Role Of Credit Rating Agencies In Financial Crisis 2008

Role of Credit Rating Agencies in Financial Crisis 2008. If you own surplus funds and make some investments then what should you do prior to creating investment? And whether you need to issue financial instrument or bonds then what should you do to increase the sale of those bonds? The answer is Rating of that specific instrument an investor prior to creating an investment always leave for its rating by worldwide credit rating agencies, and a bond issuer try to obtain high rating for that instrument to be trusted by investor. But what about insurance issued by these credit rating agencies failed and they consciously or unconsciously overestimate and below estimate an exact financial instrument? This situation happened in 2008 which leads towards financial crisis 2008 when credit rating agencies downgraded securities to speculative grade which they previously rated AAA highest likely rating on scale. What a credit rating is: A credit rating measures the ability and willingness of a borrower to pay its debt. The more creditworthy a borrower, the higher a CRA shall rate it.

What a credit rating is not: A credit rating is not a buy or sell recommendation. It does not predict profitability. Who or What CRAs rate:. Within the globe of mortgage-backed securities MBSs and collateralized debt obligations CDOs,. The instrument itself: The rated instruments at the center regarding the financial crisis with mortgage-backed securities MBSs and collateralized debt obligations CDOs.

Institutions holding the instruments: An instrument's rating affects the credit ratings regarding the investing institution. As of mid-2008, most MBSs were held by foreign investors 20%, Fannie Mae and Freddie Mac 16%, and commercial banks 16%. Key CDO investors with banks, insurance companies, pension funds and hedge funds. The issuers regarding the financial instrument. Most MBSs are issued by:.

two Fannie Mae and Freddie Mac, which are USA government-sponsored enterprises; and. 3 Banks: the top MBS issuers in 2007 were Countrywide, J. Morgan, GMAC, Lehman Bros. CDOs are issued primarily by banks. Top CDO issuers in 2007 were Merrill Lynch, Citibank, and UBS.

Credit ratings affect issuers and investors: A borrower with an above credit rating can raise capital at a decreased cost than a borrower with a little credit rating, due to the fact that investors who take on risk expect to be compensated with higher rates of return or interest rates on the risky investments. Credit ratings of an instrument shall change over time. A downgrade suggests a higher default risk and that is why creates the downgraded instrument fewer valuable. CRAs downgraded billions of dollars in MBSs and CDOs over the past year. Investors holding those downgraded instruments watched their investments crash below in value.

Brief The past of Credit Rating Agencies and the Term NRSRO. The first credit rating agency within the globe was established within the aftermath of a financial crisis. In 1841, Louis Tappan established first mercantile credit agency in New York to rate merchants' ability to pay their financial obligations. A similar mercantile rating agency followed suit in 1849. These mercantile agencies became the predecessors of credit rating agencies CRAs as we have knowledge of them today.

Nationally Recognized Statistical Rating Organization, or NRSRO is a relatively recent term, but credit rating agencies have existed for over a hundred years. In fact Standard and amp; Poor's traces its origins to the 1860 publication of Henry Poor's The past of Railroads and Canals within the United States, a precursor of modern stock reporting and analysis. Peter Moody and amp; Business published Moody's Manual of Non-residential and Miscellaneous Securities in 1900, the company's founding year. The manual provided facts and statistics on stocks and bonds of financial institutions, government agencies, manufacturing, mining, utilities, and food companies. Fitch Ratings was founded in 1913 and began like a publisher of financial statistics; in 1924, the Fitch Publishing Business introduced the AAA to D rating scale.

When the rating agencies were first established they did not operate below the issuer-pay model their ratings were purchased by subscribers. Source: Credit Rating Agencies did play in Financial Crisis 2008. Credit rating agencies played a very important role at different stages within the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, for example mortgage-backed securities MBS and collateralized debt obligations CDO. The Financial Crisis Inquiry Commission reported in January 2011 that:.

The 3 credit rating agencies were key enablers regarding the financial meltdown. The mortgage-related securities at the heart regarding the crisis should not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis should not have happened without the rating agencies.

Their ratings helped the market rise and their downgrades through 2007 and 2008 wreaked havoc throughout markets and firms. Economist Joseph Stiglitz stated:. I view the rating agencies as one regarding the key culprits. They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks should not have done what they did without the complicity regarding the rating agencies.

CRAs helped to develop the MBSs and CDOs that sparked the crisis CRAs advised issuerson how to structure and prioritize the tranches of an MBS or a CDO. The goal was to help issuers grasp the maximum profit from a CDO or an MBS by maximizing the volume of its highest rated tranches. The purpose of tranchingis to make at fewest one class of assets with a higher credit rating than the average rating of a CDO or an MBS's underlying asset pool. According to the math, huge amounts of risk disappeared when you pooled risky assets together in a CDO. The key assumption was that consequently some loans may default at the similar to time, not all of them should default simultaneously.

For example, you assumed the chances of 3 third regarding the loans defaulting at the similar to time were close to zero, you should split the CDO into a risky piece and safer piece. Then the safer piece should be rated AAA. CDO based on exactly this assumption. The banks and rating agencies assumed that, consequently some regarding the mortgage loans within the pool may default at the similar to time, the likelihood of higher than one third defaulting together was basically zero. Rating mistakes As foreclosures are increasing, MBSs and CDOs backed by MBSs are crumbling.

The CRAs admitted that they failed to adequately assess the credit risks in MBSs and CDOs. This failure occurred for multiple reasons: 1. The CRAs held an over-optimistic view regarding the housing market. Their rating model assumed that housing prices should continue to increase generally. MBSs and CDOs contain lone mortgages, and at the time of rating, the CRAs knew little related to the creditworthiness of lone borrowers behind the mortgages.

When rating MBSs and CDOs, the CRAs relied heavily on historical statistical data, not on personal facts about each borrower. CRAs underestimated the complexity regarding the MBSs and CDOs. They failed to take account of interdependencies. The SEC located that the growth within the quantity and complexity of structured finance deals since 2002 proved too many for some CRAs. Disregard of conflicts of interests, and 6.

This outline regarding the ratings dilemma should be inaccurate if it were to focus only on shortcomings on the component of CRAs. It shall also be true that investors often accepted ratings uncritically and overestimated their significance. Not enough attention was paid to the fact that ratings are only estimates regarding the relative probability of default or expected loss on a debt instrument. They can be not a detailed assessment of risk and speak nothing about an instrument's cost quality or liquidity. Ratings are no substitute for investment risk management, particularly as the facts provided by CRAs is limited.

Rating actions during the crisis. Rating agencies lowered the credit ratings on $1. 9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, another indicator that their initial ratings were not accurate. This spots more compression on financial institutions to decreased the cost of their MBS. In turn, this shall need these institutions to acquire more capital, to maintain capital ratios.

If this involves the sale of new shares of stock, the cost of existing shares is reduced. In other words, ratings downgrades compression MBS and stock prices lower. As of July 2008, Standard and amp; Poor's S and amp;P had downgraded 902 tranches of USA residential mortgage backed securities RMBS and CDOs of asset-backed securities ABS that had been originally rated triple-A out of a total of 4,083 tranches originally rated triple-A; 466 of those downgrades of triple-A securities were to speculative grade ratings. S and amp;P had downgraded a total of 16,381 tranches of USA RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over 1/2 of all RMBS and CDOs of ABS originally rated by S and amp;P. Since sure categories of institutional investors are allowed to only carry investment-grade e.

, BBB and better assets, there is an increased risk of forced asset sales, which should cause distant devaluation. The financial crisis of 2007-08 has taught us that the confidence regarding the financial market, once shattered, can not be quickly restored. In an interconnected world, an apparent liquidity crisis can very quickly turn into a solvency crisis for financial institutions, a balance of payment crisis for sovereign countries and a full-blown crisis of confidence for the entire world. But the silver lining is that, subsequent to every crisis within the past, markets have return out tough to forge new beginnings. The challenge together with the CDO market, and a good chunk regarding the financial crisis, is that the participants took complex, highly volatile, highly risky and highly leveraged assets and passed a magic stick over them to turn them into AAA.

Unfortunately, this process did nothing to remove the volatility, risk, complexity or leverage. The essence regarding the issue is that these AAAs that blew up and went to zero and this is no exaggeration, many former AAA-rated CDOS are utterly worthless were hopelessly badly drafted and or or fraudulently sold. The rating agencies should have known that this degree of complexity and an AAA rating were fundamentally incompatible, but they were financially incented to ignore it they got paid many more money for rating CDOs. The investors and insurers should have known it too. The biggest responsibility lies together with the sellers and the creators regarding the bonds they were selling something that was supposed to be super safe but turned out to be worthless and they knew this to be the case, one method or the other.

In one sentence I can speak that financial crisis of 2008 was definitely a Triple-A crisis.