Causes, Consequences and Implications for Reform
Edited by Lawrence E. Mitchell and Arthur E. Wilmarth, Jr
Chapter 5: Overdependence on Credit Ratings Was a Primary Cause of the Crisis
Frank Partnoy* INTRODUCTION A primary cause of the recent credit market turmoil was overdependence on credit ratings and credit rating agencies. Without such overdependence, the complex financial instruments, particularly collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), which were at the center of the crisis, could not, and would not, have been created or sold. Long-term sustainable policy measures should take into account both regulatory and behavioral overdependence on ratings. In the first part of the chapter, I describe how over time credit rating agencies1 ceased to play the role of information intermediaries. By the time market participants recently began to securitize large amounts of subprime mortgages, rating agencies were available, not to provide information about the risk associated with the securitized instruments, but to facilitate the use of ‘regulatory licenses’2 by enabling structurers to create and maintain tranches of these instruments with unjustifiably high credit ratings. This role went well beyond the standard reputational model of the role of rating agencies. In the second part of the chapter, I suggest how future policy might minimize overdependence on credit ratings by removing regulatory licenses and by implementing ‘shock therapy’ mechanisms to wean investors off ratings mnemonics. I also analyze how regulators and market participants can learn from the flaws in rating agency models to avoid repeating similar mistakes. In particular, I focus on the misapplication of historical data with respect to estimates of expected default probability, recovery and correlation. Finally, I assess how market measures of these estimates, based...
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