Undergraduate Honors Thesis: Public Private Pathology

Public-Private Pathology:

The Failures of Credit Rating Agency Reform

RISHI AHUJA

SENIOR HONORS THESIS

CHARLES AND LOUISE TRAVERS DEPARTMENT OF POLITICAL SCIENCE

UNIVERSITY OF CALIFORNIA, BERKELEY

MAY 2015

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Abstract: How did credit rating agencies (CRAs) in the United States escape fundamental

regulatory reform after failing to evaluate credit risk leading up to the financial crisis of 2008? In

this paper, I argue that previous regulatory decisions that delegated risk analysis to CRAs

resulted in a lack of relevant expertise in federal regulatory agencies, the development of

expertise in the private sector, and the spread of dependence on CRAs to multiple arenas of

public policy at the state and federal level. These factors coalesced to limit the scope of potential

policy options after the crisis by increasing the cost of alternative policy solutions and creating

doubt in both the private and public sector that the federal government could effectively take on

a larger regulatory role, biasing reform debates towards maintaining the status quo. This process

centered on two key junctures. First, in 1936 federal regulators empowered CRAs to determine

what were investment grade bonds for the purposes of federal rulemaking. Second, in 1975

federal regulators codified systemic dependence on CRAs through the creation of Nationally

Recognized Statistical Rating Organizations (NRSROs). These two crucial steps solidified a

deeply entrenched system that proved impossible to overturn after the crisis, resulting in

superficial reforms in 2006 and 2010 that failed to address the fundamental regulatory challenges

posed by CRAs.

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Table of Contents

I) Introduction. 4

A) The Financial Crisis and the Lack of Reform

B) Historical Background and Policy Structure

C) Overview

II) Argument....11

A) Argument

B) Independent and Dependent Variables

C) Alternative Hypotheses III) Evidence.......22

A) Evaluating Qualitative Evidence

B) Creating Regulatory Dependence: 1930-1975

C) Legitimizing Regulatory Dependence: 1975-1985

IV) The Failure of Reform...43

A) Introduction

B) 2006 Credit Rating Agency Reform Act

C) 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act V) Conclusion..59

VI) Work Cited63

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Chapter I: Introduction

In April of 2007, two Standard and Poors (S&P) analysts were discussing the merits of an

on-going deal.1 One analyst stated that the deal was ridiculous and that S&P should not rate

it. In response, the other analyst retorted: It could be structured by cows and we would rate it.

Just months later, Moodys alone had to downgrade 36,346 tranches of debt due to the fact that

the original ratings assigned were gross misrepresentations of the actual risk of the instruments.2

In fact, a third of the downgrades that took place featured AAA ratings the highest rating of

safety given to an asset.3 The inability of CRAs to effectively measure credit risk, and the private

and public sectors dependence on the accuracy of their ratings, was a central driver of the 2008

financial crisis.

CRAs are charged with an important role in the market economy: to accurately assess the

risk of financial instruments and to inform potential investors that may be seeking to purchase

those instruments. This role, since the 1930s, has extended into public policy as the federal

government began to rely on the ratings produced by CRAs when evaluating the safety and

soundness of financial institutions, assets, insurance plans, and a whole spectrum of financial

products. During the financial crisis, however, the top three firms in the market (Moodys, S&P,

and Fitch) unequivocally failed at this task. Furthermore, these three firms make up 95% of the

market.4

After the crisis, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection

Act (Dodd-Frank) in July of 2010 brought about numerous regulatory reforms to the financial 1 David McLaughlin, S&P Analyst Joked of Bringing Down the House Before the Crash, BloombergBusiness, 2 Efraim Benmelech and Jennifer Dlugosz, The Credit Rating Crisis, NBER Macroeconomics Annual 2009, Volume 24 (2010), 161. http://www.nber.org/chapters/c11794.pdf. 3 Benmelech and Dlugosz, The Credit Rating Crisis, 161. 4 Christopher Alessi, "The Credit Rating Controversy," Council on Foreign Relations, February 19, 2015, http://www.cfr.org/financial-crises/credit-rating-controversy/p22328.

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sector, but did little to alter the prominent role of CRAs. Dodd-Frank mandated that the

Securities and Exchange Commission (SEC) issue new rules regarding the regulation of CRAs.

Though hotly contested, many consumer advocates and policy analysts found the proposed

changes to be lackluster at best. According to the Consumer Federation of America, the proposed

rules did not match the scale of the problem they were intended to address nor did they

deliver the full scope of the credit rating agency reforms that Congress intended when it adopted

the Dodd-Frank Act.5 According to the World Bank, the regulatory treatment of rating

agencies has been paradoxical: regulatory standards have been predicated on credit ratings but

there has been little direct oversight of how the ratings are made.6 Furthermore, this legislation

directly followed the Credit Rating Agency Reform Act of 2006 (Reform Act of 2006) that

sought to curb regulatory challenges with CRAs, making Dodd-Frank the second failed attempt

to produce widespread reform.

Why did policy-makers only pass superficial CRA reform after the 2008 financial crisis?

In this paper, I present a path dependence model that illustrates how previous decisions to

outsource regulatory authority to CRAs produced two central effects that limited the scope of

potential reform after the financial crisis. First, federal regulatory actors grew dependent on

CRAs to assess credit risk and thus did not build the skills or capacity to fulfill this central roll,

while this expertise grew in the private sector. Second, the decision to outsource risk evaluation

to CRAs at the federal level carried over into federal and state legislation and rules governing a

host of other policy issues in finance and insurance regulation. These two effects of regulatory

5 Gretchen Morgenson. The Stone Unturned: Credit Ratings, The New York Times, March 22, 2014. http://www.nytimes.com/2014/03/23/business/the-stone-unturned-credit-ratings.html. 6 Jonathan Katz, Emanuel Salinas, and Constantinos Stephanous, Credit Rating Agencies: No Easy Regulatory Solutions. The World Bank Group, Financial and Private Sector Development Vice Presidency, Crisis Response Policy Brief 8 (2009). http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1303327122200/Note8.pdf

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outsourcing limited the scope of potential reform by increasing the cost of broader government

oversight and convincing both the private and public sector that the federal government was unfit

to measure credit risk. Though the initial hearings of Dodd-Frank proposed bold changes to the

structure and role of CRAs, the final law and rules illustrate the lasting impact of decades of

dependence. CRAs have maintained their stranglehold as the only legitimate assessor of asset

risk, primarily due to the historical dependence that was created through federal policy and rule-

making in the 1930s and 1970s. Grasping the historical process of dependence, as opposed to

purely studying the current politics of financial regulation, is central to understanding the

outcomes of Dodd-Frank.

A) The Financial Crisis and the Lack of Reform

The lack of CRA reform is puzzling due to the dramatic failure of these institutions to

accurately assess credit risk during the crisis. The financial crisis, as thoroughly documented in

the media, academia, and policy-circles, had a devastating effect on the global economy. At its

peak, domestic unemployment spiked to 10.1% and was accompanied by a sharp decline in

domestic product.7 Furthermore, a Federal Reserve study found that 63% of American household

wealth declined as a result of the 2008 crisis.8 Globally, the crisis produced a 12.2% contraction

in global trade sending ripple effects through both the developed and developing world.9

During the fourth quarter of 2009, the E.U. and Asia saw a decline in exports of 16% and 5%

7 Bureau of Labor Statistics, U.S. Department of Labor, 3/1/2015, http://data.bls.gov/timeseries/LNS14000000. 8 Jesse Bricker, Brian Bucks, Arthur Kennickell, Traci Mach, and Kevin Moore (2011): Surveying the Aftermath of the Storm: Changes in Family Finances from 2007 to 2009, FEDS Working Paper 17, Federal Reserve Board, http://www.federalreserve.gov/pubs/feds/2011/201117/201117pap.pdf. 9 World Trade Organization. World Trade Organization Annual Report 2010, (2010), https://www.wto.org/english/res_e/publications_e/anrep10_e.htm.

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respectively.10 The crisis wrecked havoc on a global scale causing immense harm to millions of

everyday consumers f