Conrail Case Study

Describe the available empirical evidence on the role played by the credit rating agencies in the Mortgage-Backed Securities markets

By Abbas Walji - 201549182

The London School of Economics- December 2016

Joseph Stiglitz said the following when asked about the role played by the rating agencies in the financial crises of 2008:

“They were a key culprit… performing the alchemy that converted the securities from F-rated to A-rated. Banks could not have sold these complex assets of evil without the rating agencies”^[1]

To assess the exact role Credit Rating Agencies (CRAs) had during the financial crises and which of their actions proved most hazardous, it is imperative we dissect who the rating agencies are and what their role should be in the markets as well as discussing the evolution and rise in popularity of structured finance. Once defined, we can discuss how the two in concert contributed at various stages to cause one of the most detrimental disasters in financial history.

CRAs evaluate debt instruments, providing an independent depiction of creditworthiness across industries, financial assets and countries. Their ratings allow investors to determine whether a company (asset) is worth lending (investing in) to. The “Big Three” - S&P, Moody’s and Fitch rate with letters to signal “investment grade” or “speculative grade” status. Ratings become extremely important to investors when comparing investments offering similar yields as naturally they go for the higher rating. Ratings also directly affect cost of capital. In 2004, S&P data showed that if any entity went from BBB to BB, borrowing costs were reduced by almost 50 percent.^[2]

The Big Three accounted 95% of the market and had their status “enshrined” by the SEC as market experts; their word was taken as Gospel and rarely doubted. Historically, ratings focussed on “vanilla” instruments namely, government/corporate bonds however, cracks began to emerge when the volume of requests for rating structured products such as Mortgage Backed Securities (MBSs) and Collateralised Debt Obligations (CDOs) increased between 2004-2006, as these were complex and hard to rate. Demand was hot; yield hungry investors wanted higher returns in a low interest rate world which encouraged risky behaviour such that the global pool of structured products doubled from $36trillion in 2000 to $72 trillion by 2006 – more than annual global spending^[3]. Additionally, structured tranches issued every year increased from 9,353 in 2000 to 47,055 in 2006 with the largest category in MBSs and CDOs.^[4] CRAs came under scrutiny for giving them investment grade status, underestimating their complexity and by being slow to downgrade their ratings when their creditworthiness degraded.  Before we discuss where they went wrong in detail, a quick description of what MBS/CDOs are is necessary.