I was working on this post Tuesday morning when the phone rang and, to use Paul Krugman's phrase, life intervened. I had something to say about it, but I don't know what it was at this point. Anyway, may as well post it now (posts from me will continue to be sparse/absent for awhile -- immense thanks for the outpouring of support):
Corrupted Credit Ratings: S&P’s Lawsuit and the Evidence by Matthias Efing,
Harald Hau, Vox EU: In its civil lawsuit against Sta)ndard & Poor's, the US
Department of Justice accuses the credit-rating agency to have defrauded
federally insured financial institutions... The US complaint alleges that
Standard & Poor’s presented overly optimistic credit ratings as objective and
independent when, in truth, Standard & Poor’s downplayed and disregarded the
true extent of credit risk...
According to the plaintiff, Standard & Poor’s catered rating favors in order
to maintain and grow its market share and the fee income generated from
structured debt ratings. In support of these allegations, the complaint lists
internal emails in which Standard & Poor’s analysts complain that analytical
integrity is sacrificed in pursuit of rating favors for the issuer banks.
Standard & Poor’s files for dismissal of the case
Standard & Poor’s denies issuing inflated ratings and any possible conflict
of interest... That some of Standard & Poor’s very own employees appealed to
their colleagues and superiors to withdraw inflated ratings is dismissed as
"internal squabbles" and interpreted as a "robust internal debate among Standard
& Poor’s employees"...
Statistical evidence on rating bias in structured products
While the US Department of Justice did not give any statistical evidence in
its deposition, our new research (Efing and Hau 2013) suggests that rating
favors were indeed systematic and pervasive in the industry.
In a sample of more than 6,500 structured debt ratings produced by Standard &
Poor’s, Moody's and Fitch, we show that ratings are biased in favor of issuer
clients that provide the agencies with more rating business. This result points
to a powerful conflict of interest, which goes beyond the occasional
disagreement among employees.
The beneficiaries of this rating bias are generally the large financial
institutions that issue most structured debt; they in turn provide the rating
agencies with most of their fee income. Better ratings on different components
(so-called tranches) of the debt-issue amount to a lower average yield at
issuance – a cost reduction pocketed by the issuer bank. ...[presents
The evidence also suggests that the two other rating agencies, Moody’s and
Fitch were no less prone to rating favors towards their largest clients than was
Standard & Poor’s. ...
Still more evidence on rating bias in bank ratings
Additional evidence for rating bias emerges for bank ratings. Hau, Langfield
and Marques-Ibanes (2012) show in a paper forthcoming in Economic Policy that
rating agencies gave their largest clients also more favorable overall bank
credit ratings. ...
Hau, Langfield and Marqués-Ibañez (2012) also show that large banks profited
most from rating favors. ... The rating process for banks may have contributed
to substantial competitive distortions in the banking sector, thus fostering the
emergence of the too-big-to-fail banks.
Ironies of the case
It is hard to read some of the legal arguments without being struck by a
sense of irony.
In its defense, Standard & Poor’s argues (without admitting any rating bias)
that it has never made a legally binding promise to produce objective and
independent credit ratings. ... For an agency whose business model is based on
its reputation as an impartial 'gatekeeper' of fixed income markets, this
defense is most remarkable.
But the accusation has its own oddities: Standard & Poor’s argues that it is
impossible to defraud financial institutions about "the likely performance of
their own products". Standard & Poor’s points out the irony "that two of the
supposed 'victims,' Citibank and Bank of America – investors allegedly misled
into buying securities by Standard & Poor’s fraudulent ratings – were the same
huge financial institutions that were creating and selling the very CDOs at
In many cases the victim-view on institutional investors may indeed be
questionable: Large banks often issued complex securities and at the same time
invested in them. It is hard to believe that the asset management division of a
bank was ignorant of the dealings by the structured product division with the
rating agencies. ... It is difficult to figure out where exactly the border
between complicity and victimhood runs.
What could be done?
The lawsuit against Standard & Poor’s highlights the conflicts of interest
inherent in the rating business, but can do little to resolve them. If new and
complex regulation and supervision of rating agencies provides a remedy is
unclear and remains to be seen. However, three alternative policy measures could
make the existing conflicts much less pernicious:
- Similar to US bank regulation under the Dodd-Frank act, Basel III should
abandon (or at least decrease) its reliance on rating agencies for the
determination of bank capital requirements.
- As forcefully argued by Admati, DeMarzo, Hellwig and Pfleiderer (2011),
much larger levels of bank equity as required under Basel III could reduce
excessive risk-taking incentives and ensure that future failures in
bank-asset allocation do not trigger another banking crisis.
- More bank transparency in the form of a full disclosure of all bank
asset holdings at the security level would create more informative market
prices for bank equity and debt, with positive feedback effects on the
quality of bank governance and bank supervision.
Our reliance on bank ratings could thus be greatly reduced. ...