Mortgage Credit Ratings and the Financial Crisis: The Need for a State-Run Mortgage Security Credit Rating Agency

33 Pages Posted: 27 Feb 2010  

Milosz Gudzowski

affiliation not provided to SSRN

Date Written: February 25, 2010

Abstract

With the exception of the investment banks, there probably has been no other financial actor with as great a hand in causing the financial crisis as the major credit rating agencies (CRAs). CRAs gave mortgage backed securities (MBSs) inflated credit ratings, enabling financial institutions to buy trillions of dollars worth of these securities. Inaccurate MBS ratings are caused in large part by the “issuer pays” system of financing, whereby issuers of securities pay the CRAs for credit ratings, thus creating an obvious conflict of interest. Many had believed that the CRAs’ incentive to maintain a strong reputation outweighed their desire in any individual case to profit from inflated ratings, thus allowing a light regulatory regime for the CRAs and ratings-based regulations for many financial institutions. The current financial crisis, however, disproves this claim.

Ratings will continue to play a critical role in our economy through ratings-based regulations, and yet because of the issuer pays system of financing and the unique characteristics of MBSs, the CRAs will continue to have strong incentives to inflate MBS ratings. The SEC response is to increase CRA disclosure. However, this paper argues that the SEC’s enhanced disclosure requirements will invariably fall short, thus leaving investors and regulators incapable of assessing CRA performance until it is too late. Academics have suggested the CRAs should be subject to liability for bad ratings. This paper finds that potential liability systems are overly complicated and ineffective in deterring bad ratings. Instead, this paper proposes that a government entity take the place of the CRAs in rating MBSs. Given the pervasiveness of ratings-based regulations, the unavoidable conflicts of interest, and certain unique characteristics of MBSs that make them susceptible to inflated ratings, this paper finds that a clean sweep is needed, one that replaces the CRAs with a government entity that does not take advantage of investors’ trust and subvert regulations.

Keywords: Credit Rating Agency, Financial Regulatory Reform, MBS, CDO

JEL Classification: K22, L14, L33, L51

Suggested Citation

Gudzowski, Milosz, Mortgage Credit Ratings and the Financial Crisis: The Need for a State-Run Mortgage Security Credit Rating Agency (February 25, 2010). Columbia Business Law Review, Vol. 2010, No. 1, 2010. Available at SSRN: https://ssrn.com/abstract=1558807

Milosz Gudzowski (Contact Author)

affiliation not provided to SSRN

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