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03/28/2012

Credit Ratings Agencies


Credit Ratings Agencies

 

Introduction

            The financial crisis due to credit bubbles and credit crunch have affected different companies and individuals not only in the US but also all over the world.  In this regard, the authorities and different agencies are trying to find ways on how this can be solved. In doing so, most authorities are investigating other agencies that have been responsible for the financial crisis. The main goal of this paper is to identify the role played by Credit Rating Agencies in the financial crisis.

Overview of Credit Ratings Agency

            A credit rating agency is not a buy/sell recommendation agency. CRA are considered as powerful since both the governments and the markets view them as authoritative sources of judgment and they are also considered as major actors that controls access to capital market (Sinclair, 1994). Accordingly, Credit rating agencies have played a critical role at different paces of the subprime crisis. These agencies are highly criticized for understating the risk that can be encountered with new complicated securities which fueled the United States Housing bubble and also the collaterised debt obligations (CDO) and mortgage-backed securities (MBS).

            CRA is not under the investigation for providing investment-grade and money safe ratings to securitization operations (MBSs and CDOs) based on the subprime mortgage loans.  Such high ratings are had been able to encouraged a flow of global investor funds into such securities to fund or give financial resources to housing bubble in the United States. Accordingly, there is approximately $3.2 trillion in loans which has been provided to different homeowners including those who have bad credit or those with undocumented profits such as the subprime or the Alt-A mortgages from 2002 up to 2007. These mortgages could be bundled intro CDO and MBS securities which received high ratings, and hence could be sold to the global investors.

            It is believed that higher ratings which have been justified by different credit enhancements that include over-collaterisations, credit default insurance and also the equity investors which are willing to bear the first losses. According to some economists, it has been viewed that the rating agencies can be considered as one of the vital culprits for the financial crisis. These rating agencies were the parties which conducted the alchemy which converted the securities from being F-rated to A-rated.

            Analysis also showed that credit ratings agencies have advised the issuers on how to prioritize and structure tranches of CDO or MBS. The main objective was to enable the issues to squeeze the maximum profit from a MBS or CDO by maximizing its size, specifically on the highest rated tranches.  The main goal of tranching is to establish at least one area of assets with a higher credit rating than those with the average rating of MBS or CDO’s underlying asset pool.  The credit rate agencies have rated each tranche based on the creditworthiness of their loans in such tranche and its priority. Those who belong in the tranches get higher credit scores and ratings based on prioritization while the issuers have guaranteed that senior tranches will be given payment first before the junior or subordinated or sub-tranches. In the hype of the housing boom, majority of the senior tranches have been given the possible highest rating which is triple AAA. Such rating have caused analysts and economists to see some mistake in the part of Credit Rating agencies. One reason why authorities are pointing at credit rating agencies to be the cause of the subprime crisis is because during the third quarter of 2007 and the second quarter of 2008, the rating agencies have lowered or reduced the credit ratings on $1.9 trillion in line with mortgaged securities. Such action is considered as an indicator why their initial ratings become incorrect.  In addition, this also put additional pressures and issues on the banking and financial organization to lower the value of mortgage-backed securities. With this, it is said that financial institutions have been involved to provide additional capital to be able to maintain the capital rations. Thus, this includes the sale of new shares of stock and the value of the present shares are affected.

            By and large, it can be said that authorities that has been blaming Credit rating agencies to be a major part of the subprime and financial crisis have some basis for their accusation. The inability of the CRAs to provide proper judgment and to provide inappropriate ratings have been seen to be a major cause of the financial crisis felt by banking industries and also other corporations in the global market.

Reference

Sinclair, T. (1994) Passing judgement: credit rating processes as regulatory mechanisms of governance in the emerging world order, Review of International Political Economy, 1 (1), pp. 133-159.

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