What
role
did
credit
rating
agencies
(CRAs)
play
in
the
financial
crisis?

University
of
Iowa
Center
for
International
Finance
and
Development

Amanda
Bahena

The
role
of
credit
rating
agencies

What a credit rating is: A credit rating measures the ability and willingness of a borrower to pay its debt. The more creditworthy a borrower, the higher a CRA will rate it. What a credit rating is not: A credit rating is not a buy/sell recommendation. It does not predict profitability. Who/What CRAs rate: Within the world of MBSs and CDOs, CRAs rate : 1. The instrument itself: The rated instruments at the center of the financial crisis include mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). 2. Institutions holding the instruments: An instrument’s rating affects the credit ratings of the investing institution. As of mid-2008, most MBSs were held by foreign investors (20%), Fannie Mae and Freddie Mac (16%), and commercial banks (16%). Key CDO investors include banks, insurance companies, pension funds and hedge funds. 3. The issuers of the financial instrument Most MBSs are issued by: (1) Fannie Mae and Freddie Mac, which are U.S. government-sponsored enterprises; and (2) Banks: the top MBS issuers in 2007 were Countrywide, J.P. Morgan, GMAC, Lehman Bros., and Citigroup. CDOs are issued primarily by banks. Top CDO issuers in 2007 were Merrill Lynch, Citibank, and UBS. Credit ratings affect issuers and investors: A borrower with a high credit rating can raise capital at a lower cost than a borrower with a low credit rating, because investors who take on risk expect to be compensated with higher rates of return/ interest rates on the risky investments. Credit ratings of an instrument may change over time. A downgrade suggests a higher default risk and therefore makes the downgraded instrument less valuable. CRAs downgraded billions of dollars in MBSs and CDOs over the past year. Investors holding those downgraded instruments watched their