21 July 2014

New Research Paper – Fixing Credit Ratings

Recent SWIFT Institute grant recipient Ann Rutledge recently published a paper on Fixing Credit Ratings, co-authored with Robert Litan, Non-resident Senior Fellow at The Brookings Institution.

The failure of credit ratings agencies to do their job – warn investors of the true risks entailed by the subprime mortgage securities they rated – was at the heart of the financial crisis. Policy makers have since wrestled with how to “fix” the ratings process going forward. Although the Securities and Exchange Commission (SEC) has required the agencies to disclose more of their methodology, the ratings process is still less than transparent. The issuer-pay rating agency business model has been criticised as a central cause and new agencies designated by the SEC after 2008 moved away from this model, though they have since moved back. Various additional ideas to fix the system have been put forward though none have been adopted: randomising the choice of ratings agency, or replacing private ratings with those of a public agency, such as the SEC.

Faulting the issuer-pay model for the crisis, which has been in continuous use for more than 40 years, cannot explain the sudden explosion and subsequent collapse of the securitisation market, which occurred over a much shorter period. Rutledge and Litan offer a different approach in their research, by showing how the absence of a single, numerical, public structured credit scale to serve as a yardstick of structured credit quality in the U.S. debt capital markets provides a more plausible explanation for the problems in structured finance in particular.

Their paper can be downloaded here.

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