The Credit Rating Agencies, Their Role in the Financial Crisis?

End of Studies Thesis What is the bureau of the assurance range agencies, which part did they goldbrick in the recent m championtary Crisis and how mountain their efficiency be changed? Thesis Supervisor David Menival Emmeline Beauchamp stave Franco- US March 2013 Ac pick out directgments I would initiative like to convey RMS and speci all toldy the CESEM to blush out out taught me a lot, help oneselfed me to grow and open up and gave me this incredible probability of studying two years in the United lands. None of this phenomenal experience would start out been possible without them.I would in like manner like to thank north University for al sufferinging me to discoer a new-fangledborn culture and a different educating re chief(prenominal)s. It withal had a trem fetch upous intent in my early accomplishment and passe-partout c arr. In addition, I would like to thank all the professors I had during these iv years of studying, whether it is at CESEM or at Northeastern University. They made this locomote in time to a greater issue profit qualified and enjoyable. I would alike like to thank David Menival, my thesis supervisor, who accepted to work with me on this project.Finally, I would like to thank my p bents for always supporting my choices and being attached to me when I essentialed them. They exact been my gui diethylstilboestrol and archetypes in smell and ware always encouraged me to be improve and push myself. Table of Content Introduction4 I. point of reference military rank Agencies purpose and methods5 1) score5 2) Role and methods7 3) The Issuer-Payer prototype 9 II. The commendation pass judgment Agencies and the monetary Crisis is the thermometer obligated for the feverishness? 12 1) Background of the fiscal Crisis12 2) address valuation Agency are non fully prudent 14 ) But they could soak up through with(p) snap off(p)17 III. What is next? 20 1) Lessons lettered from the crisis 20 2) Regularization of the existing assign evaluate system 21 3) A new range system23 4) universe of new reliance order Agency24 Conclusion26 screenings27 Bibliography32 Introduction A assurance pass judgment manner is a compe real whose type is to evaluate the negligence venture of a borrower, whether it is a private or semipublic confederacy or a State. Since 1909, when Moodys emitted its starting line rank, the character of the deferred payment Rating Agencies has considerably evolved and the methods exampled carry improved.Even though their enumerates do non prepare buying or selling recommendations, they rapidly gained an around biblical stemma office. Since the 1980s, the reference work evaluate agencies squander, thus, become a reference for robeors that want to do the consultationworthiness of an entity. Their valuations influence investors looks and they are in flat involved in the future of a State or company. After several(prenominal) economic melt d admits and the recent pecuniary crisis, the tercet big computer address Rating Agencies pee been the center of maintenance.Is their methodology appropriate to evaluate the recogniseworthiness of an entity? Does the issuer-payer pattern insure the best transparence? Their role and implications in the crisis provoke been meticulously examined and their functioning system has been questioned. Although their role in the crisis in undeniable, are the exactly responsible of the crisis? The system was defaulting and the predictions of the combining military paygrade pass judgment agencies turned out to be wrong. Which modifications should we bring to the system to make it to a greater extent(prenominal) transparent and effective?These are the questions we lead try to response passim this thesis. I. Credit paygrades agencies role and methods Credit Ratings agencies, entity tacit little known rightfield(prenominal) the fiscal communities two years ago, found themselves at the center of attention with the subprime crisis. If everyone more than(prenominal)(prenominal) or less make fors, now, familiar with what a ascribe range internal representation is, people usually do non know what are the inceptions of this duty, its rationale and its financing put. 1) HistoryThe influence of the twofoldt main denotation military rank agencies (Moodys, measuring & pitifuls and skunk Ratings) was build step by step since their inception, in the early 1900s. Historically, the places issued by the agencies did non relieve oneself more apprize than the ones presumptuousness by analysts or economic experts. They acquired this token lieu when legislators and regulators attri saveed them a big place in their systems. The development of railroads companies marked the origin of these Big trine. These railroad companies were indeed fluctuating and hireed nvestments to set up their infrastructures. As investors were concerned and questioned their capacity to deduct their debts, Henry Varnum Poor published, in 1860, nigh financial training regarding the creditworthiness of those companies in order to help investors make their decision. Later on, in 1900, John Moody would also scratch publishing economic data on these companies and netly, in 1909, J. Moody gave his first evaluates virtually railroad companies in Moodys Analyses of Railroad Investments by attributing a letter to severally of them the credit military rank was born.This system was progressively adopted by new(prenominal)s credit paygrade agencies such as foulmart Publishing Company, founded in 1913 by John Knowles skunk, which would later be known as wood pussy Ratings. Finally, Less than thirty years later, the credit grade force Standard & Poors is created aft(prenominal) the merger of the Standards Statistic assurance and the Poors Publishing Company. The development of the ratings is stimulated by several incidentors. commencement ceremony, its goal is to offer a service for investors by providing efficacious randomness that willing help them in their decision-making process.In addition, the relative large size of the Ameri crapper territory discourage investors to search for information, they would rather pay for it than waste age looking for it. Moreover, the backlashs of the 1929 financial crisis and the consequences of the World War II, giving supremacy to the economy of the United States, also favored the expansion of the concept of rating. In 1970, subsequently the money boxruptcy of Penn Central Railroad, the first doubts regarding the emancipation of the credit rating agencies appeared. This was the first time that the re obligation and seriousness of the ratings were questioned.In order to reestablish the encourage of the ratings, the instant (Securities rally Commission) created, in 1975, the Nationally Recognized Statistical Rating constitution (NRSRO) designation. The g oal was to standardize and formalize the ratings regarding brokerage firms and confides with their capital ratios. At that time, septet agencies arrive ated the NRSRO designation. In 1990, aft(prenominal) several new mergers, the identification number of NRSRO was only if of cardinal Moodys investor service, Standard and Poors and Fitch Ratings. In 2003, the Canadian agency Dominion Bond Ratings service Ltd also ained the spot of NRSRO, followed by A. M Best Company in 2005. In June 2003, by and by the disorders caused by the bankruptcy of the company Enron, the regularisation of the credit rating agencies and their NRSRO situation submited to be examined. Multiple breeds on the role played by the agencies in this case were published. Even though investors muddled faith in them, they all agreed that they should nourish the NRSRO status. In 2006, after years of critics toward the credit rating agencies, the functioning rules of the NRSROs were modified and the Credit R ating Agency make violate Act was promulgated.The objective was to regulate the internal decision process of the credit rating agencies while forbidding the SEC to swear the rating system of NRSROs. Right after, in 2007, deuce-ace more companies were added to the list of NRSROs Japan Credit Rating Ltd, Rating & Investment Information Inc. and Egan-Jones Rating Company. Since April 2011, the list of agencies that accepted the NRSRO status counts ten names (See Exhibit 1, page 27). Finally, in July 2010, the Dodd free-spoken Wall Street Reform and Consumer Protection Act reinforced the control over the ratings practices.This included a reduction of the scraps of elicit regarding the ratings of structured products and lessen dependence on ratings. It also beared investors to sue a credit rating agency in case of fake or reckless rating. For decades, the three main agencies, Moodys, Standard and Poors and Fitch Ratings, set out been controlling the merchandiseplace, as high barriers to enter exist. The major(ip)(ip) ones are the richness of the genius and the investors confidence in their ratings. Since their creation, these agencies suffer distinguished themselves with a contingent role and specific methods. ) Role and Methods The Credit Rating Agencies evaluate the creditworthiness of debtors. Ratings foot concern a company as well as a particular emission or securitization or any financial debt. They are usually solicited by the debt issuer but can also be attributed, if non-requested, after collecting public information. Credit Rating Agencies enjoyed a peachy re frame upation and an ingrained role in the financing of economies. Over time, regulators, for practical reasons, as presuppose more and more to impose the use of the notation in the investors financing.This long trend follows upon the systematic financing by the commercializeplace, whether it is in a straightforward formulation taking the shape of debenture or assimilated loans or new products w here(predicate) the put on the lineiness of defect is difficult to comprehend because it is diffuse in coordination compound financing methods such as the securitizations. Credit Rating Agencies construct the role of processing the information for financial grocery stores. They synthesize the information for market ask and the investors seemed to excessively grant their confidence to this information.Investors pay close attention to any modifications in ratings or to any entities placed under expression. The ratings issued by the credit rating agencies leave a trustworthy value. Since investors usually do not take the time to look for information regarding a company or a State, they based their investment choices upon the rating evanescen by the credit rating agencies. Therefore, the role of the credit rating agencies is essential. Basically, these agencies summarize all information available about a company or State and turn it into a rating that will t hen influence the future of an entity.However, it is necessary to underline that the ratings given are not buying or selling recommendations, they are only an paygrade of the creditworthiness of an entity, at a outlined time, and statically calculated. Next to this informative participation, credit rating agencies contribute to the management of portfolios by giving advice to the investors via the medium-term orientations emitted with the rating. If a company tries to pay itself, the received grading will be determining for the conditions of the operation.Whether it is by financing through banks or by issuing bonds on the market, the more the grade will be raised, the more the company will be able to retrieve cheap bills at low refer rates. On the other hand, a mischievously grade will imply higher(prenominal) interest rates and difficulties to make financing. The difference of levels amidst both interest rates will forge the adventure premium. This problem becomes partic ularly main(prenominal) for companies or States located inside the speculative category. Major institutional investors do not want, indeed, to take the essay and, in that locationfore, do not invest on these kinds of values. However, the rating is ot fixed and fluctuates end-to-end the life of the bonds. A reduce of the rating can lower the harm of the bond. Likewise, a raise of the rating can be associated to an increased bell of the bond. In order to correctly determine the default risk, Credit Rating Agencies use diverse quantitative and qualitative criteria that they translate into a grade. Credit Rating Agencies distinguish two types of ratings short and long-term the traditional rating that applies to loans emitted on the market and the reference rating that measures the risk of counterparty for the investor represented by this issuer.When evaluating the financial risk, credit rating agencies first take into consideration strictly financial numbers such as the profitab ility, the return on investment, the level of cash flows and debt, the financial flexibility and the liquid state. More and more, the agencies integrate non-quantitative elements such as the governance, the social responsibility of the company and its strategy. It is also necessary to highlight the circumstance that the rating is usually associated with medium-term orientation, allowing to better estimate the future trend regarding the tonus of the issuer.In some cases, a borrower can be placed under observation. The main steps in a companys life (mergers, acquisitions, big investments) are indeed, likely to influence and modify their structure. Credit rating agencies, subject to preserving the confidentiality of the received information and eliminateing cases of insider trading, can have insider information on the financial state and the future prospects of the analyzed issuer, while reducing the make up of collection and data processing. They distinguish themselves from financ ial analysts, who, in principle, only have access to the public information.Even if they can benefit from insider information on behalf of issuers, they are dependent on the information provided by these issuers. Each Credit Rating Agency possesses its own rating system. In broad outline, grades are schematic from A to D with intermediary levels. Thus, the best grade is AAA, then AA and A for Standard and Poors or Aa, A, etc. for Moodys. In addition, we can also find intermediate ratings a + or a - but also a 1 or a 2 can indeed be added to the grade (e. g. AA+, A-, Aa2, etc. ).This allows a better and more precise classification of borrowers. These different ratings can be divided in two groups the first category, High Grade includes all ratings between AAA and BBB and the warrant category, also known as speculative, for humble grades. (See Exhibit 2, page 28) The biggest advantage of this system is to provide information at low costs for voltage investors. Thanks to an easily go outable grade, but incorporating a vast amount of information, investors can quickly have an theme of the creditworthiness of a borrower.The ratings issued by these agencies are a more and more useful tool in the decision-making process of investors looking for relevant information. Current order obliges them to certify published information. As we have previously seen with the United States or Greece, the market strongly reacts and sometimes irrationally to any modification of a rating or to a simple announcement of a hypothetic revision. Credit Rating agencies have a real influence on markets. The impact of their decision on issuers and investors is decisive.On the contrary, an excessive reaction was completely predictable in front of their incapacity to forecast the financial crises of these last decades. 3) The issuer-payer model For more than half a century, investors that give to induce financial information about loan issuers financed the credit rating agencies. Thus , companies, local communities, States were given a rating, without asking for one or without their consents, but to answer to requests from bankers or investors that were retentivity these funds.Naturally, these non-requested ratings were only based on public information concerning such or such company. The Credit Rating Agencies sold their publications to bankers and capital holders who were looking for potential adequate investments. In addition to selling these manuals, the credit rating agencies could also offer others services to investors (weekly information about financial results of rated companies, actualization of the ratings, recommendations and advices of obtain and/or sell).However, the agencies will lose some profits as some investors managed to have the information and the manuals without paying for them. As from the beginning of the 1970s, Credit Rating Agencies started to charge their services to the issuers of bonded debt. This is the issuer-payer model. These i ssuers of debt (Companies or communities looking for investment) began to more and more directly solicit the agencies in order to obtain a rating. They believed that this rating would secure investors during a slowdown of economic growth.Thus, from now on, it is more much the issuers of debts that will request a rating from the credit rating agencies to get an evaluation from them that would allow them to access to credit. This approach contributed widely to consolidate the place of the Credit Rating agencies and to legitimize their intervention. In fact, this translates well a swing of the relief of power between those who look for funds to invest in industrial projects and those who hold funds, while waiting for the best yield at the slightest risk.In a world highly regulated by finance, where pensioners and holders of capital are in a strong position, and where industrial and direct investors are in a position of requestors, it is now, more often, issuers who wish to borrow an d will ask to be line of creditd, that will pay the credit rating agencies for their services. This shift from an investor-payer model to an issuer-payer model compromised the independence of the credit rating agencies. In fact, in 2011, only 10% of the revenue of the agencies came from funds holders who wanted to know more about the validity, the risk and the potential profitability of an investment.From now on, the ones looking for capital are the ones financing 90% the credit rating agencies. The issuer-payer model strongly modifies the situation of the credit rating agencies. In this situation, the rating agency is used, and give, by the market worker who wishes to be noted to then be able to hope to obtain capital on financial markets. The question of the independence of the agency in its rating process is then very directly put the rating agency will be inclined to note well a company which pays her to then try to obtain capital in good conditions on behalf of miscellaneou s investors.However, the market has faith in this independence since a credit rating agency has to protect its reputation, and thus an agency could not take the risk of over evaluating one of its customers by fear of losing its credibleness and thus all business. Credit Rating Agencies seem, indeed, more and more subjected to encounters of interests, which falling off their reliability. The issuers pay the agencies to be noted, while credit rating agencies need the revenues from these alike issuers. Besides, more and more often, the credit rating agencies mix two activities consulting and rating.Therefore, in addition to evaluating a company, an agency also advises on electric current operations. A study for the SEC in 2008 revealed that some analysts from certain agencies participated in meetings between investors and issuers in which commission and rating were fixed. These conflict of interest generated reproofs and accusations against credit rating agencies and especially d uring the recent financial crisis. As the credit rating agencies were essential and indispensable to any players on the market that wanted either to invest or to find capital, they were at the heart of the upheaval.II. The Credit Rating Agencies and the financial Crisis is the thermometer responsible for the fever? In order to determine the responsibility that the credit rating agencies have in the financial crisis of 2008, it is necessary to understand how the crisis happened, which events punctuated it and what has been the behavior of the rating agencies throughout the crisis. 1) Background of the Financial Crisis Everything started when the American housing market suddenly returnd after a steady rise in the 2000 years.To finance their consumption and acquisition of a house, American households did not hesitate to get into very high debts. The market was booming so thither was a trust in the ability to get its money back with a substantial profit. As counterparty, they pawn the ir properties. This was a guaranty for banks to be paid because if the borrower could not reimburse what he owed, his property would be sold to whiteness his debt. When the phenomenon grows and affects a large number of households, the sale of their property causes the collapse of the value of the property.The downturn of the housing market was reinforced by the subprime system. Since 2002, the American federal official declare, which encouraged easy credit to boost the economy, allowed millions of households to become homeowners thanks to premium loans called subprime, with variable interest rates that can reach 18% after three years. These interest rates are fixed according to the value of the property the greater the value, the lower the rate and vice versa. That is what happened when the housing market collapsed in the United States in the beginning of 2007.Households, lacking of ways to reimburse their debts to lenders, have caused the bankruptcy of several credit institution s that could not repay themselves since even when taking on the property, this one has a lower value than initially. Finally, banks were also touched by this phenomenon. They have indeed been numerous to invest in these lending institutions. Nevertheless, today, invested funds are gone. In order to compensate these losses on the housing market, banks were forced to sell their shares, leading to a decrease of their values on the financial markets.The crisis quickly expanded in Europe, where major European banks such as Dexia in France and Benelux or IKB in Germany lost a fine part of their investments. Besides, the bankruptcy of several European banks led to a confidence crisis on European financial markets. Banks have doubts about each others contamination by the subprime crisis and at that placefore, to be cautious, refused to lend money. Since international banks are linked to each other through financial agreements, the crisis rapidly extended, to reach Asia during the summer 2007.Only one solution seemed conceivable for banking institutions to scene this lack of liquidity sell their shares and bonds. This fast and quick intervention caused a sharp drop in business value and all the European stock markets were affected (See Exhibits 3 and 4, page 29-30). In order to assuage the crisis on the markets but also to bail out banks, the American national Reserve (FED) and the Central European Bank (CEB) decided to inject liquidity in the monetary system, hoping to gain back the confidence of investors to help modify the situation.On 9 August 2007, the CEB acted first by making available 94. 8 billion euros to banks, followed shortly by the FED which injected $24 billion to quiet the spirits of investors. However, markets initially misinterpreted the message, considering their involvement as a sign of weakness. The next day, the CEB injected again 61 billion euros and the FED, $35 billion, but the markets felt down again. Finally, on August 13, 2007, the same action was repeated and the monetary market as well as stock markets around the world unbroken their heads above water.While it seemed like the financial crisis was faded apart at the end of 2007, a second wave of crisis appeared from the banking sector at the beginning of 2008. This was callable to the creation of new products such as residential owe-backed securities (RMBS), Asset-backed Securities (ABS). In fact, credit risk, such as subprime mortgages, were pooled and backed by other assets, more or less risky, in Collateralized Debt Obligations (CDO) (See Exhibit 5, pages 31). These clusters of scattered debts were then sold on the stock exchange by the issuer, like shares of a company could be given up.This results in the transfer of the risk of non-payment from issuers of mortgages to financial institutions in particular banks, major consumers of CDO. In order to invest on the CDO market, some financial organisms went even further and created Structured Investment Ve hicles (SIV) that did not have to regard as the usual rules of prudence of the banking system. This amplified the risks taken and losses impacted on the implementation of the bank. Other new products were also created such as Credit disregard Swap (CDS), an insurance contract between two entities against a risk faced by one of two entities, such as the non-payment of a debt.The price of the CDS reflects the confidence in a particular issuer of a debt and is the undercoat for determining the value of the product of the debt. The crisis took a new dimension on September 15, 2008 with the bankruptcy of Lehman Brothers and AIG (narrowly saved by the Fed), as well as several American and European banks (HBOS in United Kingdom, Fortis in Europe, Dexia in France and Belgium, etc. ). This international and financial crisis still has repercussions on todays stock markets and the end of the tunnel seems far away. The question raised here is the role played by the Credit Rating agencies in the crisis.Are they the only ones to blame for everything that happened? Are the actions intended by the rating agencies responsible for the crisis? 2) The credit Rating Agencies are not fully responsible Ever since the crisis, the credit rating agencies have been easy targets to blame for what happened in 2007 and the years after. in effect they did not anticipate the downturn of the market, they continued to attribute good rating to banking institutions already hurt by the crisis with an increasing book of bad loans or bad papers that banks will have to deleverage.Many criticisms have been emitted about toward them. However, it is important to point out that they are not the ones and only responsible for what happened. They did not have power over a lot of factors that went wrong, and for that they cannot be the only to take the fault in the financial crisis. The thermometer could not be responsible for the fever. initiative of all, they are not responsible for the bankers or mo rtgage brokers who gave loans unwisely. These institutions lacked of mutual sense and thinking when offering credits.Banks and managers perfectly knew that unemployed borrowers would never be able to reimburse their mortgages. They have, indeed, disproportionately opened the gates of credit by taking for guarantee, when they did take some, the increase of real nation prices or their trust in the growth of the economy. They thought that they could make benefits if the debtor did not pay, as they believed that they could force the sale of the house for a higher price. However, real estate prices always end up going down and the economy is fluctuating.In an judge to reduce the risk of these new kinds of loans, banks used securitization they transformed these loans and resold them on the stock market. Therefore, mortgages securitizers are also to blame. Some companies such as Washington Mutual, Morgan Stanley or Bank of America were mortgages originators as well as mortgage securitiz ers, other like Goldman Sachs, Lehman Brothers and Bears Stearns bought mortgages directly to subprime lenders and pooled them together to resell them to investors. However, as soon as a debtor was not able to pay back his mortgages, the security measure became toxic and had no more value.Nevertheless, this was not the last step. Some banks would buy and bundled mortgage backed-securities into collateralized debt obligations, composed of different levels of risk. The creators of these new financial products are also responsible for the crisis. They bet against these risky CDOs by using credit default swap. (See exhibit 5) Government Sponsored Enterprises (GSEs) could also be blame for what happened. They indeed, control the mortgage market. When a bank or a mortgage broker wanted to take off his books a loan, it could sell it to a GSE, which led to a higher number of mortgages.Fannie Mae and Freddie mack are the two major GSEs. Alone, they own or guarantee half of the current mort gages. With their government status, investors can buy those bonds while asking for a low interest rate in return, as federal government bonds have the safest credit rating in the world. As long as debtors paid back their mortgages, Fannie Mae and Freddie Mac would be able to pay their creditors too. However, as these loans where often given out, even to people we knew could not reimburse, GSEs had to assume the risk. Therefore, we could also say that investors could be diabolic for the role they played.They bought and invest in financial products they did not know about. They should have yielded researches about what they were purchasing and should have known these were subprime and meant a higher risk of non-payment. However, we have to see the bigger picture. At that time, banks received pressure from higher instances to encourage homeownership and so, to grant loans to the poorest population. The government wanted households with a less satisfied life to be able to buy their own house. The pressure that was put on the banks forced them to give mortgages to debtors that would ikely not pay back. This being said, borrowers are also responsible for contracting loans that they pertinently knew they could not afford. Moreover, the credit rating agencies are also not responsible for the debt of the countries. They have often been accuse to do be the reason for the deficit of some countries such as Greece. Nevertheless, Greece has always had a huge deficit. They never had a break-even budget in 150 years, and governments from left to right parties systematically laid about the finance of the country.In addition, the national sport is not the Greco/Roman wrestling or the marathon but how to annul paying taxes nothing in which the rating agencies were involved. Furthermore, regulators could have also done a better job to prevent the crisis. In the United States, several regulators exist and each of them has a specific scene of action of expertise. The legisl ation of the banking sector is shared between the Federal Reserve (Fed), the social occasion of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (which guarantees the deposits of bank customers) and the Office of the Thrift Supervision (OTS).There is also The Securities and Exchange Commission (SEC) that is responsible for the supervision of stock exchanges. The Financial Industry Regulatory Authority provides the ruler of brokerage activities. Finally, the Commodity Futures Trading Commission (CFTC) insures the regulation of futures and options markets. This various regulators could have acted to appease the situation. The SEC could have, indeed, regulate lending practices at banks and force them to keep more capital reserves in case of losses.The Federal Reserve could have contained the housing bubble by setting safer mortgages lending standards, which it failed to do and especially when Alan Greenspan who was the head of the FED, refused to impro ve the examination of the subprime mortgage market. Finally, according to the Financial Crisis doubtfulness Report, executives in the main investment banks did not hold rich capital to be fully protected against losses. Some companies, such as Lehman brothers or Citigroup would just hide bad investments off their books.It is mainly a problem related to the liquidity crisis that led to the bankruptcy of Lehman Brothers. Lehman Brothers, indeed, financed itself on the short and lend on the long-term. When the source of the financing dried up (banks did not trust each others by fear of not being paid off), Lehman found himself stuck and was enabled to face its commitments. If the credit rating agencies were not responsible for the mortgage originators or securitizers, the creation of the CDO, the regulators or the executives of the investment banks, they surely played a tremendous role in the crisis ) But they could have done better The credit rating agencies are responsible for a l ot in the financial crisis. Several aspects of their business as well as the actions they have done have been pointed out as the main cause of the crisis. First of all, the pertinence of their business model was questioned, among others the oligopolistic situation of the market and the conflict of interest created by the issuer-payer model. The Big terce (Standard & Poors, Moodys and Fitch Ratings) generate 95% of the $6 billion market that the rating business represents.These three agencies dominate the market and adopt similar methodologies and practices. The business model of the rating agencies establishes itself on the independence and the credibility granted by the financial markets and the authorities of supervision. That is why, in the absence of statutory reforms and / or of the desertion of numerous customers, the leadership of the Big Three will be maintained, protected by strong barriers of entry (reforms difficult to set up and loyalty of issuers often connected to the heaviness of the rating process).Besides, the oligopolistic situation is strengthened by a consolidation, on the initiative and thus for the benefit of the Big Three. So, Fitch acquired in June 2000 the fourth American rating agency, Duff and Phelps, and in celestial latitude 2000 Thomson BankWatch. At the beginning of 2006, Fimalac gave up 20 % of Fitch Group (who, herself, holds Fitch Ratings, Fitch Training and Algorithmics, this last company having been acquired in 2005) to Hearst Corporation. Likewise, the French subordinate of Standard & Poors acquired ADEF (Agency of Financial Evaluation).Another reason why the credit rating agencies played an important role in the financial crisis is because of the conflicts of interest they were facing with the issuers. If some say that these conflicts of interest were of minor importance since there are always conflicts of interest in relationships, in that case, it had serious consequences on the world(a) economy, as they are one of the causes of the subprime crisis in 2008. It is, indeed, the issuer that pays the rating agency so that this one estimates its capacity to pay off its debt.It is thus relevant to wonder about the partiality and the objectivity of the rating agencies which find themselves at the same time judge and judged and which can be inclined to note well its customers to keep their market share. Besides, the transparentness that the rating agencies show in their methodologies and during their changes of ratings is unreliable as far as these sudden reversals seemed to have destabilized the markets. The three major credit rating agencies also contribute to worsen the financial crisis by their practices. They were, indeed, a key factor in the financial meltdown.They attributed a rating to every products offered on the stock market. Even mortgage-related securities received a good grade, which made it easier to market and sell them. As we have seen previously, the ratings that they gave had an almos t biblical authority, so investors trusted the rating agencies to be fair and to give relevant grade to each product and did not conduct further investigation regarding their investment. Credit Rating Agencies were necessary to the mortgage-backed securities market each actor in the process needed them The issuers, to approve the structure of their convey The banks, to determine what capital to hold The investors, to know what to buy Since 1970, when the credit rating agencies got the status of NRSRO, the SEC decided to base the capital requirements for banks on the grades given by the rating agencies. This is also included into the banking capital regulations as the stamping ground rule, which allows banks to hold less capital for higher-rated securities. The SEC also prevented money market funds to buy securities that did not receive ratings from at least two NRSROs.Without these good ratings, banks would not have been able to place these financial products so easily onto fina ncial markets, and the investors would have never bought them. Theirs ratings helped the market to go up rapidly and their downgrades between 2007 and 2008 wreaked havoc across markets and firms. These ratings, especially the ones for the mortgage-backed securities, appeared to have been very optimistic. But what we could observe, throughout the crisis, is the gregarious reflex of the credit rating agencies.They usually agreed on the ratings and when one of them downgraded a security, a company or even a State, the others would usually follow and did the same thing. As we have seen, the Credit Rating Agencies have indeed played an important role in the financial crisis. However, they are not the only one to blame. Thus, we can say that the thermometer is not responsible for the crisis but it could have given a better temperature of the situation. III. What is next? As we discussed, the credit rating agencies have been criticized a lot during the crisis and some flaws of them have be en pointed out.In order to improve their efficiency, it is important to understand what we have learned from the crisis and then propose a better regulation or an alternative to the Big Three. 1) Lessons learned from the Financial Crisis The first lesson learned from the crisis is the impact of the globalization of financial markets. This has linked countries together in a greater extent than they were before. That is why, in todays economy, any crisis that hits a main country or group of countries will have repercussion on all other countries. The financial crisis of 2008, started in the United States with the subprime bubble.Then it grew bigger and affected the rest of the world almost immediately compared to the 1929 crisis which also had universal impact but more gradually. We have to keep into consideration this new factor and realize that globalization plays an important role in the current worldwide economy. In addition, a country and its financial system need to be better pr epared to face the crisis, in order to find economic and financial damages. This center having a profound and well-regulated environment, keeping its flash rate low, its exchange rate flexible, and its debt position sustainable.By doing that, a country would position its vulnerability in front of any financial crisis. Moreover, the country should use fiscal and monetary policies to be able react quickly in case of external shocks. Another lesson learned is the question of the financial supervision. The global crisis is a crisis of confidence, which must impose rules on investment in the financial market, such as CDS (Credit Default Swaps) and short-selling of securities, slanging of OTC derivatives to reduce risks, CSD (Central block and Depository) regulation to protect investors and also Hedge Funds transparency.In macroeconomics, monitoring means imposing laws and rules on a structure with what is called the occult hand. In our case, the invisible hand is the World Bank a nd the International Monetary Fund and the States, which have full power to intervene and better regulate transactions in the financial markets. This crisis also revealed some weaknesses regarding risk planning. Research based on various methods, including country case studies, confirmed that the more the planning is important, the more the superior of the financial services of a country is raised and more the financial intermediation is efficient.The planning of the risks led a certain number of countries to revise their financial structures to adapt itself to the global economic transformations. Finally, we can say that every good thing comes to an end, positive times do not last forever and the end is most likely going to be painful. In todays financial system and global economy, we cannot avoid financial crisis, we can just hope that enough efforts will be done to improve our financial system and to limit the impacts of future crisis on our economy.If we focus on Credit Rating Agencies, to have a sound environment, it is worth considering a better regularization of our existing Credit Rating system, a new and improved rating system or the furtherance of totally new credit rating agencies. 2) Regularization of our existing Credit rating system After the dysfunction of our system translated for instance into the collapse of Lehman Brothers, the disappearance of famous institutions such as Bear Sterns or Merrill Lynch, G7 members in a bad way(p) the financial effort to improve its functioning mode and stir the regulation.Several critics have indeed been directed to the credit rating agencies regarding the methodologies used by those agencies (including the emergence place of the so-called political factors), the lack of transparency of their decisions, the rudimentary rendering accompanying the changes in notation, the moments selected to realize their announcements of ratings and finally, the potential conflicts of interest. All these aspects need to be taken into consideration when aiming to regulate the rating agencies. Various reform proposals have been recommended.Among them, you find some proposing the crushing of the governments influence over this industry, or even the creation of a completely government-sponsored rating entity. However, the final goal is the accuracy of the credit rating. The first main step toward a better regulation happened in 2006, when a new section to the Securities Exchange Act has been added. The objective was to improve rating quality for the protection of investors and in the public interest by fostering office, transparency, and disputation in the credit rating industry (ANNUAL SEC REPORT, supra note 22, at 16).The market is an oligopoly the Big Three set the tone for the rest of the industry. Encouraging competition should give more choices to investors, at a lower cost and with better quality ratings. Several rules were added along the way, especially in 2009, when the SECs new rule addre ssed conflicts of interest, fostered competition and required detailed disclosure. For example, a NRSRO could not anymore issue a rating in which it had well-advised the bank or the issuer for the structure of the product.Another change emerged from the Dodd-Frank Act, in 2010, where a only chapter has been dedicated to the rating agencies improvements to the regulation of the Credit Rating Agencies. The Dodd-Frank Act certified the agencies as gatekeepers for the debt market and that is why they needed public oversight and accountability. This meant reducing the investors reliance on ratings by limiting references to NRSRO ratings from rules, increasing the liability exposure, maintaining and informing on the structure of the ratings, as well as file control traces yearly.However, both of these new reforms showed weaknesses, particularly in addressing the conflicts interest flood tide from the issuer-payer model, or the oligopoly. As mentioned before, several proposals would ap pear more efficient to answer these problems. The first proposal would be the elimination of the NRSRO status, which would remove any regulatory reliance on the ratings. This would also drive prices down as there would be an increasing competition, but it would also improve the rating quality and the innovation.Nevertheless, this proposal would lead to a total revision of the entire bank regulatory system and could also increase the pressure to satisfy issuers. The second proposal was to create a totally government-sponsored rating industry. This would make the rating a public good, eliminating any conflicts of interest due to the issuer-payer model. Although appealing because it resolves one of the main critics emitted during the financial crisis, it does not say who is going to pay for the subsidization.Finally, other more recent proposal called wear or disgorge asks for the agencies to disclose the quality of the ratings they give, which means disclose to the public when a rati ng is low quality or disgorge benefits made with the rating. However, charging penalties would increase the barriers of entry on this market and discourage potential NRSROs. The rating business faces two major problems, the oligopolistic situation of the market that is being maintained by an increased regulation that secures the Big Three, and the issuer-payer model that fosters the conflicts of interest.Even though several reform proposals have been suggested, no(prenominal) appears to be totally conceivable. 3) A new rating system We have seen that a lot of reform proposals exist in order to enhance and increase regulation of the rating system. These proposals, indeed, reveal that some aspects of this business need to be improved. Eventually, a new rating system is worth considering. First of all, we have realized already touch based, throughout this analysis that the business model of the credit rating agencies needs to be modified, especially the issuer-payer model.The fact tha t the issuer is the one that pay the agencies for their ratings creates a conflict of interest that has to go away to insure an accurate and objective rating. In order to solve this issue, a new model is necessary. A possible idea to get there would be to make, not the issuer, but the investors (the ones that want to know the rating of a company or an entity) to finance the credit rating agencies. It is indeed them that need to know the rating of an entity, so it would be fair for them to pay in order to know what they are investing in.This would solved the problems related to the conflict of interest as rating agencies will not be tempted to give a good grade just to satisfy the client and avoid loosing profits. This was actually the model that existed before 1970, when the issuer-payer model was established. The shift to a model investor-payer would constitute a deep change for the whole rating industry but would eliminate the conflicts of interest. Another change that would be co nceivable would be to set up a rating planning. The credit rating agencies should emit their grading at a known rhythm.Therefore, companies or States would know when they would be rated. For example, every January 1st, they could give their ratings for all entities. This would avoid sudden downgrades as we saw during the crisis, where rating agencies lowered the rating of a company right before it went bankrupt. Furthermore, to improve the accuracy of the ratings, a eminence between the rating of a company and a State should be made. In fact, Credit rating agencies do not evaluate the same thing when rating a country or a firm.That is why different ratings should be given according to the nature of the entity. Finally, this new rating system should have a better transparency of ratings. As this has often been reproach to the agencies, it is attract that we need to improve it. In order to get more transparency in the ratings, the credit rating agencies should be forced to make publ ic some criteria that contributed to the rating process. In addition, when an entity is downgraded, there is ever a fool explanation.An explicit and standard comment should go along with the new ratings to beg off the cause of the downgrade or upgrade. All these improvements should be made to obtain a more transparent and accurate rating. These changes could lead to more efficient and regular ratings where conflicts of interest would be inexistent and where the distinction between entities would improve the relevancy of the ratings. 4) Creation of a new credit rating agency Finally, another(prenominal) solution that arises would be the creation of a new rating agency.This prompting is particularly discussed in Europe. The arguments called in favor of the creation of a European rating agency are multiple. It would be a question, first of all, of introducing more competition into a sector that is today dominated by three major actors. Standard and Poors, Moodys and Fitch Ratings ar e indeed sharing more than 90 % of the market, a situation which confers to the members of this Big Three a tremendous capacity of influence. To create a new rating agency would be a way of having a bigger transformation of points of view.The trust that would be granted by the investors to a new European agency would depend however on its capacity to avoid the criticism sent to Big Three in terms of independence and conflict of interest. It would also be necessary to specify the status of the new agency a public or a private organization? A public rating agency could face the mistrust of the investors, who could doubt its independence towards public authorities and States, which it would have the mission to evaluate. On the other hand, a private agency would look like a non-profit foundation.The rating agency would be financed by the investors who would use its notations, and not by the entities emitting the financial products, which would allow guaranteeing its independence. Never theless, the future prospects of such a structure remain uncertain to what extent would it be able to impose itself in front of Big Three, in a sector where the experience and the reputation of the institution play a determining role? In addition, a history of ratings would be necessary to evaluate the evolution of an entity and a strict method is mandatary for accurate rating.A new rating agency would not be able to have all of these factors before several years. To conclude, it is not easy to find the best solution to improve the current rating methods. Different regulations have been tried, all presenting good points but also flaws. However, what we need to enhance is clear better transparency, a more accurate rating and a suppression of the conflicts of interest. Conclusion The role of the credit rating agencies in todays economy is crucial. They evaluate the creditworthiness of an entity, influencing investors and interest rates.However, during the crisis, their role has been c riticized. Several factors can explain their controversial position. The oligopolistic situation of the market, their supposedly trustworthy evaluations given by their NRSRO status, as well as the conflicts of interest coming from their issuer-payer model are the main causes of the critics emitted toward them. Recently, the American justice even pressed charges against the rating agencies for their role in the crisis and asked for five billion dollars. Nevertheless, even if the credit rating agencies are the ensample responsible, they are not the only ones to blame.Now that the crisis revealed the different flaws of their system, we can only improve them going forward. Several regulations have already been approved and others are still under consideration. Other ideas to enhance the rating system include a new financing model, by perhaps considering going back to the investor-payer model, a better transparency of their rating, by showing the criteria used for their ratings, and a distinction between a company or a security and a State, which are two completely different entities.Lastly, we can wonder if the Credit Rating agencies still have as much influence as they used to. For instance, when downgrading both the United States and France, the repercussions were minors even nonexistent. The lost of their triple A did not bring the interest rates up as it should have, since today the interest rates are historically low in both these countries. Exhibits Exhibit 1 Credit Rating Agencies with the NRSRO designation Exhibits Exhibit 2 Rating systems of the Big Three Source Credit rating Wikipedia, the free encyclopedia. Wikipedia, the free encyclopedia. N. p. , 7 Mar. 2013. Web. 13 Mar. 2013. http//en. wikipedia. org/wiki/Credit_rating. Exhibits Exhibit 3 burning(prenominal) facts about the crisis Exhibits Exhibit 4 Evolution of market indexes from August 9 to 16, 2007 Index Evolution Dax (Germany) -4,42% Dow Jones (USA) -5,95% Nasdaq (USA) -6,16% FTSE 100 ( United Kingdom) 8,37 % CAC 40 (France) -8,42% Nikkei (Japan) -10,3% Exhibits Exhibit 5 residential Mortgage-backed securities These tranches were often purchased by CDOs These tranches were often purchased by CDOsSource The financial crisis inquiry report final report of the National Commission on the Causes of the Financial and frugal Crisis in the United States. Official government ed. Washington, DC Financial Crisis head Commission , 2011. Print Bibliography * Dupuy, Claude . La crise financiere 2007-2008 Les raisons du desordre mondial C. francetv education la plateforme des parents, eleves et enseignants. N. p. , n. d. Web. 12 Mar. 2013. http//education. francetv. fr/dossier/la-crise-financiere-2007-2008-o21596-chronologie-de-la-crise-2007-2008-780. 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