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 evidence]...
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 issue"...
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. ...