Did Rating Agencies Give Preference to Big Banks?

(Polka Dot)

At the heart of the financial crisis was the market for mortgage-backed securities (MBS). These are the “toxic assets” that larded up bank balance sheets and all but froze the credit markets in the fall of 2008. Turns out a lot of those assets are still sitting there. Though they’ve mostly been downgraded to junk status, many of them began life as gold-plated investment products thanks to the AAA ratings they received from the rating agencies Moody’s, S&P, and Fitch. These firms that allowed so much junk to be passed off as gold were essentially the enablers of the financial crisis.

The relationship between the rating agencies and banks is a perfect case study of flawed incentives. With banks paying them to rate their investment products, and so much money pouring in at the height of the mortgage-boom (driving record profits for the highly competitive rating agencies), Moody’s, S&P, and Fitch had a strong incentive to play along.

A new study adds more fodder to the argument that these agencies were unduly influenced by the institutions whose products they were grading. It basically posits that the more MBS an institution issued, the better rating their stuff received. Here’s the abstract:

We examine whether rating agencies (Moody’s, S&P, and Fitch) reward large issuers of mortgage-backed securities, who bring substantial business, by granting them unduly favorable ratings. The initial yield on both AAA-rated and non-AAA rated tranches sold by large issuers is higher than that on similar tranches sold by small issuers during the market boom years of 2004-2006. Moreover, the prices of MBS sold by large issuers drop more than those sold by small issuers, and the differences are concentrated among tranches issued during 2004-2006. We conclude that large issuers receive more favorable ratings and that the market prices the risk of inflated ratings, especially during booming periods.

And here’s the upshot of the whole study:

In our final set of tests, we examine the ex post performance of MBS securities by looking at price changes between origination and April, 2009. Both AAA- and non-AAA rated tranches sold by larger issuers in the boom perform worse than similar tranches sold by smaller issuers – during boom years, prices for these large-issuer tranches drop about 10% more than similar tranches sold by small issuers. (This result is robust to the inclusion of issuer fixed effects for the non-AAA rated tranches only.) In addition, we find price changes are attenuated slightly when we control for the initial yield, suggesting that markets rationally incorporate concerns about the ratings process into ex ante pricing.

Plus some choice paragraphs that offer context:

Many critics emphasize a potential conflict in the way agencies structure their fees. Instead of being compensated by the ‘consumers’ (e.g., institutional investors) for producing high-quality ratings, issuers themselves pay the agencies. The conflict of interest hypothesis thus stipulates that rating agencies may grant more favorable ratings to issuers who may be able to bring, or potentially take away, substantial future business. In addition, regulations contingent on ratings may further distort incentives of both issuers and rating agencies, since holding highly rated MBS securities lowers the burden of capital requirements.

The total volume of originations of subprime mortgages, for example, rose from $65 billion in the late 1990s to over $600 billion in 2006. In the case of Moody’s, profits tripled between 2002 and 2006. At the peak of the market, Moody’s disclosed that 44 percent of their revenues came from rating structured finance products, exceeding the 32 percent earned from rating corporate bonds. There is also direct evidence that rating agencies offer price discounts for large and frequent issuers of corporate bonds.

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  1. Mike B says:

    Since the Federal Government gives large benefits to the three big ratings agencies such as requiring their ratings for certain activities, shouldn’t they give the Government the same sort of preferential treatment and not threaten to downgrade its debt? I mean that will just create a self fulfilling prophesy where the resulting economic collapse would likely cause the default the ratings agencies were trying to prevent.

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  2. Craig Willis says:

    This is a great article, particularly that the island of Jersey decided the opinion of the ratings agencies was a waste of money.

    http://www.guardian.co.uk/business/2011/apr/24/credit-ratings-agencies-standard-and-poors-moodys-fitch?INTCMP=SRCH

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  3. AaronS says:

    Did we really need to do a study? Isn’t this about like a consultant brought in by a CEO and asked to evaluate that CEO’s performance? If you don’t make him look good, you can forget any references for other jobs.

    Further, this allows the bad guys to point to the OTHER bad guys (the rating agencies) and say, “Hey, we just sell this stuff–we don’t rate it. THEY DO!”

    When I am interested in a stock, I don’t ask Moody’s to tell me how they rate that stock. I read up on it from a variety of sources and then make my decision. I AM THE RATING AGENCY.

    Whether you buy bonds or stocks, it is ALL speculation to some degree. You can call it an investment if you want to, but you, too, are gambling that the company will be able to repay you or give you a profit, etc. Of course, it’s not raw gambling, I don’t think. I mean, a good company does tend to be profitable, etc. But it’s not written in stone either. You CAN lose.

    Get rid of the rating agencies. They will always give breaks when they can do so with some deniability. Now that everyone in the world knows that America is struggling, these WORTHLESS agencies are willing to come out and “boldly” state that they may have to downgrade America.

    Where was their zeal for truth before they helped wreck our economy?

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  4. Jasper says:

    Why don’t we take this one step further and look at how the enablers were enabled – namely SEC regulation of CRAs.

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  5. Chad says:

    This reminds me of grade inflation at expensive universities. Gotta be nice to the people paying you a ton of money. I bet a lot of students would get AAA grades if they existed.

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