Since 1930, the global financial crisis of 2008 was the most serious and institutional failure And government bailouts have also sparked intense public outrage. Because of this, you might think that many of the institutions suspected of triggering the financial crisis would at least undergo drastic reforms, if not shut down, in order to prevent a repeat of the crisis.
However, it would be wrong to think so. Bear Stearns is indeed dead, and Lehman Brothers has also collapsed. However, Fannie Mae, Freddie Mac, most of the banks, and the credit rating agencies in the United States have been established for a long time, not only continuing to occupy the core position of Wall Street and the global financial system, but also not easy. Despite being dubbed “a key cog in the financial unraveling,” the rating agencies’ business models have remained the same through the crisis, and their credit analysis work has remained the same. Instead of being replaced by new mechanisms, they have grown in importance, surpassing even their pre-crisis status.
Several credit rating agencies have been at the center of the bond market since the early 20th century. In recent decades, the low cost of debt financing in the capital market has shaken the traditional positioning of bank-centered corporate financing, spurred a wave of financial innovation in the banking industry, and also laid the groundwork for the global financial crisis that began in 2007. bane. Rating agencies played an important role in this drama, and most people seem to think that rating agencies inflated the credit rating of bonds with mortgages as the underlying asset in order to charge bond issuers more fees. This book aims to explore what the rating agencies have done and how to clean up the stigma left by the financial crisis.
Rating agencies are like Enigma machines. Many thought it would be possible to “hack” the ratings agencies in the same way as banks and other financial institutions, but it turns out that this cannot be done. Rating agencies are not financial institutions, and the core of their business is not to profit from financial transactions: they do not provide financing, take deposits, or participate in transactions. The business of rating agencies is to look into the future and provide judgments to potential investors about the likelihood of debt repayment. To do this, they must take into account all relevant repayment terms, the ability and willingness of the bond issuer to repay the debt (ensure that the funds will be used to repay the debt and not diverted for other purposes).
Rating agencies are touting the credibility of experts in judging the future—a quality that can be resonated with one small stroke. But even if ex-post ratings prove ineffective in predicting the future, users of ratings can still argue that they are relying on the best professional judgment available. This is in great contrast to the financial transaction of “talking about heroes in terms of income”.
“Punishment” by the financial crisis
There is no doubt that in the absence of military conflicts, pandemics like the new crown pneumonia, or famine, the financial crisis that began in 2007 has already ranked among the world’s major events in the 21st century. First the banks went down, then they were bailed out by the government. And the government itself became heavily indebted in order to save the banks. In the months since Lehman Brothers collapsed on Sept. 15, 2008, even borrowers with the best credit have struggled to raise funds. Governments have considered various options to deal with the financial crisis. Globalization has been roaring for 20 years, and the rescue action of the western government to the financial market is unprecedented since 1930.
The crisis has created fear and hostility toward financial institutions. When global trade slumped in 2009, there seemed to be a glimmer of hope for systemic change. Reflection on the mistakes made by the United States and Europe has indeed spawned calls for sweeping reforms. But lip service isn’t worth the money.
There were many doubts about the ideological frameworks that guided policy and market institutions, but the critiques ultimately failed to shake them. Not necessarily because the current framework is perfect, but since the days of the Thatcher and Reagan administrations in the 1980s, other frameworks for thinking about markets have been marginalized. After the financial crisis, the public did not inspire changes in thinking about how to examine finance, did not establish supporting new institutions, and did not carefully plan market rules with a sound structure; instead, people were basically thinking about how to “slow down” and “restrain” finance, It is hoped that financial behavior will be regulated by increasing supervision.
This kind of “response” method is vividly demonstrated by the rating agencies. For the future of rating agencies, there were many alternatives: including the establishment of a new international rating agency, the establishment of a new business model, and the establishment of a new analytical model. What we got instead was increased regulation, legislation to constrain the practice of ratings, and stricter regulatory requirements for the information rating agencies provide. Despite complaints from rating agencies, the business model has not changed. They still decide the rating process independently, and the outside world, including European and American governments, cannot substantially interfere. Rating agencies have indeed been punished by the financial crisis—there has been a lot of criticism from all walks of life, and they have been repeatedly asked to take responsibility for their mistakes. Still, the rating agencies were rock solid and made a lot of money. Although there are more regulations nowadays, the autonomy of rating agencies is no less than before the financial crisis, and their status is no less than before.
bad, bad, bad
Like rating agencies, the financial crisis that erupted in 2007 is still an Enigma. Today, many people think they know the financial crisis well. With eyes fixed on the “bad people in bad institutions,” money is being lent to people who have no hope of repaying their debts because of the greed of the financial institutions and because of the failure of the borrowers. Part of the blame for the financial crisis has been laid on people who took out loans to buy homes. It is a mistake in itself to lend to subprime applicants who either have bad credit histories or are in a predicament (such as losing their job) who have long been unable to obtain loans at regular or prime rates. Once their mortgage payments started to go awry, the entire financial system ground to a halt.
Banks (of whatever type) suck too. Banks and other lenders were not supposed to lend to subprime borrowers; the government gave implicit support to Fannie Mae and Freddie Mac (both the government credit corporations) and acquiesced in subprime lending. There are too many financial innovations based on subprime loans, and problems are inevitable—this is now common knowledge. Once people realized that housing prices in the US were not going to rise indefinitely, the subprime house of cards came crashing down. Assets are increasingly toxic or unable to change hands in the market. Financial institutions, whose balance sheets are rife with toxic assets, ultimately have to rely on taxpayer support (i.e., through government bailouts) to avoid failure, which in turn fuels public discontent with the political and banking system.
From this point of view, rating agencies have played a key role since the infancy of the financial crisis. The job of a rating agency is to make a fair judgment on the possibility of future repayment of debt and interest. Historically, however, rating agencies have been rife with errors, the most horrific of which was their rating of Enron, which went bankrupt in 2001. For Enron’s systematic financial fraud, the rating agency completely overlooked it. When it comes to financial innovation, rating agencies are guilty of stupidity. The conventional wisdom is that rating agencies are just as greedy and incompetent as mortgage agencies, investment banks and subprime borrowers.
Rating agencies earn their income from the fees paid by bond issuers for their ratings. According to this logic, no matter what the subject of the rating is, rating agencies will have a strong incentive to give a positive rating. The business model is seen by many as a conflict of interest because the issuers of the bonds pay for the ratings, and these issuers typically want the highest ratings.
It is widely believed that the ratings assigned by the rating agencies to these subprime-backed bonds are inflated. Subprime borrowers have low income levels, poor stability, or a history of financial default. Many people think that it is unreasonable for a bond backed by subprime mortgages to be rated “AAA”, and that such a high credit rating must reflect serious corruption in the rating business.
Conventional wisdom holds that rating agencies no longer offer unbiased opinions. Like the active players in the real estate market at the time, they were all seeking to maximize revenue. And once people realized that these ratings were inflated, the crisis on Wall Street broke out, because these Wall Street financial institutions that conduct financial transactions with each other no longer trust the financial products in their hands.
More recently, astute observers such as Michael Lewis have focused on the drama and emotion of these events, conducting in-depth investigations into some of the key mechanisms of the financial crisis. Through their work, more people are beginning to realize that the opacity and interconnectedness of complex financial instruments are the real culprits of this Wall Street crisis.
a different perspective
One of the “contributions” of the rating agencies to the financial crisis was a shift in their role; this book explores that shift. The general explanation is that rating agencies are only seeking profit, so they tend to give high rating results and earn high fees. This “greed theory” has evolved into a “conflict of interest theory”, which focuses on the rating business model. The core is that rating agencies are happy to give inflated ratings to satisfy customers because the rating fees are paid by bond issuers. But why did the conflict of interest between rating agencies and bond issuers, which had existed since the late 1960s, suddenly change in 2007? Although the “conflict of interest theory” is widely respected, it does not give a reasonable answer to this question.
In my opinion, the role of rating agencies at that time was no longer a referee, but a consultant. In the 20th century, the central function of rating agencies was to provide disinterested advice, thus acting as referees or judges in the bond market; a role similar to that of auditors. Rating agencies are now advising issuers on techniques for drafting the terms of financial transaction documents, as well as cash flow thresholds for the ratings they require. The status of “independent arbitrators” also disappeared as rating agencies began advising on the structuring of financial instruments. The rating agencies did not maintain the necessary distance from the issuers, which made it impossible for the rating agencies to predict the financial crisis, and their ability to review the credit quality of the underlying assets was also greatly weakened, which eventually caused the market to question the rating agency’s ability to judge. The fundamental departure from the traditional role of the rating agencies is a disastrous mistake.
Why do rating agencies accept such a role change in securitization finance at the risk of destroying their privileged rating status? According to my analysis, the reason why the role of rating agencies has changed stems from the perception of business uncertainty by rating agencies after the Enron incident.
Given the new dynamics that financial innovation has taken on, they don’t know what business disaster is coming next. Under such circumstances, the original operating mode of rating agencies seems to no longer adapt to the new situation. The instance of rating failure in the Enron case highlights the flaws in the rating methodology.