2. “There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service.” Thomas Friedman (NYT), Feb. 13, 1996

3. In subprime crisis, rating agencies  assigned too favorable ratings, especially for subprime residential mortgage-backed securities (RMBS)  did not maintain appropriate independence from the issuers and underwriters of those securities  failed to adjust those ratings sooner as the performance of the underlying assets deteriorated

4. Direct Impacts of the Crisis  Stock Market 08/15/07 Dow Jones had dropped below 13,000 from July’s 14000 First 3 weeks of 08, the Dow Jones Industrial Average fell 9% 1/18/08 Dow Jones/0.5%, S&P 500/0.6%, and NASDAQ/0.3% 01/21/08 (black Monday) the world’s biggest falls since Sept. 11, 2001

5. Direct Impacts of the Crisis  Financial Institutions – Bankruptcy New Century Financial (USA)– Apr. 2, 2007 American Home Mortgage (USA) – Aug. 6, 2007 Sentinel management Group (USA) – Aug. 17, 2007 Ameriquest (USA) – Aug. 31, 2007 NetBank (USA) – Sept. 30, 2007 Terra Securities (Norway) – Nov. 28, 2007 American Freedom Mortgage Inc. (USA) – Jan. 30, 2007

6. Direct Impacts of the Crisis  Financial Institutions – Write-Downs Citigroup (USA) - $24.1 bln Merrill Lynch (USA) - $22.5 bln UBS AG (Switzerland) - $16.7 bln Morgan Stanley (USA) - $10.3 Credit Agricole (France) - $4.8 bln HSBC (United Kingdom) - $3.4 bln Bank of America (USA) - $5.28 bln CIBC (Canada) – 3.2 bln Deutsche Bank (Germany) - $3.1 bln By 02/19/08 losses or write-downs > U.S. $150 bln Be expected exceeding $200 - $400 bln

7. Resemblance to Enron?  Similarities in fee structures (the rated- pay)  Reliance on certified opinions (investors)  Reluctance to give negative opinion on the ground of revenue consideration (accounting firms)

8. What had happened to Enron  December 2001, Enron filed for chapter 11 bankruptcy  It’s share price had collapsed from about $95 to under $1.

9.  Securities Financial instruments Obligations on the part of the issuer ○ Businesses and Governments Provide rate of return to purchasers  Money Market Instruments Bonds Stock Types of Securities

10. Money Market Instruments  Short-term Debt Securities Issued by governments, financial institutions and corporations  Investors are paid interest for the use of their funds.  Generally low-risk  Treasury bills, commercial paper, and bank certificates of deposit

11. Bonds  Government Bonds Bonds sold by the Government, Department of the Treasury.  Municipal Bonds Bonds issued by state or local governments ○ Revenue bonds are used toward a project that will produce revenue, General Obligation Bonds are not.

12. Bond Ratings  Price is determined by risk and interest rate.  Several firms rate bonds Standard & Poor’s (S&P) Moody’s  Investment-grade  Speculative/Junk

14. Credit Rating Agencies  Originally intermediaries that specialized in assessing the credit worthiness of railroads, industrial corporations, and financial institutions.  No opinion on whether debt instrument should be bought or sold

15. Ratings Agencies & Market Share

16. Why do we need them?  Information asymmetries between borrowers and lenders Issuers have superior information  Efficiency ○ Costly and duplicative for purchasers to do their own research ○ Rapid dissemination of information

17. Credit Rating Business Credit rating agencies sell  Ratings (or “opinions”)  not statements of facts and certainly not investment advice  Advice to rated firms  Credit Rating Advisory Services

18. Current Business Model Credit agencies are paid  By investors prior to 1970s  By rated issuers or by underwriters now

19. So, who should pay?  Issuers? Provides benefits via rapid dissemination of ratings. Strong potential conflict of interest Power to suppress unwanted ratings

20. So, who should pay?  Investors? Free-riding problem If to a select group of willing and able investors, may stoke populist fears Still has conflicts of interest - creating demand for lower rating which means higher interest. “go back to their roots and have investors pay for the ratings” Sen. Schumer (D-NY), Sept. 26, 2007

21. Conflicts of Interest  Inherent conflicts under the “issuers- pay” model  Issuers only cares about high rating - accuracy becomes less relevant  Rating and advisory business “ Credit rating agencies are playing both coach and referee in giving advice to issuers of debt”

22. Conflicts of Interest  Traditional corporate bond rating business  Large base of clientele  Lower profit margin  Reputation risk

23. As Investors…  Be objective towards rating agencies and their ratings  The investor’s reliance on rating results has an amplifying effect on the products