Is There Misdiagnosis and Mistreatment in the Market for Credit Ratings?

Rosa Abrantes-Metz, Dec 30, 2013

Credit Rating Agencies were at the center of the recent financial crisis, with some critics going so far as to blame them for the crisis itself. A number of proposals have been made to reign in the CRAs and recently we have seen the creation of a new CRA in Europe, welcomed by many as the first step to solving the problem generated by a supposed lack of competition in this market. But we must first define the problem accurately before we can find an appropriate solution.

First, look at the historical facts. In the recent financial crisis, the problem with ratings was largely contained to structured finance. Corporate ratings performed within typical recessionary levels, and municipal ratings performed quite well, despite concerns for a time that they could become the next crisis. Within structured finance, the problem was largely contained to U.S. Residential Mortgage Backed Securities and related derivatives, as the CRAs (along with most everyone else) underestimated the potential for catastrophic price declines in the U.S. housing market.

With this history in mind, I argue that the underlying problem is “rating shopping,” combined with a monopsony power unique to the structured finance market. The structured finance market is characterized by a few large investment banks who issue these securities and who have the market power to influence CRAs to at least adopt more liberal analytics-if not outright compromise them. (It should be no…


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