After the fall: Rebuilding in the post-crisis world
S&P Global Market Intelligence takes a look at the lasting impact of the worst global economic crisis since the Great Depression. For a complete list of stories, click here.
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After inflated ratings played a critical role in the 2008 financial crisis, policymakers across the world called for more competition in credit ratings and changes to agencies' business models. Ten years after the crisis, rating agencies make money the same way, and the top three companies are as dominant as ever.
The U.S. government's 2011 post-mortem report on the crisis called the rating agencies' actions "essential cogs in the wheel of financial destruction." When European regulators unveiled a suite of rules for ratings agencies, they cited the role of ratings in both the 2008 crisis and the European sovereign debt crisis. Policymakers from both continents argued that the agencies' very business models were central to the failures, reasoning that since issuers paid for ratings of their own securities, agencies "felt pressured" to give high ratings even though emails showed ratings analysts knew the housing market was a "house of cards."
While rating agencies stress they have taken steps to improve methodologies and transparency, their business models remain effectively unchanged, and the largest rating agencies retain dominant market share. Data from the U.S. Securities and Exchange Commission show the "big three" rating agencies — S&P Global Inc. unit S&P Global Ratings, Moody's Corp. and Fitch Ratings — accounted for 94.4% of all rating agency revenue in 2016.
"It seems strange to think that despite their role in the financial crisis and the billions of dollars of losses suffered by investors and taxpayers, the business model of rating agencies remains unchanged," Dominic Lindely, director of policy at London-based New City Agenda, a financial services think tank focused on improving social value in the financial services industry, wrote in an email.
In the U.S., the Dodd-Frank Act sought to mitigate the conflict of interest in the agencies' business models by encouraging unsolicited ratings — ratings from agencies that were not paid by the security's issuer. There were two significant mechanisms: the Franken Amendment and a disclosure website.
Dodd-Frank directed the SEC to study business models for "nationally recognized" rating agencies — a crucial certification that is required for financial firms investing in securities. If the SEC could not recommend an alternative business model, the Franken Amendment dictated the establishment of a board that randomly assigns securities to rating agencies. The SEC produced a study of various business models and held a roundtable discussion on the topic in 2013, but it did not recommend a specific business model and declined to establish a random-assignment board. The issue has received no political attention in recent years, and the driving force behind the amendment, Sen. Al Franken, D-Minn., has resigned following a sexual harassment scandal.
"We're doing new financial regulatory reforms right now. How about looking at ratings agencies again? But there doesn't seem to be any appetite for that," said Marc Joffe, a senior policy analyst for libertarian think tank Reason Foundation who recently authored a report calling rating agencies the "weakest link" in the financial system.
The law also required greater transparency from rating agencies, mandating the disclosure of the methodology behind ratings as well as specific data used to determine the rating. An SEC rule forces rating agencies to disclose data on password-protected websites accessible by competitors. The idea was that other agencies would access the data and issue an unsolicited rating, serving as a check against any ratings that might be overly accommodating to issuers. The websites are operational, but industry observers say they are rarely used and unsolicited ratings remain non-existent.
"It creates a lot of bother for everyone in structured finance, but it never created its intended effect of unsolicited ratings," said Mark Adelson, a former chief credit officer in charge of ratings methodologies for Standard & Poor's Ratings Services who is now editor of The Journal of Structured Finance.
In Europe, regulators increased oversight of rating agencies and forced methodology changes. The European Commission also issued rules meant to decrease investors' reliance on ratings. But the top three rating agencies maintain a dominant presence in Europe, too, with a 93.0% market share as of December 2017.
Without a market for unsolicited ratings, rating agencies continue to use the issuer-paid model. Some ratings agencies have tried to focus on payments from subscribers rather than issuers, but success has proven elusive. Kroll Bond Rating Agency launched in 2009 with the goal of a subscription-based model but began allowing issuer-paid ratings due to market pressure. Egan-Jones Ratings Company has also promoted its subscription-based approach, but its market share remains tiny. Media representatives for both Kroll and Egan-Jones did not respond to requests for comment.
What has changed
While regulations have not spurred a market for unsolicited ratings, there have been changes. The law led to several SEC rules, which have required ratings agencies to be more transparent in how they determine ratings. Other rules require agencies standardize so that a rating of "AAA" on a structured finance product matches a rating of "AAA" on corporate finance. The 2011 governmental report on the crisis noted that 83% of all mortgage securities rated AAA in 2006 were ultimately downgraded. In 2009, S&P Global Ratings downgraded just 8.6% of AAA-rated corporates to AA ratings.
"We have strengthened our independence from potential issuer influence, improved our methodologies, increased our monitoring of global credit risks, and have enhanced our regulatory compliance and analytical quality," wrote John Piecuch, a spokesman for S&P Global Ratings, in an email. Media representatives from Moody's and Fitch declined to comment.
The changes are evident: Documents published after the crisis show more detail in how the agencies calculate risk and include examples of hypothetical companies or issuances.
"Comparability and transparency were the watchwords that everything else was built off of," said Adelson, who was tasked with many of the post-crisis changes at S&P.
For rating agency critics, however, the changes are insufficient. Bill Harrington, a former credit officer at Moody's, said ratings agencies continue to operate with impunity, issuing substandard ratings, enabled by a compliant SEC that suspended a Dodd-Frank provision that would have increased legal liability for inaccurate ratings.
"The SEC will not go near the content of ratings or methodologies. It picks and chooses which rules to enforce and which rules not to enforce," Harrington, who is now a senior fellow at the nonprofit Croatan Institute said. "It leaves ratings agencies unaccountable."
Whether the post-crisis changes have yielded ratings that are more robust will not be known until the ratings are tested by a credit downturn. Adelson said ratings agencies clearly have invested heavily in updating methodologies, changes that have generally improved the transparency and consistency of ratings.
Consistency for structured finance ratings has been a goal ever since the crisis, which was driven, in part, by highly rated collateralized debt obligations that ultimately collapsed. In 2008, Moody's downgraded 91% of single-family CDOs, but it only cut 37% of residential mortgage-backed securities. Ann Rutledge, CEO of CreditSpectrum, an unlicensed credit rating agency, said the changes instituted by Dodd-Frank failed to address those core issues in structured finance.
"I think the whole thrust of Dodd-Frank was legal and moral," she said. "And the problems leading to the crisis were technical."
S&P Global Ratings and S&P Global Market Intelligence are both owned by S&P Global Inc.