For instance, a company looking to open a factory in a particular country may first look at the country's credit rating to assess its stability before deciding to invest.

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The financial crises of 2007:

Before the Beginning

Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession. Although the economy nicely withstood terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the fear of recession really preoccupied everybody's minds. To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money, once out of the bottle, always looks to be taken for a ride. It found easy prey in restless bankers - and even more restless borrowers who had no income, no job and no assets. These subprime borrowers wanted to realize their life's dream of acquiring a home. For them, holding the hands of a willing banker was a new ray of hope. More home loans, more home buyers, more appreciation in home prices. It wasn't long before things started to move just as the cheap money wanted them to. This environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold. The Fed continued slashing interest rates, emboldened, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started resembling a candy shop where everything was selling at a huge discount and without any down payment. "Lick your candy now and pay for it later" - the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments. Unfortunately, no one was there to warn about the tummy aches that would follow. (For more reading on the subprime mortgage market, see our Subprime Mortgages special feature.) But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. They decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks - Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MS) - which freed them to leverage up to 30-times or even 40-times their initial investment. Everybody was on a sugar high, feeling as if the cavities were never going to come.

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The Beginning of the End

But, every good item has a bad side, and several of these factors started to emerge alongside one another. The trouble started when the interest rates started rising and home ownership reached a saturation point. From June 30, 2004, onward, the Fed started raising rates so much that by June 2006, the Federal funds rate had reached 5.25% (which remained unchanged until August 2007). Declines Begin There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was interested in buying or eating more candy. Then, during the last quarter of 2005, home prices started to fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. Not only were new homes being affected, but many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans. This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also filed for bankruptcy. Investments and the Public Problems in the subprime market began hitting the news, raising more people's curiosity. Horror stories started to leak out. According to 2007 news reports, financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting. By June, Bear Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. But even this large move was only a small affair in comparison to what was to happen in the months ahead.

August 2007: The Landslide Begins

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the United State's borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

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The Housing Bubble

Up to 2006, the housing market in the US was flourishing. It was easy to get a home loan, so more people wanted to buy a house. The increased housing demand increased in return the prices. The increased prices attracted investors who were looking to buy houses as an investment, only to sell it later for more. This further created more demand and further increased the prices - a classic speculative housing bubble. And because of the rising prices, the consequences from all the "bad" loans given to people who could not afford them were delayed. Whenever people experienced difficulties making their mortgage payments, they could easily take another loan against the value of their house, simply because now it was worth more. Basically, they went into more debt in order to pay off their debts. Thus, the housing bubble made home equity loans and home equity lines of credit extremely popular.

The Breaking Point which Turned the Problem into a Crisis

However, in contrast to the rising house prices, the average household income didn't increase. Thus, despite all the incentives and exotic mortgage products, people just couldn't afford those high prices and it was only a matter of time for the problem to come out. And it did. The big housing bubble burst, the property values stopped increasing and the whole thing came to a point when the mortgage lending industry started witnessing something new many people defaulted on their very first mortgage payment. What happened was a chain of reactions very similar to those in the housing bubble but only in the opposite direction. The number of people who defaulted on their mortgages increased more and more which in return increased the number of houses on the market. The oversupply of houses and lack of buyers pushed the house prices down till they really plunged in late 2006 and early 2007. That was the point when people on Wall Street started to panic. They no longer wanted to buy risky mortgages. Mortgage companies, which used to sell risky loans, experienced the devastating consequences of going out of business. Unfortunately it was already too late for everybody. The market has already absorbed enormous amounts of these securities. All kinds of investors from all over the world - individuals and big financial institutions - basically have bought these AAA rated mortgage securities thinking that it was almost as safe as putting money in a savings

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account. Now that the complexity and the real risk of these securities came out, most of them are already worth less than half their initial value and all those investors lost a great deal of money. Moreover, foreclosures keep springing up. In the past mortgages were held in the books of financial institutions such as banks, who had real interest in working with their borrowers and making sure that everything possible is done to pay back the loans. However, in the current situation, mortgages have been sold and resold and pooled together into securities and sold to investors in the financial market. It is really really hard to even find who the actual current owner of mortgage is. And it is just as hard to prevent foreclosures.

Multidimensional Problems
The subprime crisis's unique issues called for both conventional and unconventional methods, which were employed by governments worldwide. In a unanimous move, central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the interbank market back on its feet. The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired by JP Morgan Chase (NYSE:JPM), Merrill Lynch was sold to Bank of America, and Fannie Mae and Freddie Mac were put under the control of the U.S. federal government. By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown. The U.S. government then came out with National Economic Stabilization Act of 2008, which created a corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different governments came out with their own versions of bailout packages, government guarantees and outright nationalization.

Rating Agencies: Possible Conflict of Interest

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. Moreover, some have pointed to the conflict of interest between rating agencies, which receive
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fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand.

The Downside of a Credit Crisis

Credit shocks have several negative effects on both consumers and businesses. Some effects are felt right away, while others take time to be seen.

Consumers Cut Spending

As a credit crunch runs its course, the economy continues to slow. This creates a situation in which consumers are less optimistic about the future prospects for the economy and cut back dramatically on their spending. Since consumer spending accounts for 70% of economic activity, even a slight cutback in spending can cause the economy to slow dramatically

Banks Fear Making Loans

Credit shocks can create a situation in which banks are afraid to make new loans. This fear causes many businesses and consumers to cut spending dramatically, or even close their doors. This causes a ripple effect in the economy as more businesses struggle to survive and consumer wealth erodes.

Businesses Lose Access to Capital

When businesses do not have access to the capital they need to expand, pay expenses or pay bills, a liquidity squeeze can occur. This squeeze can force many businesses that have been thriving for years to shut their doors and let their employees go. (Find out how this economic cycle affects both small and big businesses in The Impact Of Recession On Businesses.)

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Rising Foreclosures May Bring Property Values Down for Communities

If banks are forced to foreclose on too many borrowers, this can have dire consequences on communities. Not only do property values decline in communities where foreclosures are high, but there are several untold economic consequences as well. These include a loss of property tax revenues for both state and local governments, economic blight for areas being affected by waves of foreclosures and the failure of local businesses that are dependent on the community to survive

The Crisis May Force the Government to Take Emergency Measures

As the economy becomes weaker and the credit shock spreads from Wall Street to Main Street, a cycle of economic weakness spreads throughout the country, creating rising unemployment and negative growth. This forces the government to take drastic measures to break the cycle once and for all by spending hundreds of billions of dollars to revive the economy.

A Falling Stock Market Eats away at Wealth

The credit shock and uncertainty about future earnings cause many investors to sell their stock holdings and move into safer investments. This causes the equity market to go into a free fall that eats away the values of 401(k) plans, IRAs and pension plans. Diminished nest eggs force many who were planning on retiring to work longer.

Consumers and Businesses Start to Panic

Left unchecked, credit shock can create a loss of confidence in the nation's financial system. This causes many people to assume the worst and take drastic steps to protect what little wealth they have left. It is at this point that bank runs become more common and even more financial institutions collapse *****

Credit rating agencies and the financial crises:

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Introduction
The "Big Three" global credit rating agencies--U.S.-based Standard and Poor's, Moody's, and Fitch Ratings--have been under intense scrutiny since the 2007-2009 global financial crisis. They were initially criticized for their favorable pre-crisis ratings of insolvent financial institutions like Lehman Brothers, as well as risky mortgage-related securities that contributed to the collapse of the U.S. housing market. But since 2010, the agencies have focused on U.S. and European sovereign debt. That resulted in S&P's unprecedented downgrade (Reuters) of the United States' long-held Triple-A rating in early August, initially prompting a global sell-off and market volatility not seen since December 2008. Since the spring of 2010, Greece, Portugal, and Ireland have all been downgraded to "junk" status. In so doing, EU politicians contend, the rating agencies have compounded a burgeoning eurozone debt crisis. Both the United States and Europe have taken steps to regulate the three main rating agencies and ensure more transparency and competitiveness. In July 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created an Office of Credit Ratings at the Securities and Exchange Commission to hold rating agencies accountable and protect investors and businesses. In early 2011, the EU established an independent authority known as the European Securities and Markets Authority (ESMA), tasked with regulating the activities of rating agencies relative to EU standards.

The Role of Credit Rating Agencies

The growth of the international financial markets over the last twenty years would have been unthinkable without CRAs. Only because of the availability of clear, internationally accepted indicators of the risk of default were investors willing to invest in international securities whether corporate or government bondswhose credit quality they would have been virtually unable to assess on their own. The CRAs worked for decades on designing a simple and readily understandable system that would allow any investor to invest in international securities with which they were not directly familiar. Where corporate and government bonds are concerned, this system has proved reliable and enabled investors to diversify their portfolios. Credit rating agencies are meant to provide global investors with an informed analysis of the risk associated with debt securities. These securities include government bonds, corporate bonds, CDs (certificates of deposit), municipal bonds, preferred stock, and collateralized securities, such as CDOs (collateralized debt obligations) and mortgage-backed securities. The riskiness of investing in these securities is determined by the likelihood that the debt issuer--be it a corporation, bank-created entity, sovereign nation, or local government--will fail to make timely interest payments on the debt.

Role in the Financial Crisis

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Over the past two years, changes in the ratings of structured credit have been far more volatile than the historical record for single name credits, and far more weighted toward downgrades. The resulting instability of ratings has not only had direct procyclical effects, but has undermined confidence in the future stability of credit ratings. Against this backdrop, calls for CRAs to be regulated in a new and more stable world financial order fell on fertile ground, all the more so given that the CRAs could be accused of making some serious errors A number of official European reports have now described in detail how certain flaws in the rating process and the conditions governing the financial markets contributed to the crisis. The first comprehensive analysis appeared on 7 April 2008, when the Financial Stability Forum (FSF) published its report on enhancing market and institutional resilience (Financial Stability Forum 2008). This report concluded that the CRAs substantial underestimation of the risk inherent in structured finance products was partly due to methodological shortcomings. Singled out for criticism were the inadequate historical data, which significantly increased model risk, and the fact that CRAs had not taken sufficient account of deteriorating lending standards. The report took a positive view of the measures already introduced by the CRAs; nevertheless, a need was seen for further steps to improve internal governance, the transparency of rating procedures, and compliance with international codes of conduct. There was criticism, too, of CRAs failure to publish verifiable data about their rating performance. The agencies were urged to disclose this information in as standardized a form as possible. The report also called for a distinction to be made between ratings of structured finance products and other corporate bonds in order to highlight the differences in the methodologies used and the significantly different risk characteristics involved. The FSF felt, however, that more in-depth analysis was needed of the implications of such a step for the functioning of the market and the regulation of the industry. In addition, the FSF report criticized CRAs for failing to adequately monitor the quality of securitized products. More rigorous scrutiny of lending practices was therefore called for. And last but not least, investors and supervisors were called on to examine whether they may have placed too much confidence in ratings. Further reports by expert bodies and regulators were published over the course of the following twelve months. In October 2008, the President of the European Commission, Jos Manuel Barroso, mandated Jacques de Larosire to chair a committee to give advice on the future of European financial regulation and supervision. In February 2009, the committee published a report that cited the following shortcomings (de Larosire Group 2009)1 CRAs lowered the perception of credit risk by giving AAA ratings to the senior tranches of structured finance products like collateralized debt obligations (CDOs), the same rating they gave to government and corporate bonds yielding systematically lower returns. Flaws in rating methodologies were the major reason for underestimating the credit default risks of instruments collateralized by subprime mortgages. The report was especially critical of

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the following factors, which were all felt to have contributed to the poor rating performances of structured products: the lack of sufficient historical data relating to the US subprime market. The governance of credit rating agencies did not adequately address issues relating to conflicts of interests and analytical independence. Agencies competing for the business of rating innovative new structures may not have ensured that commercial objectives did not influence judgments on whether the instruments were capable of being rated effectively. Rating shopping by issuers contributed to a gradual erosion of rating standards among structured finance products. This negative effect resulted from the right of issuers to suppress ratings that they considered unwelcome, thereby exerting pressure on the agencies. In 2008, during the global financial crisis, rating agencies were chastised in congressional hearings and lawsuits for miscalculating the risks associated with mortgage-related securities. They were accused of creating complex models to calculate the probability of default for individual mortgages and also for the securitized products these mortgages made up. Raters deemed many of these so-called "structured" products top-tier triple-A material for several years during the housing boom, only to downgrade them to below investment-grade status when the housing market collapsed. In 2007, as housing prices began to tumble, Moody's downgraded 83 percent (USAToday) of the $869 billion in mortgage securities it had rated at the AAA level in 2006. Critics said the raters failed to judge the likelihood of the decline in housing prices and their effect on loan defaults. These inflated ratings also failed to account for the greater systemic risks associated with downgrading structured products, as opposed to simpler securities like corporate and sovereign bonds. Rating agencies also came under fire for allegedly sacrificing quality ratings to win a bigger share of the booming structured products business. By 2006, Moody's had earned more revenue (WSJ) from structured finance--$881 million--than all its business revenues combined for 2001. The Big Three argued that rating decisions were made by rating committees, not individual analysts, and that analysts were not compensated based on their ratings. As for the criticisms of the issuer-pays system, the agencies maintained that subscriber-pays raters suffered from their own conflicts of interest. Investors might pressure rating agencies for lower ratings because the securities, if deemed riskier, would pay higher yields. Short-sellers might also benefit financially from negative ratings. The real issue then, the Big Three argued (Bloomberg), was not whether the system was issuer-pays or subscriber-pays, but how transparent raters were with the models they used. This outline of the ratings dilemma would be inaccurate if it were to focus only on shortcomings on the part of CRAs. It is also true that investors often accepted ratings uncritically and overestimated their significance. Not enough attention was paid to the fact that ratings are only estimates of the relative probability of default or expected loss on a debt instrument. They are not a detailed assessment of risk and say nothing about an instruments price quality or liquidity.
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Ratings are no substitute for investment risk management, particularly as the information provided by CRAs is limited.

Unprecedented Downgrade
91% of the AAA-rated, residential mortgage-backed securities issued in 2007 and 93% issued in 2006 have now been downgraded to junk status. Thus, in July 2007 when Moodys and S&P announced mass downgrades of hundreds of subprime mortgage-backed securities, those downgrades shocked the markets and banks, pension funds and others were held holding billions of dollars of unmarketable securities. According to Chairman Levin, had the credit agencies taken more care in issuing rating or revised ratings more swiftly, the impact of those toxic mortgages on the financial markets would have been greatly reduced. However, the credit agencies felt pressure to provide favorable credit ratings for complex securities, amid concerns about competition and the lack of data about the mortgage securities the analysts were rating. On August 5, S&P downgraded (NYT) U.S. debt for the first time in U.S. history, by one notch from AAA to AA+ . The move came after weeks of wrangling (WSJ) between Republican and Democratic lawmakers over how to cut the deficit to allow for a rise in the nation's $14.3 trillion debt ceiling--a requirement imposed by House Republicans--before an August 2 deadline that could have seen the nation default on its debt obligations. Congressional leaders and the White House reached a deal to avert default in the nick of time, but, in the opinion of S&P, did not implement significant measures to reduce the U.S. deficit over the next ten years. The Obama administration lambasted the rating agency's decision, with Treasury Secretary Timothy Geithner saying S&P showed "terrible judgment" (Market Watch) and a "stunning lack of knowledge." In an August 8 address to the nation, President Obama sought to diminish the importance of S&P's verdict, citing investor Warren Buffett, who said the United States should have a "quadruple-A rating." S&P forcefully defended its decision in the wake of criticism. Nonetheless, in the first days of trading after the downgrade, global markets (Reuters) from Asia to Wall Street responded with a steep sell-off, which triggered volatility in equity markets not seen since the financial crisis. *****

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Credit Rating Agencies role in European Sovereign Debt Crisis

The "Big Three" global credit rating agencies--U.S.-based Standard Moody's, and Fitch Ratings-have been under intense scrutiny since the 2007-2009 global financial crisis. They were initially criticized for their favorable pre-crisis ratings of insolvent financial institutions like Lehman Brothers, as well as risky mortgage-related securities that contributed to the collapse of the U.S. housing market. But since 2010, the agencies have focused on U.S. and European sovereign debt. That resulted in S&P's unprecedented downgrade (Reuters) of the United States' long-held Triple-A rating in early August, initially prompting a global sell-off and market volatility not seen since December 2008. Since the spring of 2010, Greece, Portugal, and Ireland have all been downgraded to "junk" status. In so doing, EU politicians contend, the rating agencies have compounded a burgeoning euro zone debt crisis. Both the United States and Europe have taken steps to regulate the three main rating agencies and ensure more transparency and competitiveness. In July 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created an Office of Credit Ratings at the Securities and Exchange Commission to hold rating agencies accountable and protect investors and businesses. In early 2011, the EU established an independent authority known as the European tasked with regulating the activities of rating agencies relative to EU standards.

Impact on the Euro zone Crisis

Conversely, the EU has long accused the Big Three of issuing overly aggressive ratings in the euro zone financial crisis. Many EU officials continue to blame the rating agencies for accelerating the European sovereign debt crisis as it spread through Greece, Ireland, and Portugal--all which have received EU-IMF bailouts to avoid defaulting on their debt obligations. The ball was set into motion with S&P's April 2010 decision (Guardian) to downgrade Greece's debt to junk status. The move weakened investor confidence and deepened the country's debt woes, making a financial rescue package in May 2010 all but inevitable. European countries again came under the "grip" (DerSpiegel) of the Big Three through the spring and early summer of 2011. Efforts by EU leaders to negotiate a second bailout for Greece--one that would see private creditors pick up some of the slack--have been complicated by S&Ps July 4 announcement (BBC) that it would likely classify as a default any planned or voluntary restructuring of Greek debt. European officials reacted strongly, with German Chancellor Angela Merkel (AFP) saying, "It is important that we do not allow others to take away our ability to make judgments." But many experts, including Benn Steil, a senior fellow and director of international economics at CFR, think S&P's forceful stance on Greek debt is justifiable. "It [a restructuring] is clearly not voluntary if the terms can be said to involve significant concessions from the creditors--and in this case, the creditors know that the alternative to accepting some sort of voluntary plan is an outright default," he says.
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The eurozone crisis was also compounded when Moody's downgraded Portuguese debt to junk status (WSJ) July 5 and warned that the country may need a second bailout, just over a month after EU and IMF leaders agreed to a first rescue package. German Foreign Minister Wolfgang Schaeuble said there was "no factual justification (DeutscheWelle) for such an assessment at this early point," citing Portugal's efforts to implement austerity measures as a prerequisite for its financial aid package. "A reasonable, informed spectator can reach the judgment that a Portuguese default was, say, reasonably likely," says Steil. "In that regard, I think it's justifiable." Frederick Erixon, director of the Brussels-based European Centre for International Political Economy [ECIPE], adds that the judgment was justified "because Portugal will need more resources in order to finance itself." Nicolas Vron, a senior fellow at Brussels-based Bruegel, who also concurs, puts the rating into context, explaining, "One thing that was new in Moody's decision is the way that they factored in things that were not about Portugal, but were about the eurozone--like ongoing discussions about Greece--into their opinion on Portugal's credit." However, Steil and Erixon acknowledge that Portugal's downgrade undermines investor confidence in the country's existing bailout, complicating EU efforts to resolve the debt crisis. "[The downgrade] is a clear message to markets that the bailout fund will have to be larger, and longer term, in order to avoid default," says Steil. As Erixon puts it, "This is what the consequence is going to be. And, as with all matters related to foreign relations, a beggar cannot be a chooser." The rating agencies have been undeterred by EU criticism. A week after Moody's verdict on Portugal, on July 12, the agency downgraded Ireland to junk status (Bloomberg), unleashing temporary panic in European and global markets. And while Merkel, French President Nicolas Sarkozy, and other euro zone leaders moved forward July 21 with a new $109 billion bailout plan (FT) for Greece that is set to include a voluntary bond swap or rollover by private investors, S&P maintained it would likely proceed with a "selective default" (Bloomberg) for Greece when the plan is implemented. *****

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THE REGULATION OF CREDIT RATING AGENCIES BEFORE THE FINANCIAL CRISIS The Importance of the IOSCO Code In 2004, the Code of Conduct Fundamentals for Credit Rating Agencies were published by IOSCO (2004) in response to the CRAs failings in the Enron and WorldCom affairs. They set out rules on ensuring the quality and integrity of the rating process, including the monitoring of ratings; on guaranteeing appropriate internal procedures and analyst independence in order to avoid conflicts of interests; on making sure that rating methods are transparent and that ratings can be adjusted if necessary without delay; on handling confidential information; and on disclosing the extent to which CRAs follow the Code. These rules were of a general nature; they did not prescribe methodological details such as ratios, models, or rating categories. For good reason, this was left to the agencies themselves. The expectation was that the CRAs would incorporate the IOSCO Code into their own codes of conduct or explain in clear terms why certain aspects had not been adopted (comply or explain). Though the competent authorities monitored compliance with the Code, there was no sanctions mechanism. The Code provided the credit rating industry with an internationally accepted framework of self-regulation. Most CRAsincluding the three market leaders implemented the Code, often verbatim. The Regulation of Credit Rating Agencies in the US In the US, CRAs are officially registered as nationally recognized statistical rating organizations (NRSROs) if they satisfy the requirements set by the Securities and Exchange Commission (SEC); they are subject to extensive vetting. The SEC requirements incorporate many elements of the IOSCO Code. The NRSRO system was introduced in 1975 and fundamentally revised in 2006. The approval process became a registration process. While this made it easier to obtain recognition as an NRSRO, the criteria to be met by agencies under the Credit Rating Agency Reform Act were significantly tightened (US Congress 2006). Since 2008, CRAs have been subject to SEC oversight in the form of disclosure requirements, among other things, and liability has been increased. CRAs are now held accountable for compliance with their own standards, which they file with the SEC (see Partnoy 2009; Dittrich 2007). Areas covered by the rules include the misuse of confidential information, the management of conflicts of interests, a ban on certain practices, the appointment of a compliance officer and the disclosure of the agencies financial development. The SEC has extensive powers to enforce these rules. Regulation in the US thus goes somewhat further than the IOSCO Code. Some of the Codes provisions are enshrined in law or in regulations issued by US supervisors and consequently have a more stringent effect than is the case in the EU, for example.

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Interference by the SEC in the methodologies used by CRAs is strictly prohibited, however: Notwithstanding any other provision of law, neither the Commission nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedures and methodologies by which any nationally recognized statistical rating organization determines credit ratings. The Credit Rating Agency Reform Act may definitely be deemed a success. Since its introduction, there has been a significant increase in the number of registered CRAs. While previously only the big three rating agencies were registered as NRSROs, 2008 saw ten agencies apply for and obtain NRSRO status from the SEC (2008a).8 The Regulation of Credit Rating Agencies in the EU Before the outbreak of the financial crisis, the regulatory setup in Europe was based mainly on self-regulation within certain supervisory crash barriers in the form of the IOSCO Code. In 2005, the CESR recommended the European Commission not to regulate the credit rating industry at EU level for the time being. Instead, it proposed adopting a pragmatic approach and reviewing how CRAs implemented the standards set out in the IOSCO Code of Conduct (CESR 2005). CESR therefore drew up a strategy on the basis of voluntary compliance by CRAs and in December 2005 issued a press release outlining a process to review implementation of the IOSCO Code. This framework, agreed with the main CRAs operating in the EU, included the following three elements: an annual letter from each CRA to be sent to CESR, and made public, outlining how it had complied with the IOSCO Code and indicating any deviations from the Code; an annual meeting between CESR and the CRAs to discuss any issues related to implementation of the IOSCO Code; and an undertaking for CRAs to provide an explanation to their national CESR member if any substantial incident occurred with a particular issuer in their market. Four rating agencies agreed to this voluntary framework (Moodys, Standard & Poors, Fitch Ratings, and Dominion Bond). In January 2006 the European Commission concluded that no new legislative proposals were needed as things stood. The European Commission considered that the existing financial services directives, combined with self-regulation by the agencies on the basis of the IOSCO Code, were sufficient to address all major issues of concern in relation to CRAs (see European Commission 2006). Against this backdrop, the CESR (2006) and the European Securities Markets Expert (ESME) Group (2008)both on behalf of the European Commissionpresented proposals that appeared to show a way to keep up the required pressure. On top of this, however, CRAs are also regulated directly in the EU by the Capital Requirements Directive, which implements Basel II in Europe. In practice, only the big three agencies are affected. To be recognized as an external credit assessment institution (ECAI) under the
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standardized approach of the Basel II Capital Framework, an agencys rating methods must satisfy criteria set by supervisors concerning objectivity, independence, continuous monitoring, and transparency. ECAI recognition is a prerequisite for banks being able to use the agencys ratings to calculate their risk-weighted assets in accordance with the Capital Requirements Directive. A CRA may be recognized by supervisors if its rating methodology meets the following requirements: ratings must be objectivethe methodology used must, in particular, be systematic and subject to some form of validation; the process should be free from political influence and economic pressure; ratings should be reviewed at least once a year; and general information about the methodology should be documented and publicly available. It must be possible for supervisors to monitor the frequency with which methodologies are reviewed (see Everling and Trieu 2007: 109). In addition, ratings should be judged credible and reliable by users, and should be available to all institutions with a legitimate interest in them on the same terms. These criteria do not interfere in the methodologies used by CRAs but are general quality standards, which are admittedly monitored. They apply solely for prudential purposes. *****

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Regulating the Rating Agencies: why and how

Critics of the Big Three in the U.S. and Europe have long voiced concern that legislation and financial regulations have created institutional frameworks that rely too heavily on the raters, leaving investors few alternatives. In 1975, the U.S. Securities and Exchange Commission began choosing which raters could be used to determine the minimum capital levels required for financial firms to trade certain debt securities, depending on their riskiness. The three raters initially chosen--Moody's, S&P, and Fitch--were deemed "nationally recognized statistical rating organizations," or NRSROs. Though the SEC added more rating agencies to the list over the years, Moody's, S&P, and Fitch maintained their dominant positions. In addition to creating an Office of Credit Ratings at the SEC, the July 2010 Dodd-Frank Act invested the SEC with the authority to examine NRSROs on an annual basis, levy fines when necessary, and even deregister an agency for providing inaccurate ratings. Similarly, the EU's oversight mechanism, the ESMA, "contributes to the development of a single rulebook in Europe" by ensuring the "consistent treatment of investors across the Union . . . and enabling an adequate level of protection of investors through effective regulation and supervision." In the wake of the Portugal downgrade, Commissioner Barnier, in addition to calling for a European agency, said the EU would reveal further measures (Guardian) to regulate the Big Three in the fall of 2011, forcing them to be more transparent.

The question of whether and, if so, how CRAs should be regulated is therefore determined not least by the numerous potential areas of conflict with the state. If CRAs are regarded as normal companies, the focus will be on the lack of competition and efficiency arguments. If ratings-based regulation is taken as the starting point for consideration of the issue, the state will be interested in a smoothly functioning, reputable system delivering ratings of high quality. Conflicts of interests that adversely affect quality are also a concern The financial crisis has revealed elements justifying regulation in all of the above functions performed by ratings. Where structured products were concerned, information asymmetry was reduced far less than investors had anticipated. The gatekeeper role led to conflicts of interests and the use of ratings both to enforce legal rights and for prudential purposes increased procyclicality. Any approach to regulating CRAs must therefore address the question of what should be regulated and with which toolsin other words how. Regulation will only succeed if it takes account of what ratings can and cannot achieve. A rating of a financial instrument provides information about the credit quality, i.e., the probability of default, of a specific company or

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financial product. It says nothing about systemic riskthat is to say the danger of a chain reaction resulting in a number of financial institutions getting into difficulties. It may thus be concluded that, while it may be perfectly rational for individual firms and institutional investors to be guided by a rating when making their investment decisions, these decisions can destabilize the financial markets at a systemic level if downgrades and rating triggers result in mass selling, write-downs, and additional capital requirements. The key point determining whether systemic risk arises is consequently the extent to which individual defaults occur at the same time. Ratings provide no information about this. Hence, it would be a mistake to believe that regulating CRAs could have mitigated procyclicality. Regulating credit rating agencies can do nothing to solve the problems caused by using ratings for regulatory purposes. Lawmakers should therefore refrain from overreacting. Instead, they should consider enhancements to current regulation that will work in a prosperous economy as well as in challenging times.

REGULATION FROM THE PERSPECTIVE OF MARKET PARTICIPANTS

From the outset, market participants have had reservations about state regulation of CRAs. They believe it is first and foremost the responsibility of the rating agencies themselves to remedy the shortcomings that came to light in the financial crisis and repair their damaged reputation. This calls, in particular, for modifications to rating procedures, improved transparency, and a review of internal processes in the interest of high quality. This is seen as the key prerequisite for ensuring that the securitizations market will function smoothly over the long term. In the view of market participants, the financial crisis does not change the fact that securitization has contributed significantly to the efficiency of the financial markets. Securitization allows risk to be spread more broadly and enables many categories of investor to diversify their investments more widely. It also facilitates improved risk management among issuers. This presupposes that risks have been accurately assessed. The CRAs were aware of this problem and responded swiftly. They revised their models and the rating of originators, insurers, servicers, and law firms. They also expanded their disclosure practices, launched various consultations with market participants on methodological issues, subjected their internal structures and processes to a thorough analysis, and made certain adjustments. As a result, the risk of a repeat of the developments in the credit rating industry that led to the subprime crisis has doubtless fallen. Market participants have nevertheless recognized that the rating process unquestionably contains incentive structures that canat least in theoryencourage misconduct by agencies. Owing to the lack of competition in the ratings market, the pressure that clients can potentially exert is not, on its own, enough to force rating agencies to behave properly. Even so, regulative action should be taken with care. It should always be capable of achieving the twin objectives of ensuring financial market stability and promoting the efficiency of the financial markets. No one will be
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helped by tight regulation that stifles innovation and growth in the financial sector. Regulation is not an end in itself. It should also be borne in mind that national responses to these challenges will not suffice. Even the EU would be a suboptimal stage for action because ratings are usually addressed to investors worldwide. For these reasons, the supervision of CRAs should be globally consistent; on no account should ratings be influenced by having to meet differing regulatory requirements. This would destroy the international comparability of ratings, which is one of their key contributions to financial market efficiency, and there would be competitive distortions between issuers and financial centers. In the absence of an international regulator, a consistent approach to regulating CRAs can be achieved only by coordinating the rules at international level. The IOSCO Code of Conduct represents such an internationally coordinated set of rules. This should therefore be the basis of any state regulation. *****

Global markets react to downgrade of U.S. credit rating

Standard & Poor's move lowering the U.S. credit rating from AAA to AA+ shook global markets over the weekend as traders reacted to the news. Shares dipped across the Middle East Sunday as the region's exchanges were among the first global markets to open since the historic downgrade. Israel's stock market fell more than 6%, and the Tel Aviv 25 Index ended the trading day down 6.99%. The Dubai Financial Market (DFM) General Index fell 3.7% on Sunday. And the General Index on the Abu Dhabi Securities Exchange lost 2.5%. In Saudi Arabia, the Tadawul All-Share Index gained less than 0.1% after dropping nearly 5.5% Saturday. Analysts predict more slides as markets in other countries open Monday at the beginning of the work week there. U.S. Treasury Secretary Tim Geithner will participate in a conference call Sunday evening with other representatives of Group of Seven industrialized nations to discuss the downgraded U.S. credit rating, a G-7 official told CNN. The G-7 nations are Canada, France, Germany, Italy, Japan, Russia, the United Kingdom and the United States. The Bank of Israel issued a statement Sunday aimed at reassuring investors.
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"So far the debt crises abroad have had a limited impact on Israel, due to its macroeconomic strength, achieved by means of adherence to fiscal discipline, among other things, in the last few years," the statement said. But one analyst said the U.S. debt crisis may be a symptom of a larger problem Israel faces. The United States is in serious trouble, gradually weakening, in a major crisis," said Pinchas Landau, an independent financial advisor in Israel and the publisher of the Landau Report. "This constitutes bad news for the state of Israel. It means that the strategic, financial, military, political backup for Israel is weakening." The move by S&P, one of the leading credit rating agencies, came Friday -- just days after Congress approved a deal to deliver $2.1 trillion in savings over the next decade. The deal followed heated debt-ceiling talks in Washington. One person close to S&P's decision to downgrade the U.S. credit rating told CNN Saturday that the agency expects the action to have "very mild real-world impact." Rating agencies such as S&P, Moody's and Fitch analyze risk and give debt a grade that is supposed to reflect the borrower's ability to repay its loans. The safest bets are stamped AAA. That's where the U.S. debt has stood for years. Moody's first assigned the United States an AAA rating in 1917. Fitch and Moody's, the other two main credit ratings agencies, maintained the AAA rating for the United States after last week's debt deal, though Moody's lowered its outlook on U.S. debt to "negative." A negative outlook indicates the possibility that Moody's could downgrade the country's sovereign credit rating within a year or two. Stock market values fell Friday across Europe and Asia, where reaction to news of the U.S. credit downgrade was mixed. A scathing editorial in the Chinese state-run Xinhua News Agency criticized the United States for living outside its means. "China, the largest creditor of the world's sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China's dollar assets," the editorial said. "To cure its addiction to debts, the United States has to re-establish the common sense principle that one should live within its means." *****

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How the three big Credit Rating Agencies (CRAs) are criticised and circumvented- (reforms)
The debt crises of Greece, Portugal and Ireland, that lead to the Euro crisis, reveal the crucial role played by a mere three rating agencies who have been determining whether governments have access to finance or not. In addition, these three played an important role in undermining the credibility of the rescue packages agreed by politicians. After some previous weak EU reforms of credit rating agencies (CRAs), the European Commission has now announced further reforms of CRAs, to be presented in November 2011. These reforms are aimed at achieving more independence from the three big CRAs, something long overdue, as discussed in Newsletter nr. 5. The European Central Bank (ECB) has recently been using the rating of the unknown but officially recognised Canadian agency DBRS to circumvent the ratings of Standard & Poor, Moodys and Fitch. The three big US credit rating agencies Standard & Poor (S&P), Moodys and Fitch dominate up to 90% of the world market for ratings of governments and companies that want to receive loans or investments. The role of credit rating agencies in the European sovereign-debt crisis has become the subject of extensive and heated debate after they successively downgraded Greece (June), Portugal (5 July 2011) and Ireland (12 July 2011) to junk status. These downgrades mean that investors are being told there is high risk that any money they invest in bonds of these countries will not be paid back in full. Rating agencies were much more lightly reformed in the EU than in the US after the financial crisis. Further reforms of CRAs, such as breaking the oligopoly by three CRAs in a world market, have been pending (see Newsletter nr. 5). Although their ratings were proven wrong in almost all financial crises of the last two decades, CRAs still are accepted by most investors and financial markets all over the world. Up to recently EU governments and the ECB also accepted the ratings of these CRAs as very important evaluators of credit worthiness of governments, companies and others requiring a loan. Their ratings have been used as legal benchmarks in investment and lending rules for banks, insurances, many investment funds and other institutional investors. In other words, politicians and regulators are themselves also partly responsible for the problem. As a result of the legal entrenchment, many institutional investors are legally obliged to follow the ratings. Consequently, CRAs have the power to decide not only on the creditworthiness of a single company, but also of democratic countries. Downgrading or low grading of countries means that bonds can only be issued, or loans obtained, at very high interest rates, or not at all, from commercial banks or investors, which has negative impacts on the entire economy of a country and its population.

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The CRAs and the Euro-zone (reforms)

In the Euro crisis, European politicians are now learning that their efforts to rescue the EU countries with high deficits and financial problems are useless, if the big three decide otherwise. For example, in early June, S&P downgraded Greece and rendered it the lowest rated government in the world. This meant that Greek government bonds needed to be issued with very high returns to investors, thus augmented the countrys debt problems. Greece criticised this decision in light of the fact that their discussions with the European Commission, the ECB and the IMF had not yet been concluded. Moreover, this downgrading had followed closely on the heels of a downgrade in May 2011 from Fitch, which Fitch claimed to reflect the scale of the challenge facing Greece in implementing a radical fiscal and structural reform programme necessary to secure solvency of the state and economic recovery. Furthermore, Moodys had downgraded Greece on 1 June 2011, arguing that it was increasingly probable that Greece would have to restructure its debt, and that there was a 50-50 chance of this. A reality politicians refused to consider at that time, but which they needed to face in July 2011. However, in June Greece hit back and argued that this downgrade was influenced by intense rumour in the media and overlooked the Greek governments pledges to achieve its fiscal targets for 2011 and to accelerate privatizations. Moodys downgrading of Portugal to junk status on 5 July only added fuel to the fire. Moodys reasoning here was that Portugal, like Greece, would not be able to meet the deficit reduction targets specified in its bail-out agreement, and that it ultimately would need further commercial loans or a second bailout. The Portuguese government, the European Commission and others all argued that this very low rating was arrived at without sound evidence or information. Early in July, S&P derailed Sarkozys debt rollover plan for Greece (whereby, when a bond matures, bond holders would reinvest 70% of their loan in new 30-year bonds). S&P also worsened the crisis by declaring that the Greek government's financing needs in 2011-2014 could require private sector debt restructuring in a form that S&P would declare an effective default of Greeces debt obligations under S&P ratings criteria. On 12 July, Moodys downgraded Ireland to junk status, stating that private debt restructuring might be needed in the future. However, this started to look like a self-fulfilling prophecy as junk status makes Irelands access to finance much more costly, thus increasing its debt and economic problems, and making debt restructuring with participation of the private sector even more necessary. The European Commission reacted angrily to the downgrade that took place just before a press conference by the IMF and EU about how Ireland was on track with meeting its budget cuts targets. However, some market researchers are more sympathetic towards Moodys: Ireland has been trading equivalent to a junk credit for many months. *****
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CONCLUSION
Globalization and financial innovation combined with the asymmetry of information are effectively the main reasons for this financial crisis. The financial system would have contained the effects from the housing bubble and there would be limited repercussions if there were not as much systemic risk in the system. The need for a new regulatory framework is the new paradigm which is being discussed across the world and which will shape the financial system in the decades to come. In the end, the financial regulation systems failed in predicting consequences of the housing bubble. The effect from greater regulation is debatable and the chance for the regulatory reform to improve financial system's robustness with as little damage as possible to its efficiency and creativity is negligible. The crisis itself, however, has made economic agents aware of the existence of black swans which will probably rationalize expectations on a larger scale than the regulatory framework could ever achieve. Human knowledge, however, has continued to suffer. My personal belief is that the future of financial innovation lies in further research on how to measure and learn more about the underlying systemic risk *****

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Bibliography
http://www.nber.org http://www.forbes.com http://www.business-standard.com http://economictimes.indiatimes.com http://www.ft.com http://www.stockmarkettoday.cc/

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