| Credit Rating Agencies And The Financial Crisis |
| Written by Brain Summer | |
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Unlike the start of the Great Depression, no specific date can be placed on this recent recession. It is acknowledged that December 2007 was when results started indicating that a recession was on the cards but September 2008 is when it had gained enough momentum and intensity that its true effects were starting to be felt. Although the reasons for this financial crisis are many, the underlying principle has been recognized and accredited to bad lending practices which were both unsustainable and reckless. In short, credit was given, backed by poor quality assets. What about the ratings agencies involvement?Ratings agencies research and analyze a company’s financial health, then offer investors a view. They do this using a simple symbol systems to express relative creditworthiness that is designed to provide a relative measure of risk, with the likelihood of defaulting increasing when a lower rating is allocated. However they always state that a rating should be considered along with other internal and external analysis and criteria. Even with this disclaimer in place, a ratings agency still has a responsibility to the investor base to remain objective and thorough in its processes.The competitiveness of the three major international ratings agencies had increased to an all time high and according to the SEC’s findings and other research, there were significant deficiencies in the processes with regards to all three companies. Some of these shortcomings arose from conflicts of interest, to staff shortages, to modeling errors, all driven by the competition for market share and fees. When the asset backed securities were structured by the investment banks, it appeared that the agencies failed to exercise enough due diligence and thus did not investigate the strength of the underlying assets which were of poor credit quality. But as stated in the disclaimer of the ratings agencies, investors should consider further analysis and criteria. This too, did not always happen, as the investors began to put too much reliance on the reputation and processes of the large ratings agencies, and not conduct their own internal risk assessments. The banks believed that the risk assessment performed by the ratings agencies was enough; essentially outsourcing their responsibilities to a firm that had no financial liability to cover any losses should default occur. In the cases where a due diligence was performed, it was done using models that were flawed as they were often based on historical data that didn’t take into account the changing times, or observations from previous crisis periods which would take into account low probability events. To restore confidence in the rating agencies, the various regulatory bodies are putting forward proposals to better manage and regulate these entities. In Europe a proposal was adopted, as part of a larger scheme of various proposals dealing with the financial crisis, which sets forth new rules that make certain that credit ratings uphold the highest quality levels and are not influenced by conflicts of interests that are found within the industry. Secondly the rules are set out to ensure that credit ratings agencies are continuously observant and testing the quality of their methodologies and ratings. Lastly the proposals rules are aimed at creating the credit rating agencies acting in a transparent manner and thus regulators can supervise their actions and investors can question their methodologies. The latest rules that have been adopted with this proposal are:
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