Introduction

Credit rating agencies play a key role in todays and the last century’s financial life. Their function is to analyze and then publish country’s and firm’s or basically any financial entity’s/product’s creditworthiness. However, their defining impact on today’s economics is goes way beyond their definition.
The Three Big, Moody’s, S&P and Fitch are in possession of 95% market share, that means the competition is negligible. The lack of competition multiplies their individual effect on the markets and raises the question of whether they work with the moral standards today’s stakeholders are expecting from them. (The Role Played by Credit Rating Agencies in the Financial Crisis, Asian Development Bank Institute, 2012)
Major investors and creditors are knowingly deciding about their financial moves based on a very narrow and far from comprehensive information. The three bigs ratings are certainly part of these data and they do have major consequences on whether a company will invest in a certain country or on what terms will a bank lend capital to a given enterprise. If we go even further, we can see that credit ratings will have impact on a country’s fiscal and monetary policies, industries’ success or in many case failure, and through that, on people’s everyday life and economic well-being.
Now that the concept of ratings are not so abstract, let’s take a look at how they relate to the financial crises. The 2007 credit crisis were caused by the overvaluation of structured securities in the US, namingly the subprime mortgages. In belief of constant real estate price growth, the credit rating agencies gave better ratings to subprime borrowers, thus the investors and issuers could maximise their profit on them. As the subprime borrowers could not meet their paying obligations and the real estate prices started to decline, these ratings proved to be misleading. (The Credit Rating Controversy, Christopher Alessi, Roya Wolverson, and Mohammed Aly Sergie, Council on Foreign Relations, 2013)
In the next paragraphs a closer look will be taken onto the nature and history of the Three Bigs. Furthermore, the reasons and circumstances of the Three Bigs contribution to the crisis will be taken under scrutiny, concluding with the changes in their rating methods after the crisis, mentioning the possible pitfalls they shall avoid in the future.
The history of the Three Bigs

Fitch

"The Fitch Publishing Company was established by John Knowles Fitch, in 1913. He was 33 year old investor who had just started to continue his parent’s printing firm. Fitch had an unusual objective for his company: to publish financial data on stocks and bonds.
By the year of 1924, Fitch expanded the services of his firm by creating a system for rating debt instruments looking at the company’s ability to repay their obligations and fulfill their liabilities. Even though Fitch’s rating system of grading debt instruments later turned out to be the standard for other credit rating companies, Fitch is now the least relevant of the “big three” firms. " (Investopedia, A Brief History of Credit Rating agencies)
Moody’s

John Moody and Company first published "Moody's Manual" in 1900. The manual contained basic statistics as well as general data regarding stocks and bonds of numerous industries. From 1903 until the stock market crash of 1907, "Moody's Manual" has been published nation wide. In 1909 the company began publishing "Moody's Analyses of Railroad Investments", which added analytical information about the value of securities. Taking the next step on the road of credit agencies this led to the 1914 creation of Moody's Investors Service, which was to provide ratings for almost every government bond markets at the time. By the 1970s Moody's began rating bank deposits and commercial paper taking the role of a modern scale-rating agency. " (Moody’s, History)
Standard and Poor’s

To talk about the history of S&P we have to return to the 18th century. In 1860, Henry Varnum Poor's published History of Railroads and Canals in the United States. After the turn of the century, the Standard Statistics Bureau started to offer information on US companies. Furthermore, in 1916, it began to assign ratings to government bonds and to corporate bonds. By the year of 1941, the two companies merged, becoming the Standard & Poor's Corporation, which was sold to McGraw-Hill in 1966.
S&P is mostly known for the ratings it provides for the debt and structured-finance transactions of states, firms, governments, and institutions. Anyhow Standard and Poor’s is also well recognized for its illustrious S&P 500 Index that has been used around the globe as the benchmark for US’s financial performance. The firm maintains numerous different indices as well, embracing the S&P Europe 350, S&P Global 1200, and so as the S&P Global Equity Indices. To conclude, Standard and Poor’s is the world’s most prestigious and largest index provider." (Standard and Poor’s, History)

The credit rating agencies’ contribution to the crisis

As it has been mentioned above, the credit rating agencies overvaluation of collateralized debt obligations did contributed to the crises however, they could not be named as only responsible for the financial downfall experienced after 2007. The three bigs are successfully operating for almost a 100 years now and a took major part in enhancing capital mobility in the last 20 years. Without their analysis and rating securities, it would have been impossible for investors to judge opportunities abroad or outside their industry as they do not have the knowledge nor the necessary information to make such calls. Then again, prestigious companies, with such experience beyond their back how could make mistakes in valuation that costed billion dollars and led to one of the most painful financial crisis of our history?

Conflict of interest

After the crisis there was an increase in views from professionals in the industries that pointed out the possible conflict of interest between rating agencies that received fees from a security's issuer, and their ability to provide an impartial evaluation of risk deriving from their business. In a nutshell, we could say that rating agencies were lured to give better ratings in exchange for receiving further service fees and maintaining profitable financial connection with the issuer. Otherwise, they take the risk of the underwriter choosing another rating agency strengthening their competition. Moreover, taking a look at the other half of the picture, it's hard if not impossible to sell a security if it is not rated by a trustable rating agency. Refusing rating securities could have led the agencies to losing revenue, which obviously is not desirable as they are profit driven private companies. This leaves us the question whether a private company can stay independent, without the trade-off between profit maximizing and reliable, trustworthy ratings. (The Credit Rating Controversy, Christopher Alessi, Roya Wolverson, and Mohammed Aly Sergie, Council on Foreign Relations, 2013)

Flaws in rating methodologies

In October 2008, José M. Barroso, the President of the European Commission, mandated Jacques de Larosière to lead a committee in pursuance of providing advice on the coming up of European financial regulations and supervision. Five months later, in February 2009, the committee presented a report that came to reveal the following imperfections:
● "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 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 underestimation of correlations in the defaults that would occur during a downturn, and
○ an inability to take into account the severe weakening of underwriting standards by certain originators.
● October 2008 also saw the German government appoint Otmar Issing, former Chief Economist at the European Central Bank, to chair a committee to draw up recommendations first for the Group of Twenty (G-20) summit in Washington and then for the follow-up summit in London. The committee's report drew attention to the part played by various unresolved conflicts of interests (Issing Committee 2008). It leveled the following criticisms at CRAs:
● 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. " (de Larosière Group 2009)

As the Larosière report points out, collateralized debt obligations got the same ratings (AAA) as government bonds or other products bearing with only systematic risk. After the crisis, we know that there are no such thing as risk-free investment, not even government bonds, anyhow, putting the CDO’s promising significantly higher yield than the products mentioned above is clearly a mistake that could have been avoided by the agencies.
The article gives further insight on the background of the overvaluation. Firstly, mentiones the lack of historical data in regards of subprime mortgages in the US, as they were relatively new on the security market, a certain weariness should have define the rating process. Secondly, the crisis happened fastly, and often described as a bubble, which means the subprime mortgages defaults were closely connected and had a relevant impact on each other. Not taken into account these correlations proved to be toxic and irresponsible as the defaults and the underwritten securities were fallen like dominos. At last, the report brings up the question of the credibility of the security originators. It implies that the raters did not pay sufficient attention when examining their underwriting standards, which again is a question of control and the relationship between the rated and rater.
The report furthermore discusses the issues risen from the possible conflict of interest and points out flaws in the credit rating agencies corporate governance that could not deal efficiently with maintaining analytical independence opposed to commercial interests. What is more, the issuers had the possibility to suppress unwelcomed ratings, thus putting raters under pressure. (The Role Played by Credit Rating Agencies in the Financial Crisis, Asian Development Bank Institute, 2012)

Industry structure Let’s take a look at the very basics of the industry. As it has been mentioned above, when talking about the conflict of interest, we need to deal with the financial interests of the credit rating agencies. The issuer pays model, where the bond’s issuer pays the raters for rating the securities met many criticism during the last years. However, until the 1970s the subscribers payed for the data provided by the agencies. The reason why the shift occurred in the structure of the industry, is probably that the rating agencies discovered that issuers are more willing to pay for the ratings as without these qualifications they might not be able to sell their securities. (The Credit Rating Controversy, Christopher Alessi, Roya Wolverson, and Mohammed Aly Sergie, Council on Foreign Relations, 2013) In order to repair this glitch in the industry, many smaller rating agencies have adopted an alternative model, letting the investors pay for the ratings instead of the issuers. For instance, Egan-Jones Rating Company is one of these firms and based on a 2008 report conducted by the American Enterprise institute, they provided more accurate ratings than Moody’s or Standard and Poor’s. At the end of day, these firms are still in possession of an irrelevant market share, thus they are yet to make a difference.

Independence

The Three Bigs have been accused more than once of being biased and not exclusively because the nature of the industry, European authorities often criticised them with giving favorable, but unrealistic ratings to the USA, while downgrading European countries one by one. Many claimed that they took a major part in accelerating the Eurozone crisis, with downgrading Greece's debt to junk status. (S&P warning puts damper on Eurogroup plans, Andrea Rönsberg, Deutsche Welle, 2011)
In order to put a stop to the alleged preferential treatment of the US, recently has been much talk about the possibility of creating an independent European credit rating agency. However, the necessary financial resources are not yet available. (The Credit Rating Controversy, Christopher Alessi, Roya Wolverson, and Mohammed Aly Sergie, Council on Foreign Relations, 2013)

Changes after the crisis, possible solutions for the flows of rating agencies

After the crisis several steps have been made in purpose of avoiding such financial downfall in the future. One of the most important one is the Dodd Frank act that has been named after Senator Christopher J. Dodd and U.S. Representative Barney Frank, who were the sponsors of the legislation. The act created an Office of Credit Rating at the Securities and Exchange Commission (SEC) to be in possession of a more effective monitoring over credit ratings agencies like Moody's, Fitch and Standard & Poor's. The Securities and Exchange Commission need to monitor agencies rating systems and decide whether they deliver accurate results from relevant and sufficient data. What is more, they have the right to de-certify agencies that provide misleading ratings. (Dodd-Frank act, Mark Koba, 2012)
Although this could have led toward regulating the credit rating agencies, many claim that the SEC succumbed to reduce the Big Three’s influence as the SEC’s regulations are still not finalised almost seven years after the crisis. (Economist, Credit where credit’s due, 2014) What is more, Standard and Poors have been sued for their alleged contribution and misleading security ratings by the US Department Of Justice. However, the rating agency claimed that they are the victim of the US government trying to punish them for downgrading US credit from AAA to AA-plus. Based on the Standard and Poors view the government’s "impermissibly selective, punitive and meritless" lawsuit was brought "in retaliation for defendants' exercise of their free speech rights with respect to the creditworthiness of the United States of America." (S&P calls federal lawsuit 'retaliation' for U.S. downgrade, Jonathan Stempel, Reuters, 2013)
As it have been mentioned above, an alternative business model (subscriber pays for ratings) might seem like a possible solution for avoiding the conflict of interest between the agencies and the issuers. In contrast to this views, Thomas Cooley of the Stern School of Business claims that investors might decide not to publish undesirable ratings that they have paid for, which would take security mispricing to an even further level. (Economist, Credit where credit’s due, 2014)
Conclusion
To debate a certain part of responsibility from the side of the credit rating agencies would be irrealistic. It has been pointed out above the CRAs rating were instead of being accurate, often favored the issuer’s interests in hope further cash flow. Although, the valuation methods did posses certain flows and the overvaluation of the CDOs did accelerate the crisis, credit rating agencies cannot be names as the only or the main responsibles for the financial downfall of 2007 and burst of housing bubble.
Firstly, let’s take a look at the very beginning of this nuclear chain, the lenders. When lenders started to give out loans to people who had a very high chance of credit default, they committed the mistake of underestimating the systematic market risk, they thought real estate prices will constantly grow without an end. What is more, the investors also took a major part in accelerating the economical downfall with instead of buying Treasury bonds they purchased these collateralized debt obligations with unreasonably down priced premiums. The undeniably attractive low rates are the reason for the unusually large increase in demand for subprime loans. The investors are definitely guilty in this case as it was up themselves to evaluate their investments and by that, form reasonable expectations. As they failed in this by taking the 'AAA' collateralized debt obligation ratings at face value, part of the blame is ought to be put on them. (Investopedia, Who to blame)
Based on Standard and Poor’s definition of CROs role: " In short, credit ratings can help reduce the knowledge gap, or "information asymmetry," between borrowers (issuers) and lenders (investors). The essential subject matter of this information asymmetry is a borrower's creditworthiness. A borrower knows its own creditworthiness better than a lender does. And because creditworthiness is not a directly observable attribute, a lender generally has to estimate it from attributes that are observable, using various approaches. One is to perform its own analysis; another is to use credit ratings from independent rating agencies; and another is to use information and analysis provided by third parties or other analysts. Using multiple approaches will likely permit a lender to be more confident about its conclusions, especially if the approaches lead to the same result." (Standard and Poor’s, Missions)
To sum up the inefficiency of today’s CROs we have to examine the beginning and the ending of S&P’s self definition. It points out that the main role of CROs in the financial word is to reduce information gap and information asymmetry between issuers, borrowers and lenders, investors. But as it has been discussed, investors are relying so heavily on the Big Threes ratings, that they might contribute to widening the gap instead of narrowing it.
Until investors are looking at the Big Three’s ratings as the only defining quality of the securities, they will base their decisions on possibly biased asymmetric information, which will lead to mispriced securities and possible economic downfalls.
Even though the credit rating agencies took a big hit in revenues after the crisis, surprisingly they seem to thrive today. Mood’s hit a record in profit last year and Standard and Poor’s is neither far from them. The ratings agencies’ swelling profits derive in part from increased activity in the bond markets, according to Flavio Campos at Credit Suisse, a bank. Last year companies issued a record amount of bonds by value. What is more, thanks to the US regulations it is still almost impossible to sell unrated securities, thus the issuers are still willing to pay for the Big Three’s services. (Economist, Credit where credit’s due, 2014)
After seeing how fundamental is the Big Three’s role in today’s economy, we have to ask ourself whether it’s profitable and sustainable to have private companies in possession of such power and responsibility? If not, what sort of authorities or regulations could reduce their impact on financial life? Is it ethical to restrict them or is it in contrast of capitalism’s fundamentals?
These are questions often discussed recently and still waiting for answers. To conclude, it can be clearly stated that credit rating agencies are partially responsible for the crisis but cannot and should not take all the blame for the housing crisis. They did contributed to the acceleration of capital mobility in the past 20 years, and with improving internal control and rating methods they have the chance to work more efficiently and raise less controversy in the future
Bibliography
● History of Credit Rating Agencies and How They Work. 2014. History of Credit Rating Agencies and How They Work. [ONLINE] Available at:http://www.moneycrashers.com/credit-rating-agencies-history/. [Accessed 12 April 2014].
● S&P calls federal lawsuit 'retaliation' for U.S. downgrade | Reuters . 2014.S&P calls federal lawsuit 'retaliation' for U.S. downgrade | Reuters . [ONLINE] Available at: http://www.reuters.com/article/2013/09/03/us-mcgrawhill-sandp-lawsuit-idUSBRE98210L20130903. [Accessed 12 April 2014].
● Dodd-Frank Act Rulemaking: Credit Rating Agencies. 2014. Dodd-Frank Act Rulemaking: Credit Rating Agencies. [ONLINE] Available at:https://www.sec.gov/spotlight/dodd-frank/creditratingagencies.shtml. [Accessed 12 April 2014].
● Dodd-Frank Financial Regulatory Reform Bill Definition | Investopedia. 2014. Dodd-Frank Financial Regulatory Reform Bill Definition | Investopedia. [ONLINE] Available at:http://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp. [Accessed 12 April 2014].
● Dodd-Frank Act: CNBC Explains. 2014. Dodd-Frank Act: CNBC Explains. [ONLINE] Available at: http://www.cnbc.com/id/47075854. [Accessed 12 April 2014].
● Who Is To Blame For The Subprime Crisis?. 2014. Who Is To Blame For The Subprime Crisis?. [ONLINE] Available at:http://www.investopedia.com/articles/07/subprime-blame.asp. [Accessed 12 April 2014].
● 2008 crisis still hangs over credit-rating firms. 2014. 2008 crisis still hangs over credit-rating firms. [ONLINE] Available at:http://www.usatoday.com/story/money/business/2013/09/13/credit-rating-agencies-2008-financial-crisis-lehman/2759025/