Analysis of Credit Ratings across Market Sectors and Agencies - Term Paper Example

Term Paper, Macro & Micro economics Contents Contents 2 Introduction 3 Discussion: 4 To what extent were the credit ratings agencies (CRAs) responsible for misperceptions of risks associated with structured securities? 4 Are there organizational reasons why CRAs might tend to misrepresent the riskiness of these financial instruments 6 What might be done to overcome these problems? 8 Conclusion 10 References 13 Introduction The main role of the credit rating agencies is forecasting the consequences or the probability in default of the due payment by the issuer of the debt liability. Credit rating agencies are considered as the large set of people or the organizations that mainly attempts to forecast and predict different aspects related to future. The rating agencies make every effort to allocate consistent objectives and comparative credit ratings as an indicator in a particular and definite scale. The topic is related to the structured securities that are associated with the three credit rating agencies namely Standard and Poor, Moody’s and Fitch. Mistakes if committed by the credit agencies have serious impact on the financial sectors. The structured securities have forced the three credit rating agencies to enter into the bond market of US. Two probable paths for the public policy in relation to the credit rating agencies are imposing stringent regulation of the rating agencies and the decrease in the centrality of the rating agencies (Bayar, 2014). The topic also focuses on the evolution of the credit rating agencies and there interaction with the regulatory authorities that resulted in the barrier to entry and the combination of the various elements that contributed towards the failure of the subprime mortgage that is associated with the financial crisis. The credit rating agencies acts as a hedge in developing the integrity in the process of rating and also ensures that the investors are assisted with the ratings that are of high quality. The ratings of the structured securities results in measurement of quality. The investors assume the assignment of value of the structured securities that develops with the improvement in the credit rating agencies (Ryder, 2014). Discussion: To what extent were the credit ratings agencies (CRAs) responsible for misperceptions of risks associated with structured securities? Credit rating agencies have been introduced in United States in the year 1990. Credit rating agencies have contributed efficiently and effectively in the functioning of the securities market. Credit rating agencies have assigned the securities in indicating the risk related to structured securities. Credit rating is considered as important determinants of the rate of the interest which the corporate banks, insurance companies and the government face in the securities market. The credit rating agencies mainly applies the investor pay models (OICU-IOSCO, 2008).The credit rating agencies generally rate the government securities by the corporate and the government. The credit rating agencies mainly performs four important functions which includes increasing and improving the function related to the securities market, developing the participation of the market with a common language or standard for referring to all credit related risk, resolving the information developed between the investors and the issuers by evaluating the credit risk effectively and objectively of the issuer. Credit rating agencies identifies , determines and evaluates the willingness and capability of the government for paying of the future debts fully and on time and focusing on the evaluation of credit ratings. The government bonds are mainly represented by more than 40% for issuing the bonds in the global securities market. The sovereign credit rating is considered as a vital indicator for the investors making investment in the government bonds. The investors are mainly concerned with recognizing the limitations on the methodologies related to credit rating agencies. The credit rating agencies mainly depend on analyzing the financial analytical tools (White, 2010).Credit rating agencies publishes the historical performance of the data but the complaints related to this data is not always easily comparable. Credit rating agencies determines a common standard in order to evaluate the performance and efficiency of their ratings which is not desirable and practical under the different methodologies that are applied. There are some investors who have identified the limitations of the methodologies of credit rating agencies for the structured securities. The methodologies mainly depend on the models which are similar to most of the financial analytical tools that determines and assumes the extent of inductive connection amid the past and future or among the assets that are analogous to each other. The past performance or the past record does not provide any guarantee for the future performances, for expansion purposes the probabilistic and the statistical modeling of referencing is applied for maintaining homogeneity in assumptions in which the credit rating agencies mainly assumes or predicts the behavior of the interest of the variables that will not differ in a unruly fashion. The more concern is that the investors may reap the benefits and the comfort of the credit rating agencies in relation to the performance of statistics for structured securities (Matthews, 2009).The main difficulty is that the long term default rate does not provide information related to the probabilities of the short term default. The turmoil of the subprime market has focused on the most common and important misperception that the credit risks is similar as that of the liquidity risk. The securities that receive the highest credit ratings such as the AAA are also liquid irrespective of the market events. There is always the availability or the presence of the buyer and seller for such type of securities even if the transaction is not done in the favorable or preferred price. Similarly the historical price for the highly rated securities is not as much volatile as compared to that of the low rated securities (CESR, 2008). Certainly there are regulations in some jurisdictions in terms of the capital adequacy requirements for the financial firms determine the debt securities with elevated credit ratings are very liquid and practice low volatility. Nevertheless the connection between the low volatility, high liquidity and low default rates are not compulsorily logical and justified. The credit rating agencies is required to consider the application of the separate system related to the characteristics of the structured securities and default risk. The structured securities may provide the investors with the impression that Credit rating agencies are prone to liquidity risk and volatility of the securities. The most common and familiar misperception that exist is in relation to the performance of the credit rating agencies and the task force that the credit rating agencies recommends or suggests. The credit rating agencies determines the desirability and efficiency of the task force approach. The credit rating agencies mainly assist the investors in improving the understanding of the credit rating and the limitations in the application of the credit ratings. The most appropriate and feasibility of the credit rating agency is the information that is provided to the issuer of the critical information and the standard upon which the rating will be based and provides the issuer with an opportunity to clarify such similar types of factual misperceptions. Are there organizational reasons why CRAs might tend to misrepresent the riskiness of these financial instruments Credit rating agencies play an important and critical role in the present market turmoil. In contrast the security that is trading on the transparent and the deeper markets, the credit ratings generally has an inordinate influence on the liquidity and the valuation of the subprime residential mortgage backed securities. This has resulted because many market participants and investors have effectively and efficiently the analysis of risk and its valuation of the Residential Mortgage backed securities. Some people believe that the credit rating agencies generally has a tendency to provide incentive in order to discourage the profitability and growth. There are confusion in relation to whether the credit rating done by the credit rating agencies are based on the incorrect and inappropriate information, facts and faulty models. The credit rating agencies are not the auditors that they will provide the data. It is required by the credit rating agency to reassess the quality and the performance of their methodologies that are based on the assumptions that at the time of rating the structured subprime finance instruments in the perspective of the credible information that is provided in context of the housing market bubbles in United States and the absence of the incentives for the lenders of the mortgage for conducting proper and due diligence for increasing and developing the fraud mortgage between other things. It is visible and observed that the responsibility in relation to the market turmoil and the responsibility for the failures are directly related to the credit ratings and it widens beyond the scope of credit rating agencies. There are arguments and confusions whether the institutional investors either through the internal governance or through ignorance and the risk management is excessively dependent on credit ratings in relation to the underlying risk of the various financial instruments that are bought and sold and sometimes it is designed and redesigned. Similarly there are various question while considering that the originators shares a considerable and remarkable responsibility for the turmoil since the progressive tax is employed or introduced for underwriting the standards and it provides the credit rating agencies with misleading and inaccurate information during the process of rating and few incentives in order to clarify and verify the validity of the information and the rating that is shopped in some cases among the credit rating agencies in order to ensure and confirm the rating in spite of the risk that is underlying for a given instruments (Goodhart, 2008).Finally it is required that the regulators to revisit the policies that generally equate the low default in the risk with low liquidity risk and low volatility which mainly encourages and motivates the market participants in conducting a separate and through risk assessment themselves. The punishment is more likely or favorable in case of the new financial instruments that is generally structured finance securities where the demand for the financial instruments may extinguish. By considering the wider perspective it is noticed and observed that the punishment that is imposed generally varies in case of the regulatory environment due to the public outcry which includes enforcing the liability claims. Credit rating agency provides an incentive in order to overate the credibility of the debtors for not losing the present or the current clients and also attracting the clients .The credit rating agency have faced little risk or no loss from the inaccurate ratings. The potential gain received from the inaccurate ratings increases over time (Hull and White, 2011).The security issuers require high credit ratings in order to sell and develop the financial instrument that is complex in nature. Since the individual and the institutional investors could not conduct valuation associated with the riskiness of the new and complex securitized assets when combined together generally lacks transparency. The credit rating agency provides rating and consulting services before the present crisis. Therefore the conflict that arises when the credit rating agency generally offers advisory or the consulting services to the insurers. The emergence of such situation will contribute towards the introduction of conflict in interest in case of the credit rating market. The credit rating is considered as the bilateral process in which the credit rating agency determines and identifies the rating that is based on the information and data that is provided voluntarily to the issuers. Therefore the credit rating agency does not possess the power to ensure and evaluate the information that is provided and it does not require any information that is additional by force. Hence there is a risk in which the insurer can manipulate or conceal the information (Bolton, Freixas and Shapiro, 2012). What might be done to overcome these problems? The problems can be overcome by adopting the necessary measures by credit rating agencies: The credit rating agencies are required to adopt necessary steps for designing and ensuring the reviewing of the decision making process and downgrading potentially the present rating related to the structured financing of securities that is conducted and performed in an objective manner. This mainly includes the application of the different analytical teams for identifying the subsequent monitoring and initial rating of the structured financial products and securities or other preferable means. If different teams are used then it is required that each team should develop required level of expertise and skill and also the resources that are required to perform the respective functions in an orderly and timely manner. The subsequent monitoring is required to incorporate the required experience. The changes or the modifications in case of the ratings assumptions and the criteria are applied (White, 2010). The credit rating agencies are required to establish and develop an independent function that is responsible for reviewing on a periodical basis the models and the methodologies and also the related changes in the models that is used in the rating process. The credit rating agencies are required to adopt a considerable and reasonable step towards ensuring that the information that is used consist of sufficient data and quality in order to support and apply a credible and trustworthy rating. If the rating includes different financial products or the securities with minimum historical data on which the rating is based or analyzed. The credit rating agency is required to provide a clear picture in an important place regarding the limitations of the rating and the risk that is associated with the credit rating of the various securities and the products. The credit rating agencies are required to ensure that the employees that are included in the rating committees have proper knowledge and experience for developing an opinion in regards to rating for the different types of credit. The credit rating agencies are required or expected to establish and introduce new products that are reviewed for the functions that consist of one or more than one senior managers with proper experience for reviewing the feasibility of issuing the credit rating for a definite type of structure that is considered as different from the structure of the credit rating agency materially in case of the current rates. The credit rating agencies are expected to evaluate and assess the models and the methodologies for determining the credit rating of the structured securities and the products that are considered perfect and appropriate when there is underlying risk related to the assets. In situation where the structure of a new products or securities is complex or lack of data about the underlying assets and the structured products or securities raises the confusion that the credit rating agency determines the security that is suitable for the credit rating. Credit rating agencies is required to prohibit and impose restriction on the analyst of the credit rating agency for making the recommendations and proposals required for designing the structured financing of products and securities that are rated by the credit rating agency. Credit rating is required to ensure that the adequate resources are accumulated and allocated for updating and monitoring its ratings. Conclusion Credit rating agencies was emerged in US in the year 1990. The credit rating is regarded and considered as the indicator towards the riskiness that is associated with the debt securities for the investment done in the corporate and government bonds and the regulatory purposes in US. The credit rating agency is regarded as an important participant and performer in the financial system globally. However there are no remarkable and significant regulations on the credit rating agency till 2000 both nationally as well as internationally. The credit rating market is regarded as the most unregulated market before the emergence of the global financial crisis and the sovereign debt crisis of the Euro zone (Lopatta, 2013). Therefore the reduction in the application of the credit ratings required for various regulatory purposes and also encouraging the investors for conducting the analysis of the credit rating agency in relation to the new regulations that are determined and evaluated in order to decrease partially the conflict of the interest. This is because the credit rating of the securities is still considered as important and vital factor of the borrowing cost of the issuer and the rate of return. Therefore it is required that the present or the current regulations of the credit rating agencies are required to develop the accountability and transparency of the credit rating agency and consequently decreasing the over reliance on the credit rating agencies. But if the present regulations of the credit rating agencies does not seems to eliminate or reduce the conflict of interest completely and the increase in competition among the credit rating agencies and also the decrease in the rating shopping in case of the short run. Therefore further regulations are required for efficient and effective functioning of the credit rating market or the public credit rating agencies that are established as an option to the private credit rating agency. Credit rating agencies are required to establish the procedures and policies that are required for analyzing and reviewing the previous work of the analyst that mainly leaves the employees of the credit rating agencies and joining as an insurer that is rated by the credit rating agency. Credit rating agencies are required to determine whether they should or should not consider the ancillary businesses. References Bayar, Y., 2014. Recent financial crises and regulations on the credit rating agencies. Journal of Faculty of Business Administration, Karabuk University, 5(1), pp. 48-50. Bolton, P., Freixas, X., and Shapiro, J., 2012. The Credit Ratings Game. Journal of Finance, 67(1), pp. 85-111. CESR, 2008. The role of credit rating agencies in structured finance.[pdf]. Available at: < http://www.esma.europa.eu/system/files/08_036.pdf>. [Accessed 5 January 2015]. Goodhart, C.A.E., 2008. How, if at all, should Credit Ratings Agencies (CRAs) be regulated.[pdf].Available at: < http://www.lse.ac.uk/fmg/documents/specialPapers/2008/sp181.pdf>. [Accessed 5 January 2015]. Hull,J., and White, A., 2011. Ratings, mortgage securitizations, and the apparent creation of value. [pdf]. Available at: < http://www.russellsage.org/sites/all/files/Rethinking-Finance/HullWhiteRussellSage.pdf >. [Accessed 5 January 2015]. Lopatta, K., 2013. Misconceptions about Credit Ratings: An Empirical Analysis of Credit Ratings across Market Sectors and Agencies. [Online]. Available at: . [Accessed 5 January 2015]. Matthews, D.J., 2009. Ruined in a conventional way: responses to credit ratings role in credit crises. Northwestern Journal of International Law & Business, 29(1), pp. 245-248. OICU-IOSCO., 2008.Technical committee of the international organization of securities commissions. [pdf]. Available at: < http://www.fsa.go.jp/inter/ios/20080328/04.pdf> [Accessed 5 January 2015]. Ryder, N., 2014. The Financial crisis and white collar crime: the perfect storm. Great Britain: Edward Elgar Publishing. White, L., 2010. Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs Is a Better Response. Journal of International Banking Law and Regulation, 25(4). pp.170-179. White, L., 2010. Markets: The Credit Rating Agencies. Journal of Economic Perspectives, 24(2), pp. 211-226. White, L.J., 2010. Markets the credit rating agencies. Journal of Economic Perspectives,24(2), pp.211-226. Read More