Question

6. Moody’s Investors Service and Standard and Poor’s adjusted the way they graded securities after Goldman Sachs Group Inc., UBS AG and at least six more banks pressured them, according to a U.S. Senate report. “The world’s two largest bond-ranking companies made exceptions to rules when bankers asked for better safety ratings on complex mortgage-backed securities, the Senate Permanent Subcommittee on Investigations said yesterday. When Moody’s and S&P changed their assessments of hundreds of those bonds in July 2007, it helped trigger the financial crisis, the panel said. The ratings agencies weakened their standards as each competed to provide the most favourable rating to win business and greater market share,” according to the report. This occurred in 2007 and was in part responsible for the Global Financial Crisis – discuss in class.

Answer 1

Rating Agencies are like watchdogs. The fiduciary responsibility of the Rating agencies stems from the fact that they receive the data on the portfolios. Now, ratings are a necessity for an instrument to be listed or in simple terms, accepted by the investors and/ or the markets. Its a due diligence of a kind on an investment grade paper basis which the Banker sells the paper or instrument to the investors, thereby transferring the risks and rewards of discounted interest and principal cash flows being accrued by the underlying assets ( loans against securities which is mortgage in this case) in exchange of upfront cash and a fee. Each portfolio comprises of several underlying assets that are distributed in nature and belong to individual or retail loan borrowers as against a property which was sometime provided earlier to finance a house. The responsibility of the rating agencies is to study the performance of these underlying assets in terms of repayments ( portfolio analysis) and stress test the same by creating mathematical models to foresee what could be the "delinquency" levels if the credit behavior was impacted on account of several socio-economic factors.

In this case, Moody's & S&P's, instead of playing their role, were more interested in increasing their revenues from big bulge banks who didn't mind paying handsomely for the ratings certificate. What they did was to totally demean the efficacy of the ratings of such instruments. Instead of "downgrading" the rating (which means to predict poor behavioral symptoms of the portfolio that comprised of the underlying assets) of those instruments sold by the Banks for rising delinquencies, which would have otherwise created awareness of the fragility in the market, they continued upholding the ratings based on rudimentary analyses that were based on past performance of such portfolios. The rating agencies completely overlooked the ramifications of the model being under stress and on the financial markets which religiously followed and had faith in such agencies to buy/sell or " trade" with several market participants and who, in turn, continued to undertake financial leverage so as to increase their returns and thus increase their exposures to more cash losses if the portfolio began to deteriorate.

This caused the bubble to grow even bigger and eventually the Banks were making their fee on selling such instruments to other banks and other investment firms. These firms were cross border in nature and thus the US based problem became a global one with all assuming that the rating agencies must have done their work prior to providing their comfort to the risk management committees of these firms.

Thus it is not untrue that the rating agencies played foul and were deeply motivated by the revenues earned by luring Banks with higher ratings instead of undertaking their fiduciary duties more seriously and this contributed to the Global Financial Crisis in a substantial way.