Credit Rating Agencies, or CRAs, are organizations that are hired to determine the creditworthiness of companies and debt issuers. The major CRAs in the United States are Standard & Poor and Fitch’s and Moody’s. After the global financial crisis of 2007, the CRAs fell under major criticism for their perceived part in granting high-credit ratings to mortgage-backed securities that contained high-risk, subprime mortgages. According to the conclusions made by the Financial Crisis Inquiry Commission, “the failures of the credit rating agencies were essential cogs in the wheels of financial destruction”. (Financial Crisis Inquiry Commission, 2011) The report goes on to state that although many of these mortgage-backed securities were given top credit ratings, over 73% of these securities were later down-graded, many to junk status. (National Commission on the Causes of the Financial and Economic Crisis in the United States, 2011)
Part of their inability to correctly apply accurate credit ratings to these securities was due to the inherent co-dependent relationship that the CRAs had with the financial institutions that sold these same securities. Since CRAs are hired by these same companies, they had a financial incentive to rate these securities drastically. However, in doing so, many investors who believed the rating lost their investment when the underlying problems with these securities became evident as many of the mortgages within them faced foreclosure during the 2007-2009 recession.
Even prior to the recession, many within the government and the securities industry began to recognize the overabundant influence the big 3 CRAs had within the credit rating industry. A few months before the recession began, the President George Bush signed the Creating Credit Rating Agency Reform Act into law. This law required that the Securities and Exchange Commission eliminate “nationally recognized ratings agencies’, and allow smaller companies to register as statistical ratings organizations. (Scheeringa, 2011) In addition, it eliminated several industry business practices, such as sending unsolicited ratings to a company with a bill.
The Dodd Frank Act, enacted in July of 2010, was in response to some of the problems that were perceived to have caused the financial meltdown and ensuing recession and further imposed new rules on credit rating agencies. The repeal of Rule 436(g) under the Securities Act of 1933 allowed Nationally Recognized Statistical Rating Agencies (NRSROs) to become exposed to liability when their reports were included within a Securities Act registration. In addition, it repealed credit rating agencies from being exempt from Regulation FD. This regulation prohibits companies from disclosing non-public information to securities professionals and shareholders, an exemption CRAs had enjoyed for a long period of time.
CRAs are finding that many of the protections that have allowed their industry to grow and flourish are beginning to disappear. Many of the causes of increased scrutiny are due to the increasingly cozy relationship CRAs began to have with the institutions whose products they were in charge of rating. Ultimately, the new rules that have been introduced should help increase competition within the industry, and make CRAs more careful with the ratings they provide.
Financial Crisis Inquiry Commission. (2011). Conclusions of the Financial Crisis Inquiry Commission. Stanford, CA.
National Commission on the Causes of the Financial and Economic Crisis in the United States. (2011). Final Report. Washington, DC: GPO.
Scheeringa, D. (2011). Dodd-Frank Credit Rating Agency Reform in the Crosshairs. Illinois Business Law Journal, 1.
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