Mind Map Activity: Credit Rating Agencies

Mind Map Activity: Credit Rating Agencies

1. Consequences of the Crisis

   • Loss of Credibility
     • The CRAs were heavily criticized for their failure to accurately assess the credit risk of mortgage-backed securities and other complex financial instruments that were at the heart of the crisis，because they are overly optimistic
   • Legal Action
     • Because of their inaccurate ratings, CRAs faced a lots of legal actions, such as lawsuits from investors who had purchased securities based on their ratings.
   • Regulatory Scrutiny
     • Because of the crisis, CRAs faced increased regulatory scrutiny, with calls for greater transparency and accountability in their rating processes. In response, regulators introduced new regulations and guidelines for CRAs, for example like requirements for more detailed disclosures and increased oversigh.

2. Conflicts of Interest

   • Incentivized based on issuer pays model. Banks want to get a good rate, so they will continuously ask one rating agency to do the rating for them. If one rating agency give the bank a low rate, the bank won’t ask them to rate for them again.
   • Some banks will give the rating agencies more businesses if they give the bank a high rate.
   • Role in the finical crisis: all the rating agencies was giving banks a very high rate due. So the public can’t know the exact risk of an product.

3. Regulatory Response and Reforms

   • European Union regulations
     • Credit Rating Agencies Regulation (CRAR)
       • It is a regulatory framework that regulates credit rating agencies (CRAs) and their operations. Its goal is to increase transparency and accountability in the credit rating industry and to provide investors with more reliable and accurate information about the creditworthiness of the entity issuing the bond.
   • Alternatives to traditional credit rating agencies
     • Public credit rating agencies
       • Credit rating agencies not only evaluate the credit-worthiness of an institution but also serve as business analysts who can evaluate industrial risks and classify the stock as high grade, non-investment grade speculative, substantial risk or default.
     • Peer-to-peer ratings
       • Peer-to-Peer reputation systems allow users to assess the trustworthiness of unknown entities based on subjective feedback from the other peers. However, this cannot constitute sufficient proof for many transactions in which users require more solid proof of the quality from trusted third parties.
   • Dodd-Frank Wall Street Reform and Consumer Protection Act
     • It established a number of new government agencies to supervise the various components of the law and the various aspects of the financial system.

4. Major Credit Rating Agencies

   • Fitch
     • It is dual headquartered in New York and London, which is founded by John Knowles Fitch in 1914. Hearst Corporation owns 100 percent of the company.
   • Moody's
     • It is the bond credit rating business of Moody's Corporation founded by John Moody in 1909. In Moody's Investors Service's ratings system, securities are assigned a rating from AAA to C, with AAA being the highest quality and C the lowest quality, which is different from Fitch’s and S&P’s investment scale.
   • Standard & Poor's
     • It is considered the largest of the Big Three credit-rating agencies located in New York City. It is a combination of H.V. and H.W. Poor Co. and Standard Statistics Bureau, which are merged to become Standard & Poor's Corp by Paul Talbot Babson in 1941.

5. Role of Credit Rating Agencies

   • Assess the credit risk of specific debt securities and the borrowing entities
   • Determine the trust worthiness of the institutions. Getting more AAA, the bank may sell more products and show its reliability to the borrowers.

6. Ratings of Mortgage-Backed Securities (MBS)

   • AAA (extremely strong capacity to meet its financial commitments)
   • Rating methodology: The ratings are based on the assessment of factors such as vacancy risk, pricing risk, counterparty credit risk, customer and geographical profile, quality of the property, liquidity adequacy, refinancing ability of the issuer, and its management quality.
   • Impact on CDO’s : people evaluate the effects of CDO issuance on the pricing of subprime residential mortgage-backed securities