What are Credit Ratings?
Credit ratings are published for the use of investors seeking to get a third party perspective on the reliability of investment opportunities. Credit ratings are also used by the issuers of securities as a means to gain the confidence of investors. Most credit ratings are done on a scale using letter grades. The scale goes: AAA, AA, A, BBB, BB, B, CCC, CC, C, D (Q&A…). The ratings describe the perceived level of “creditworthiness” of the institution or investment vehicle in question. A lower rating represents a higher the risk of default. One important industry standard is investment grade securities which include investments from AAA to BBB, with all investments lower than this considered speculative investments (Q&A…). Credit ratings are assigned to many types of securities including company stocks and bonds as well as debt issued by countries.
Credit rating began around the turn of the century when John Moody decided to assign letter grades to certain types of bonds issued by companies in the railroad industry (Kiviat). By 1916 there were several companies whose primary business was the rating of credit worthiness, but the business did not gain popularity until the market crash during the 1930s (Kiviat). During this time, investors were extremely wary of the risk inherent in their practice and they wanted to gain as much insight as possible into the reliability of their investments. In these times of doubt, people put their faith in rating agencies. From their birth, to the early 1970s, ratings agencies were hired and paid by investors to rate securities of companies and governments, leaving the issuers of securities out of the financial equation. However the fundamental business model of the industry changed in the 1970s when rating agencies realized they could make more money if they charged the issuers of securities to have their investment products rated (Kiviat). Around the same time, the SEC published a list of “nationally recognized statistical ratings organizations” (NRSRO’s) giving even more legitimacy to the ratings of these agencies (Kiviat). Currently there are only 3 NRSRO’s: Standard & Poor’s, Moody’s, and Fitch Group (Q&A…). Together these companies control almost all securities rating in the United States (Q&A…).
The financial meltdown of 2008 saw its beginnings in the early 2000’s with the emerging popularity of a new investment vehicle called a CDO. Collateralized debt obligations are a form of investment which bundles different types of consumer or corporate debt together and sells the bundle to investors who then collect on those debts (Gagliano). In the early 2000’s, it became popular for banks and mortgage brokers to package mortgages into these bundles to sell to investors. This investment vehicle was by nature complex and left investors unsure of the precise implications of their structure (Crotty). Investors therefore looked to credit rating agencies to provide insight into the reliability of these investments. Credit ratings agencies were consistently granting these investments AAA ratings meaning that they were extremely safe investments in the eyes of the agencies (Gagliano). Reassured by the rating agencies, demand for CDO’s grew during the early 2000s. Banks and mortgage brokers especially liked CDO’s because they meant that instead of holding onto a mortgages and collecting on it periodically, they could collect all the fees associated with writing up and distributing a mortgage and then sell it to investors thereby recouping their initial loan (Purnanandam). For this reason, banks and mortgage brokers continued to bundle mortgages together into CDO’s. Further, banks and mortgage brokers, who now retained none of the risk associated with loaning money (because they immediately recouped it) were motivated to grant as many loans as possible, since the only measure driving profit was the number of loans and not the quality (Purnanandam). This meant that the quality of loans declined and the associated risk of the new loans was passed on to investors. Normally, risk-averse investors would have avoided these types of bundled mortgages, but the AAA ratings granted to the investments by ratings agencies lead investors to believe the CDO’s to be sound investment products.
In July of 2007, the ratings began “a flood of downgrades” which revealed to many investors the true risk behind their securities (Younglai). As the ratings for these investments fell, many investors sold their CDO’s and in very little time, the market was filled with sellers and devoid of buyers, meaning that many investors were stuck with the securities. An S&P spokesperson said on the subject of CDO downgrades, “[these] reflected the unprecedented deterioration in credit quality, but were not a cause of it” (Crotty). Ratings agencies maintained that CDO’s were rated with the same diligence paid to any investment they rated, but internal emails suggested otherwise. In one email from an S&P employee, the actions of the rating agency and the impending financial disaster were described as “watching a hurricane from FL move slowly up the coast towards us” (Younglai). In another email from an S&P employee, the conflict of interest arising from the billing of issuers was described as “a kind of Stockholm syndrome” meaning that S&P was starting to align its ratings to the wishes of the people purchasing the service, and no longer in an objective, or third-party manner (Younglai).
Immanuel Kant, one of the most famous ethical thinkers of all time, developed a grounding for morality which has lead a school of thought known as deontology. According to the Kant’s deontological theory, morality can be determined according to an actions adherence to certain rules (Bowie). Kant calls his rules the categorical imperative and they hold that one must act so that their actions can be universalized without causing incoherence, you must always treat others as ends in themselves and not simply means, and live such that you are simultaneously the author and the subject of the moral law derived from this ethical reasoning (Bowie).
According to Kant one needs to ensure that their actions do not undermine essential functions or systems set up within their society (Bowie). The actions of rating agencies undermined two different social constructions, each with its own lasting effect. First, rating agencies are granted certain clout in the financial industry because of the title of NRSRO granted to them by the SEC, a type of distinction deemed a “regulatory license” in some circles (Partnoy). This means that investors, in cases involving capital requirements on certain types of portfolios, must disclose the overall risk of their held securities (Partnoy). In this way, the ratings published by these companies have implications for investors which cause the ratings to be taken very seriously; more seriously than if the SEC had not publicly recognized their services. By abusing this privilege, rating agencies erode confidence in the ability of the SEC to accurately assess legitimacy of ratings. This has the markings of rendering NRSRO’s incoherent, since these actions undermine the body through which rating agencies receive their special authority. The second violation of Kant’s categorical imperative is a product of the way rating agencies abused the business relationship they shared with issuers of securities. Rating agencies calculated that by granting AAA ratings to these securities they would encourage banks and mortgage brokers to keep constructing these securities for them to rate. “It is therefore hardly surprising… [rating agencies] gave high ratings to dangerous products during the bubble” since they stood to profit enormously as a result (Crotty). In effect, they were able to drive the demand for their own services. This type of strategy provided increased profits in the short term, but ultimately caused huge losses for investors and investing institutions who are the end users of the services provided by rating agencies. Importantly, two large bodies were affected by these actions, both individual investors and institutional ones. Many of the institutions heavily invested in CDO’s lost huge amounts of money (Younglai). Individual investors also lost money and in many cases became disillusioned with investing in general and moved their money out of the markets (Osili, Paulson). A system in which these end users cannot trust the ratings being published is truly incoherent and therefore in this manner, rating agencies also violated Kantian ethics.
By Kantian standards, the actions of rating agencies with regard to CDO’s were clearly immoral. In general we as a society wish to punish actions that we find to be immoral, but I believe that if we adhere to Kantian ethics we will find that we cannot be justified in punishing rating agencies under the current situation. At first glance, it would seem most just to hold these agencies accountable for their actions, but currently there is little legal liability for these agencies. Rating agencies have been brought to court many times in the past for a series of offenses, but very rarely are they held responsible since their ratings function as publicly published opinions and therefore garner the same rights of journalist under the 1st amendment (Sack). Currently, it does not seem that legal ramifications are possible, however if there were a way to subvert the law in order to do so, I believe it would be a tempting option and seemingly just. Deontology would find this to unjust however and the reasoning relates to Kant’s categorical imperative. Subverting the law would seem to provide a manner to justly punish the rating agencies, but it would instead undermine our justice system. If this action were universalized the law would cease to be meaningful as everyone would have the ability to choose to ignore it whenever convenient. For this reason, punishment of rating agencies would be seemingly just, but unless a legal manner can be found to do so (something we can be sure doesn’t currently exist) it would actually violate Kantian ethics and be immoral. Therefore, I find that it would be immoral according to Kant to attempt to hold rating agencies accountable for their actions, given that legal precedent did not hold them liable at the time of the actions. The proper societal reaction to the events surrounding the financial crisis should therefore be to let the actions go without punishment. This does not mean that we allow the system to rest however. I believe that under the current legal system ratings agencies are exempt from legal liability in these cases, but I don’t believe that to be just legislation and it is something that we need to address in our legal system. We need regulation which either mitigates the moral hazards which created this crisis, which finds a new role for ratings in general, or creates a solution to rating outside of the market system.