The Impact of the 2008 Financial Crisis on Credit Rating Agencies
The year 2008 will remain etched in the minds of the United States citizens because of the global financial crisis that was witnessed then. During the financial meltdown, the three big credit-rating agencies were involved in a scandal that entailed giving high ratings to risky securities during the financial meltdown. According to Gartner and Fung, (2011), the scandal damaged their reputation a great deal because it has never been restored to date. The three companies that were involved in this mess were Standard & Poor's, Moody's Investors Service and Fitch Ratings. The investors accuse the agencies of having not spelt out the dangers of investing in many mortgage-backed securities in the midst of a financial crisis. The investors believed that the three companies benefited by not pointing out the dangers involved.
The Role of Credit Rating Agencies in the Financial Crisis
The three credit rating companies find themselves in this awkward position because they played a very critical role when it came to marketing the risky venture through the ratings they provided. It brought the country's financial system down to its knees. According to various financial analysts, they stand by the position given by many investors that related securities at the heart of the crisis would not have been marketed without their approval and because of this he delivered a verdict of guilty as charged. For this particular reason, Standard & Poor's is being sued by the justice department for the role they played. The investment banks were unable to sell the individual mortgages, and so they enlisted the services of the credit rating companies so that they could get high ratings that would tempt the investors who wanted a high return on investment. The high ratings were important because the majority of the market funds are allowed to invest in debt that fits the highest rating categories. For this sole reason, the companies were said to have been the cause of the economic meltdown because without their approval the securities could not have been sold. The biggest lesson learnt from this was that private rating agencies could have a massive impact on macroeconomic outcomes.
Factors Influencing Biased Ratings
Osphin and Uhlig(2018), state that both overextensions of mortgages caused the financial meltdown to borrowers to weak borrowers which are then rebranded and sold to other willing lenders who are mainly brought by faulty risk ratings for the back mortgage securities. They further note that securities that were backed by agencies were given great support by the taxpayer and explicitly by programs of the Federal Reserve Bank and this made investors not to expect losses on investments. According to Baghai and Becker, (2018), the rating agencies are very important information providers to the functioning of the entire financial system. The main question then is what causes a rating company to exaggerate the ratings? The answer to this question is mainly because their main source of revenue is the companies whose securities they rate. This basically means that they benefit from favourable ratings of the securities. It, in turn, leads to a conflict of interest between producers of ratings and the users of the ratings. The main problem essentially is the flow of money from the bond issuers to the rating companies, and this normally leads to the rating companies giving biased ratings.
Addressing the Issues with Credit Rating Agencies
The existing government regulators and the investors have lost their faith in credit ratings and therefore feel the compelling need to change reorganize the structure the credit rating agencies which are usually biased. According to Amiraslani et al. (2017), an analysis of Moody's financial statements revealed that between the year 2002 and 2006 the company's profits tripled because of the growth of structured products. An analysis of one of their products revealed that 40% of their total revenues in 2006 had higher margins charged for their products this raised eyebrows. In their defence, the credit rating agencies explained that some products were sophisticated and this made investors question their credibility because it showed that they were rating products that they were not sure of. One interesting fact that came up is the fact that some financial analysts had noted there was the wrong pricing of the structured debt products and they even said that the market would crash. The main problem that was cited was the fact that the economic forecasting division and the rating divisions are separate entities. The models used were bound to fail because they rely too much on the historical patterns of default which the main flaw is the fact that they believe that the past data will remain relevant even when the mortgage industry is undergoing a lot of changes. The second flaw in the model is that the model did not check for underlying assets.
Measures to Prevent Future Crisis
According to Almeida et al. (2017), several measures can be put in place to avoid the crisis that was witnessed in 2008 is not relying too much on the recent past where they believe that what happened is likely to happen. Recently the rating companies have continued to pay attention to recent history rather than using the human judgement to determine how the market might change. The second intervention would be for the government regulatory bodies to look for ways to ensure that profits are regulated because the companies pay the credit rating companies huge profits which can lead to the rating companies bending their standards so that they can gain more business (Gartner, 2011). Thalassinos et.al (2014), argues that the next measure that can curb an incidence similar to the 2008 crisis is to stop overlying on the ratings. Instead, investors can exercise due diligence instead by trying to do conduct their research. The other measure that can be put in place is that the prediction and rating department can work hand in hand. Lastly, the most important way to prevent such phenomenon is for the credit rating companies to recognize the important role they play towards the stability of an economy and not to let the need for money set the precedence rather the ethical obligation they have towards the investor. It means that everyone has a role to play in ensuring future incidences do not occur.
References
Almeida, H., Cunha, I., Ferreira, M.A. and Restrepo, F., 2017. The real effects of credit ratings: The sovereign ceiling channel. The Journal of Finance, 72(1), pp.249-290.
Amiraslani, H., Lins, K.V., Servaes, H. and Tamayo, A., 2017. A matter of Trust? The bond market benefits of corporate social capital during the financial crisis.
Baghai, R.P. and Becker, B., 2018. Non-rating revenue and conflicts of interest. Journal of Financial Economics, 127(1), pp.94-112.
Gärtner, M., Griesbach, B., " Jung, F. (2011). PIGS or lambs? The European sovereign debt crisis and the role of rating agencies. International advances in economic research, 17(3), 288.
Ospina, J. and Uhlig, H., 2018. Mortgage-backed securities and the financial crisis of 2008: a post mortem (No. w24509). National Bureau of Economic Research.
Thalassinos, E., Liapis, K. and Thalassinos, J., 2014. The role of the rating companies in the recent financial crisis in the Balkan and black sea area. In Economic Crisis in Europe and the Balkans (pp. 79-115). Springer International Publishing.
