undergraduate honors thesis: public private pathology
Post on 14-Apr-2017
128 Views
Preview:
TRANSCRIPT
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
2
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.
3
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 Cited………………………………………………………………………………………………………………63
4
Chapter I: Introduction
In April of 2007, two Standard and Poor’s (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, Moody’s 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 sector’s 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 1930’s, 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 (Moody’s, 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.
5
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
6
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.
7
respectively.10 The crisis wrecked havoc on a global scale – causing immense harm to millions of
everyday consumers far removed from the complex debt obligations at the center of the collapse.
By failing to accurately assess the safety of financial assets, CRAs enabled financial institutions
and investment funds to take on high levels of risk that eventually collapsed, resulting in
widespread consumer harm.
Furthermore, the financial regulatory system’s dependence on CRAs is also puzzling due to
the fact that evaluating the credit risk of financial institutions is clearly under the purview of
federal regulatory agencies. According to the Federal Reserve, “A key goal of banking regulation
is to ensure that banks maintain sufficient capital to absorb reasonably likely losses.”11 To
evaluate whether a bank has “sufficient capital,” the Federal Reserve must have clear metrics for
evaluating the riskiness of a bank’s leverage, investments, and strategic positions. Similar
language can be found in a variety of other federal and state regulatory descriptions. Given the
fundamental nature of credit evaluation, it seems counterintuitive that this role was outsourced to
the private sector.
Lastly, previous attempts at major financial regulatory policy in the wake of a financial crisis
have yielded significant results. The last piece of holistic financial regulatory legislation, The
Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), created significant changes in the public
accounting industry in light of a host of corporate governance scandals. Sarbanes-Oxley created
the Public Company Accounting Oversight Board, stricter definitions and criteria for auditor
independence, stricter penalties for corporate fraud, and higher standards for disclosure.12 In the
10 World Trade Organization. “World Trade Organization Annual Report 2009,” (2009), https://www.wto.org/english/res_e/publications_e/anrep09_e.htm. 11 Federal Reserve System Publication Committee, “The Federal Reserve System: Purposes and Functions,” (2005), http://www.federalreserve.gov/pf/pdf/pf_complete.pdf. 12 Bernhard Kuschnik, “The Sarbarnes Oxley Act: ‘Big Brother is Watching You’ or Adequate Measures of Corporate Governance Regulation?” Rutgers Business Law Journal, (2008), http://businesslaw.newark.rutgers.edu/RBLJ_vol5_no1_kuschnik.pdf
8
case of Dodd-Frank, similar scrutiny was not applied to CRAs. Though Dodd-Frank removed
references to CRAs in federal regulation and agency rules, the law did not give the SEC broad
authority to scrutinize the practices of CRAs or to fully replace them and conduct internal risk
analysis for the purpose of federal regulation. Furthermore, while the securities industry poured
in $100,207,423 in 2013 towards lobbying the federal government, the three largest CRA’s paid
approximately $2,220,000 total in the same calendar year – a paltry sum in comparison.13 This
raises questions as to whether traditional forms of regulatory capture by the private sector are
applicable to the example of CRAs and the lack of reform after Dodd-Frank.
B) Historical Background and Policy Structure
It is crucial to establish the historical setting that influenced the regulatory environment for
CRAs. The first CRAs arose to address the basic need for information as investors became
spatially distant from the products they sought to invest in.14 As noted by Richard Sylla, the
desire for information regarding the soundness of investments in new railroads during the
booming expansion of the late 19th and early 20th century provided the back drop for the creation
of the first bond rating agency by John Moody in 1909.15 Shortly after, Poor and Fitch joined the
industry in 1916 and 1924 respectively and the three firms quickly consolidated market share.
CRAs played an important role in easing informational asymmetry between investors and those
seeking capital, serving as a third-party that could provide impartial risk evaluations for
investors. The incentives for these firms were also aligned to produce quality information: if the 13 Center for Responsive Politics, Open Secrets, Lobbying expenditures by the Securities Industry, (2013): https://www.opensecrets.org/lobby/indusclient.php?id=F07&year=2013. Lobbying Expenditures by Moody’s, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000043203&year=2013. Lobbying Expenditures by S&P, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000035733&year=2013. Lobbying Expenditures by Fitch, (2013): http://www.opensecrets.org/lobby/clientsum.php?id=D000050935&year=2013. 14 Richard Sylla, “A Historical Primer on the Business of Credit Ratings.” The World Bank, Washington, DC, (2001), 7, http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf. 15 Richard Sylla, “A Historical Primer on the Business of Credit Ratings.” 6.
9
investor found the information untrustworthy or unprofitable, the investor could opt to pay
another CRA for information.
It is also important to clarify the major actors in the financial regulatory systems during the
financial crisis of 2008. Several agencies are responsible for evaluating the safety and soundness
of the nation’s financial system.16 The central regulator for the securities industry, the SEC,
promulgates rulemaking over securities markets and establishes the guiding principles
surrounding the exchange of assets. The Commodity Futures Trading Commission oversees the
market for futures (contracts regarding the future sale of an asset) and options (contracts
regarding the purchase of the “option” to buy or sell a given asset at a particular price point). The
Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency (OCC), and
the Federal Reserve, all seek to regulate financial institutions of various sizes and levels of
complexity to ensure legal compliance and stability in the financial markets. Up until Dodd-
Frank, the Office of Thrift Supervision also participated in prudential regulation and has been
since combined with the OCC.
C) Overview
In Chapter II, I will lay out my hypothesis that path dependence offers the best
mechanism to explain the lack of regulatory reform after the crisis through two primary
mechanisms. First, the lack of skills development at the federal level due to the decision to
outsource regulatory responsibility in the 1930’s eroded trust in a larger role for the federal
government in evaluating asset safety and credit risk. Furthermore, the decision to outsource
16 For a more robust breakdown of the federal regulatory framework, see Edward Murphy. “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets.” Congressional Research Services. (2013), http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=2154&context=key_workplace.
10
regulatory authority to CRAs spread to multiple policy arenas at the federal and state level,
increasing the cost of alternative policy structures. Additionally, I will highlight the foundations
for this hypothesis in the literature as well as competing hypotheses that seek to explain the lack
of reform. Chapter III will delve into the path dependence model, examining the historical
evidence of regulatory outsourcing in the 1930s and 1970s that created a lack of relevant federal
expertise as well as the spread of regulatory outsourcing to CRAs across multiple policy arenas.
In Chapter IV, I will examine the aftermath of the path dependence model – the lack of reform
exhibited by both the Reform Act of 2006 and Dodd-Frank. Lastly, I will provide an overview of
the analysis presented, concluding remarks, and potential directions for future research.
11
Chapter II: Argument
In this section of the paper, I seek to describe the theoretical underpinnings of the path
dependence model that I will utilize to examine the lack of regulatory reform after the financial
crisis of 2008. First, I will lay out my model of path dependence, specifically focusing on an
“increasing returns” perspective as described by Paul Pierson, and place this model in the context
of the path dependence literature. Second, I will identify the independent and dependent
variables that interact through this process and the evidence I will use to examine the
development of regulatory dependence. Lastly, I will evaluate potential alternative hypotheses in
the literature and how they may address the research question at hand.
A) Argument
In this paper, I argue that a path dependence model provides a robust explanation of why
CRAs avoided effective regulatory reform after the financial crisis of 2008. The historical path
limited the scope of future regulation primarily through two mechanisms. First, after initially
allocating regulatory authority to CRAs in the 1930s, federal regulators failed to develop the
internal expertise to analyze the safeness of assets. This lead to the SEC being unwilling and ill
equipped to play a larger role in overseeing securities markets after both the Enron scandal of
2001 and the financial crisis of 2008. Private and public actors, as a result of this allocation of
regulatory responsibility in the 1930’s, developed a deep distrust of the government taking a
larger role in overseeing an increasingly complex securities market. Second, regulatory
outsourcing to CRAs spread over time into a variety of policy spheres at the state and federal
level. The spread of dependence on CRAs throughout multiple policy arenas increased the cost
of effective reform. For the federal government to play a larger role in evaluating asset risk,
12
dozens of laws and rules at the state and federal level needed to be substantively altered. The
confluence of both of these factors biased reform debates, and the eventual laws, towards
maintaining the status quo.
The path dependence model presented in this paper takes place in two distinct phases. First,
in the 1930’s, federal regulators codified structural dependence on CRAs to evaluate the
soundness of bank investments and defer, for the first time, to their ratings when assessing the
safety of financial institutions. Second, in the 1970’s, federal regulators furthered this
dependence, systemizing the role of CRAs as NRSROs and fully allocating regulatory
responsibility to these organizations. In outsourcing regulatory responsibility to CRAs, regulators
did not develop the capacity and skills needed to carry out this role internally. Furthermore, this
dependence was established in other state and federal laws and regulatory rules in a host of other
areas of financial and insurance oversight. This lead to an increase in switching costs in that
pursuing an alternative regulatory structure would involve undoing decades of dependence and
building new internal capacity from the bottom up. Faced with these challenges, Congress and
the SEC opted to make minor changes as opposed to instituting a bold set of reforms. To
understand the effects of these two historical junctures, I will assess the scope of reforms
proposed by both the 2006 and 2010 laws and their corresponding outcomes.
To ensure that my model of path dependence does not simply recap the regulatory history, I
will employ an “increasing returns” perspective on path dependence as offered by Paul Pierson.17
Adopting this model will enable me to be more precise in teasing out causal relationship in the
evidence. Under this model, path dependence manifests itself if the following criteria are present:
1) multiple equilibria – a wide range of outcomes are possible at the onset of policy decision-
17 Paul Pierson, “Increasing Returns, Path Dependence, and the Study of Politics,” The American Political Science Review, Vol. 94, No. 2 (2000), 251-267, http://www.unc.edu/~fbaum/teaching/PLSC541_Fall06/Pierson%20APSR%202000.pdf.
13
making, 2) contingency – small events have major policy impacts, 3) timing and sequencing –
when an event occurs is of great importance, and 4) inertia – once a policy choice has been
made, an equilibrium develops that is challenging to change. This framework helps constrain
broad historical arguments around a narrower confine of factors that help drive path dependent
relationships between historical junctures.
B) Independent and Dependent Variables
Path dependence can be operationalized to understand the lack of reform in Dodd-Frank
and the subsequent rule-making pertaining to CRAs. In this model, the independent variables are
the various historical events, particularly in the 1930’s and 1970’s, that eventually had a causal
effect on the outcome of interest: the lack of reform for CRAs in both the Reform Act of 2006
and Dodd-Frank. Thus, the dependent variable in this model is the regulatory outcome. I argue
that the two central independent variables were the policy decisions to initially create regulatory
dependence in the 1930’s and the further ossification of that dependence in the 1970’s. The
dependent variables of interest are the regulatory outcomes of both the Reform Act of 2006 and
Dodd-Frank.
Applying this framework, the evidence in this paper illustrates that regulatory
outsourcing to CRAs lead to a lack of actual and perceived expertise at the federal level and
spread to multiple policy spheres. Thus, in both critical historical junctures, I will provide
evidence that indicates a growing lack of internal expertise to analyze risk by federal regulators
as the financial sector, and the role of CRAs, grew in complexity. Additionally, I will identify
various areas of policy where dependence on CRAs was codified during the historical junctures.
These initial historical facts, however, only influenced the subsequent policy-making decisions if
14
they constrained the set of potential options in a direct fashion. Thus, legislative hearings and
debates during both the Reform Act of 2006 and Dodd-Frank must show that historical
dependence bound the scope of policy alternatives. More specifically, policy alternatives must be
bound by the lack of internal expertise and the proliferation of CRAs across multiple policy
realms. For the evidence to support my hypothesis, regulators and public sector actors must show
hesitancy and concern regarding a larger role for federal government oversight into an area that
they lack long-established expertise, as well as references to the cost of undoing the deeply
embedded nature of dependence on CRAs.
C) Alternative Hypotheses
Additionally, it is important to identify potential alternative hypotheses that seek to
explain why regulatory reform of CRAs failed. The most significant alternative hypothesis in
relation to my argument is that the regulatory history simply does not matter. If the regulatory
outcome of the Reform Act of 2006 and Dodd-Frank can be purely explained by the politics,
influence, or other factors that were unique to the passage of both laws and not dependent on
previous historical developments, then a path dependence model provides little utility in
understanding the regulatory outcome. The two primary alternative explanations that embody
this principle include the politics of regulatory and cultural capture in addition to the creation of
privileged positions in the regulatory process. It is important to note that these two alternative
hypotheses are not mutually exclusive in regards to the hypothesis I am proposing: regulatory
decisions are complicated processes with historical policy developments blending with the
current political dynamics. The central question, however, is which hypothesized process had the
greatest influence on the final outcomes of the Reform Act of 2006 and Dodd-Frank.
15
One potential alternative explanation for the lack of reform is that the regulatory actors in
charge of overseeing CRAs were “captured” by private interests. Capture theories apply scrutiny
to the regulatory bodies in charge of policy implementation and provide insight as to why
regulatory bodies, and the SEC in particular, failed to substantially retool CRA oversight.
Capture arguments are primarily focused on the dynamics of regulatory application – seeking to
understand the intricacies of the relationship between the regulator and regulated body. In the
case of CRAs, capture arguments could relate both to CRAs directly capturing the SEC’s
decision making or to large financial institutions utilizing their influence to subvert effective
regulatory reform of CRAs to preserve the status quo that had proved historically profitable. An
argument of regulatory capture could have nothing to do with the history of regulation and
everything to do with the politics of both reform bills – rejecting my contention that the historical
path is the most significant factor in understanding the dependent variable (regulatory outcomes
of the Reform Act of 2006 and Dodd-Frank).
This school of thought can be evaluated through two lenses: regulatory capture and cultural
capture. Regulatory capture describes a scenario where “regulation, in law or application, is
consistently or repeatedly directed away from the public interest and towards the interest of the
regulated industry, by the intent and action of the industry itself.”18 Under this framework, CRAs
avoided substantial regulatory scrutiny after the financial crisis through the traditional means of
interest group influence – firms provide support to legislators who in turn pressure regulatory
bodies to ease regulation or industry regulators frequent through the revolving door into private
sector positions in the industry. Or, more simply, the regulator and regulated industry
participants were too close, leading to suboptimal levels of regulatory scrutiny. Carpenter and
18 Daniel Carpenter and David A. Moss, Preventing Regulatory Capture: Special Interest Influence and How to Limit It (Cambridge: Cambridge University Press, 2014), 1-22 and 451-66.
16
Moss establish criteria for effectively demonstrating capture by defining the public interest in the
market in question, illustrating how policy has shifted away from that interest, and producing
evidence that the private interest actively steered the change in policy.19
Alternatively, capture can be viewed as a spectrum, with “cultural capture” reflecting the
degree to which the regulatory body internalizes the views or analysis conducted by the regulated
body as accurate and effective policy. The former calls for a more rational choice based
approach to regulatory failure, whereas the later points towards a behavioral analysis of the
various cognitive shortcomings that allow regulators to make crucial mistakes in their policy
evaluation. James Kwak lays the intellectual foundation for the idea of cultural capture in the
financial sector by establishing a clear framework for identifying and explaining how capture
permeated the financial industry and contributed to the lack of reform after the financial crisis of
2008. Kwak identifies three essential components: identity (in-group, out-group identification of
policy stakeholders), status (perception of private sector contributors to be of a higher intellectual
caliber than the regulatory body), and relationships (regulators are more likely to agree with
those in their networks).20
The works of Carpenter, Moss, and Kwak provide several key insights into the analysis of
capture. First, capture must be analyzed on a spectrum as opposed to a binary system of capture
versus no capture. Specific institutional designs may exacerbate the degree of capture that occurs
in a given industry and looking for those design aspects is highly salient. Second, capture may
not manifest itself through the advancement of specific material incentives of the regulator, but
rather through the amalgamation of the public and private interest as one and the same. This may
19 Carpenter and Moss, Preventing Regulatory Capture: Special Interest Influence and How to Limit It, 1-22 and 451-66. 20 James Kwak, “Cultural Capture and the Financial Crisis.” In Preventing Regulatory Capture, ed. Daniel Carpenter and David Moss (Cambridge: Cambridge University Press, 2013).
17
be aggravated where there are high levels of complexity in determining the public interest and
when industry participants are able to proffer a compelling argument as to why their interests and
the public’s may in fact be aligned. Lastly, they provide a strong burden of proof for both
cultural and regulatory capture.
The challenge with applying and considering regulatory capture as a potential explanation for
the lack of reform, though, is the absence of an agreed upon conception of the “public interest.”
Economists have engaged in a robust debate as to whether the current system of credit ratings is
in need of reform, and if so, how said reform should be structured. In the case of CRAs,
indicating that they improperly analyzed mortgage-backed securities during the financial crisis as
the sole evidence of capture would be insufficient. All regulation is subject to potential failure
and the public interest is not always agreed upon, especially in the case of complex financial
products.21 There is, however, empirical evidence to explore in terms of the degree to which
CRAs lobbied for their interests.
A second potential alternative is that CRAs held a “privileged position” in the regulatory
structure, leading regulators to fear that any policy changes would have negative effects on the
economy as the country emerged from the Enron scandal in 2001 and the financial crisis of 2008.
This analysis, championed by Charles Lindblom, critiques the embedded nature of market
participants and their central role in the economic health of the nation. Since some private actors
are crucial to the overall health of the economy, regulators are forced to ease on regulation out of
fear of potentially triggering unemployment or market constriction through higher levels of
regulatory oversight or policy change.22 Furthermore, entrenched private actors exaggerate the
21 Kwak, “Cultural Capture and the Financial Crisis.” 22 Charles Lindblom. “The Markets as Prison.” The Journal of Politics, Vol. 44, No. 2, (1982). http://www.jstor.org/stable/2130588?seq=1#page_scan_tab_contents.
18
threat of these “punishments” and attempt to portray the costs of increases in regulatory
oversight as dramatically detrimental to the economy, despite their potentially trivial effects.
This logic may have played a role in constricting the options for CRA reform. CRAs ideally
play a key role in the market economy by providing prospective investors with quality
information about the assets available in the market for investments. The implicit “punishment”
that these companies could present is that tampering with the ratings system would hurt the
economy. In fact, Jerome Fons of Moody’s, in a 2002 article on the role of CRAs, stated, “I
believe that regulators want to preserve the objectivity, and hence the accuracy, of ratings.
Inaccurate ratings will result in bank capital levels that could either put the payment system at
risk or lead to a misallocation of funds within the economy.”23 Thus, the possibility of regulation
harming the economy was a tool leveraged by CRAs. Another potential area of leverage that
CRAs have in relation to the U.S. federal government is the ability to downgrade U.S. debt.
Interestingly, S&P did in fact downgrade the value of U.S. debt from AAA to AA+ in August of
2011, around the time when rules and regulations were being established for CRAs after Dodd-
Frank.24 It is conceivable that CRAs utilized this role to punish the federal government through
the downgrade, though the decision only had symbolic ramifications on the value of U.S. debt.
CRAs arguably had a “privileged position” in the market for credit ratings that could have
been utilized to limit the scope of reform. The central challenge with adopting this hypothesis,
however, is that these potential punishments or threats are inherently hard to measure. CRAs
could justify their downgrade of the U.S. debt, for example, due to the debt ceiling fight that was
on-going at the time as opposed to any veiled threat against government oversight. Furthermore,
23 Jerome S. Fons, “Policy Issues Facing Rating Agencies,” in Ratings, Rating Agencies and the Global Financial System, ed. Richard M. Levich, Giovanni Majnoni, and Carmen Reinhart. (New York: Kluwer Academic Publishers, 2012), 343. 24 Damien Paletta and Matt Phillips, “S&P Strips U.S. of Top Credit Rating,” The Wall Street Journal, August, 6 2011. http://www.wsj.com/articles/SB10001424053111903366504576490841235575386
19
Lindblom argues that these threats often go unfulfilled and that the specter of potential action
limits the scope of reform. The impact of these implicit threats is a theoretical concept rather
than an easily observable phenomenon, restricting the ability to test this hypothesis in the
legislative debates surrounding both the Reform Act of 2006 and Dodd-Frank.
Lastly, it is also possible that federal regulators thought that this regulatory system was
simply the most efficient way to tackle a complex policy problem – even in light of the financial
crisis of 2008. At the time this decision was made in the 1930’s, federal regulators had several
strategies to fulfill their prudential regulatory role. First, they could rely on the financial
institutions to undertake positions that were safe and to maintain stable positions in the bond
market. Second, federal agencies could conduct internal tests to determine the safety and
soundness of banks under their purview. Third, prudential regulators could rely on third-party
actors to evaluate the soundness of these financial institutions. The first alternative, however,
could be viewed as a prima facie failure to follow through on regulatory responsibilities. If
financial institutions were completely left alone to evaluate the risk of their own investment
positions, prudential regulators would not be carrying out their statutory roles. Practically,
financial regulatory authorities faced two policy choices: internal or external risk analysis to
measure the safety of financial institutions.
First, cost-savings are one potential benefit of outsourcing credit evaluation to private
actors. Developing internal metrics for analyzing risk is ultimately a costly process. Thus,
establishing a principal-agent relationship with a specialized agent could be considered an
efficient solution – reducing the workload and informational challenges for the principal.25 If
third party actors were incentivized to provide this private service that in turn helped stabilize the
25 Andreas Kruck, Private Ratings, Public Regulations: Credit Rating Agencies and Global Financial Governance (London, Palgrave MacMillan, 2011), 85.
20
financial system, federal authorities only had to adequately incentivize the use of this third party
service. The benefit described above is further strengthened if financial markets are relatively
stable. Such was the case in the 1930s, as postwar bond market stability lessened concerns about
possible issues in the financial markets, effectively reducing the cost of relying on a third party
to provide this service.26 Complimentary to favorable market conditions after the crash of 1929,
the National Bureau of Economic Research’s statistics on bond markets during the 1930’s, 40’s,
50’, and 60’s demonstrated that CRAs were generally measuring risk accurately and consistently
with market trends.27 Furthermore, the default rates on bonds were incredibly low, and as such,
the information promulgated by CRAs was not a large market force.28
There are, however, serious potential costs involved with this delegation. First, federal
regulators left themselves vulnerable to financial distress if CRAs failed to adequately assess
risk. Ultimately, if banks were overly leveraged in risky bond investments, and CRAs were
unable to evaluate those positions as such, the federal government would be responsible for
dealing with the macroeconomic fallout. This cost, however, is minimized if federal regulators
believe that 1) the probability of CRA error is low and 2) the eventual cost from this
misinterpretation would be minimal.
Both capture arguments and discussions about the structural role of private actors in the
market economy offer important lenses through which to view the question of interest – but fail
to be easily operationalized in the context of this paper. Though capture theoretically covers the
mechanism through which regulators fail to enact effective oversight, defining the public good in
26 Richard Sylla, “A Historical Primer on the Business of Credit Ratings.” 10. 27 Braddock Hickman, “Introduction and Summary of Findings to ‘Corporate Bond Quality and Investor Experience,” in Corporate Bond Quality and Investor Experience (New Jersey, Princeton University Press, 1958), 3-27. 28 Braddock Hickman, “Introduction and Summary of Findings to ‘Corporate Bond Quality and Investor Experience,” 3-27.
21
financial markets is a significant challenge. Furthermore, understanding the interpersonal
relationships between regulators and CRAs is nearly impossible without higher levels of direct
access to market participants. While understanding the unique role of CRAs in the current
government structure and the potential “privileged position” that these actors hold in the market
economy is also important, it often relies on implicit and veiled threats which are impossible to
observe in the evidence. Lastly, the experience of the financial crisis of 2008 calls into question
whether regulatory outsourcing is in fact the most efficient system of oversight. Both politically
and analytically, ignoring the massive failure of CRAs during the Enron scandal and the
financial crisis of 2008 illuminated the high costs of this regulatory system. It is important to
note that both of the theoretical models of capture and privileged positions can coexist with my
hypothesis and path dependence model. The central goal of this paper, though, is to understand
which process provides the highest level of explanatory power in terms of understanding the
regulatory outcome.
22
Chapter III: Evidence
A) Evaluating Qualitative Evidence
A variety of tools exist in the social sciences to assess the strength and utility of
qualitative data for the purpose of teasing out causal arguments. For the purpose of this thesis, I
will be relying on “process tracing” as discussed by David Collier to assess the degree to which
the evidence I present can be connected to the causal argument of path dependence and the
binding constraints it produced on policymaking after the financial crisis of 2008.
Process tracing “is an analytical tool for drawing descriptive and causal inferences from
diagnostic pieces of evidence – often understood as part of a temporal sequence of events or
phenomena.”29 Under Collier’s approach to process tracing, the researcher must identify
diagnostic evidence: evidence that helps develop the foundation upon which causal inferences
will be built. Second, descriptive inferences can stem from the diagnostic evidence, evaluating
how that diagnostic evidence builds over time through precise explanations of static moments of
significance that contribute to the development of a longitudinal process. Thus, process tracing
focuses on the sequence of events within a case that build together to form causal arguments.30
For the purposes of this paper, the “case” in question is the sequence of events that lead to the
lack of reform for CRAs after the financial crisis of 2008.
Collier utilizes these components to build several tests that can be generated to analyze
potential causal inferences. First, straw in the wind tests allows the researcher to confirm the
relevance of their hypothesis in relation to the inferences in question. Thus, evidence in this
29 David Collier, ‘‘Understanding Process Tracing.’’ PS: Political Science and Politics 44:823-30, (2011). http://polisci.berkeley.edu/sites/default/files/people/u3827/Understanding%20Process%20Tracing.pdf. 30 Andrew Bennett and Jeffrey T. Checkel, “Process Tracing: From Philosophical Roots to Best Practices,” in Process Tracing in the Social Sciences: From Metaphor to Analytic Tool, ed. Andrew Bennett and Jeffrey Checkel, (Cambridge University Press, 2012), 1.
23
category is neither necessary nor sufficient, but provide basic facts and concepts that support the
hypothesis. Second, hoop tests provide clear benchmarks that the hypothesis must meet to
remain viable. Evidence in this category is necessary for the hypothesis to stand, but is not
sufficient for understanding the causal process. Third, smoking gun tests provides strong support
for a hypothesis without giving evidence to reject other competing theories. Evidence in this
category is not necessary for the hypothesis to stand, but provide strong support for the
sufficiency of the proposed solution. Fourth, double decisive tests produce the highest standards,
both confirming the argument posed and rejecting competing hypotheses for a given
phenomenon. These pieces of evidence point towards the hypothesis being both necessary and
sufficient. I will utilize these tests at the conclusion of both critical historical junctures to
evaluate the strength of the evidence presented in supporting my argument and potentially
disproving the alternatives. For the purposes of this paper, I will not be able to prove that capture
or the embedded position of CRAs had zero impact on the regulatory process. I will instead seek
to demonstrate the necessary and sufficient nature of the evidence supporting the impact of the
historical junctures on the regulatory outcome, giving weight to the argument that the historical
factors were the chief explanatory variable of the lack of effective reform.
B) Creating Regulatory Dependence: 1930-1975
From 1930-1975, the federal regulatory framework for financial institutions grew dependent
on CRAs to evaluate the riskiness of assets, and thus the safety and soundness of financial
institutions. This produces the first critical juncture where regulatory outsourcing and
dependence is established. When presented with the policy challenge of evaluating the stability
of financial institutions, federal regulators made the crucial decision, among multiple choices, to
rely on the analysis conducted by CRAs.. During this period, the initial development of the lack
24
of internal expertise and the spread of regulatory outsourcing across multiple sectors is observed.
First, the regulatory role of evaluating credit risk was outsourced to CRAs and the private sector
– with explicit discussion by regulators that this role would be carried out only in the private
sector. Second, once regulatory outsourcing was codified at the federal level, it spread
throughout numerous policy spheres. Thus, this critical juncture establishes the baseline
consequences of regulatory outsourcing that eventually shaped the next historical juncture and
contributed to limiting the scope of reform in 2006 and 2010.
First, it is important to describe some of the key themes in the financial markets at the time.
The Crash of 1929 and the onset of the Great Depression provided the first financial setting that
demonstrated the fragility of bond ratings issued by CRAs. During the period, numerous ratings
were scaled back as a variety of bonds that were considered safe defaulted.31 The paradox in this
development was that despite the lack of success by CRAs to predict risk, the overall higher risk
environment generated elevated demand for assurances of asset quality. The Great Depression
went on to cause massive economic hardship, with bank failures spiking to 12.9% of total banks
in 1933. This economic harm was compounded by the lack of a deposit insurance system.32 At
the time, CRAs operated exclusively in the private sector with no government supervision. The
market was also controlled by S&P, Moody’s, and Fitch, the same firms that hold the lions share
of the market today.
a. Regulatory Outsourcing and the Lack of Internal Expertise
In 1931, the United States Department of the Treasury through the OCC codified the first
31 Frank Partnoy, The Paradox of Credit Ratings,” University of San Diego Law & Economics Research Paper No. 20, (2001). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=285162. 32 Ben Bernanke, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.” National Bureau of Economic Research, No. 1054, (1983). http://www.nber.org/papers/w1054.pdf.
25
systemic regulatory dependence on CRAs by making it essentially more expensive for banks to
hold bonds that had lower than a BBB rating, as defined by CRAs.33 As stated in the Wall Street
Journal on September 12, 1931, “it was asserted that state, municipal, and government bonds and
issues given the four highest ratings by statistical corporations did not have their intrinsic value
impaired by market fluctuations.”34 The Wall Street Journal echoed a commonly shared
sentiment: the ratings given by statistical organizations were an effective indicator of the stability
of assets and that relying on them to carry out this role would be prudent public policy.
In 1936, the OCC furthered the push towards regulatory dependence on CRAs. On February
15th, the OCC stated that the “purchase of ‘investment securities’ in which the investment
characteristics are distinctly predominantly speculative… is prohibited. *
*The terms employed herein may be found in recognized rating manuals…*”35 The OCC thus
bestowed a strong incentive for financial institutions to hold “investment grade” bonds, as
determined by CRAs. If a bond portfolio was found to be “investment grade,” than the financial
institution would be able to value the portfolio at the purchase cost, whereas portfolio’s graded
lower than investment quality would have to be “marked to market” and more closely
evaluated.36 Investment grade was to be measured by “recognized rating manuals” which, in
practice, referred to the primary players in the market: Fitch, Moody’s, and S&P.37 This
development is striking: not only did the federal government entrust CRAs with the responsibility
of accurately measuring risk in the financial markets, they built a system in which regulatory
33 Gilbert Harold, Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness (New York, Ronald Press,1938), 25. 34 Wall Street Journal, September 12, 1931, at 1. 35 Regulations governing the Purchase of Investment Securities, and Further Defining the Term “Investment Securities” as Used in Section 5136 of the Revised Statutes as Amended by the “Banking Act of 1935,” Sec. II, issued by the United States Comptroller of the Currency, Washington, February 15, 1936). 36 Lawrence J. White “Credit Rating Agencies: An Overview,” Annual Review of Financial Economics, Vol. 5. (2013). 37 White, “Credit Rating Agencies: An Overview.”
26
effectiveness was contingent on the CRAs existence, with limited to no supervision. Additionally,
the federal government provided a customer base to CRAs by establishing the expectation that
banks must pay attention to the information produced by these agencies.38 Lastly, it is important
to note that the OCC decisions applied to all national banks.
In 1936, the Missouri Banker’s Association raised a resounding critique of the OCC’s
decision: “We further believe that the delegation to these private rating agencies of the judgment
as to what constitutes a sound investment is unprecedented in our history and wholly
unwarranted by their records in the past.”39 The Association, citing the inability of CRAs to
effectively measure risk during the Great Depression, rebuked the government’s dependence on
these institutions. This challenge came in sharp contrast to the initial assessment by the Wall
Street Journal in 1931: “Comptroller Pole pointed out that he had discussed the policy which his
office had adopted with Treasury officials and prominent bankers throughout the country, all of
whom agreed that it was sound and within the public interest.”40 Weeks after the association
raised their concern, the OCC immediately stepped back from their strong stance, stating “the
responsibility for proper investment of bank funds, now, as in the past, rests with the Directors of
the intuition, and there has been and is no intention on the part of this office to delegate this
responsibility to the rating services.”41 O’Conner went on to state “reference to the rating
manuals was made… in recognition of the fact that many banking institutions, by reason of lack
of experienced personnel and access to original sources, are unable personally to investigate the
background, history and prospects of a particular issuer of securities, and consequently must rely
38 White, “Credit Rating Agencies: An Overview.” 39 Resolution of the Missouri Bankers Association at its 46th annual convention, Kansas City, Mo., May 5, 1936. 40 Wall Street Journal, September 12, 1931, at 1. 41 J.F.T. O’Connor, Comptroller of the Currency, Address at a convention of the California Bankers Association, Sacramento, Cal., May 22, 1936.
27
to some extent upon such information as has been compiled by various rating services in their
large rating manuals...”42
Analyzing the discourse at the time, it is clear that regulatory authorities sought a limited
to non-existent role in assessing the safety of assets. Based on O’Connor’s statements in 1936,
the OCC was far from ready to play a prominent role in forcing banks to be subject to the
analysis of CRAs, let alone scrutiny by federal regulators. Furthermore, banks viewed the
allocation of regulatory discretion to private CRAs as a removal of banker autonomy, arguing
that such an allocation was an unprecedented decision to allocate regulatory responsibility to a
private actor.43 Braddock Hickman’s account of the decision to outsource credit rating
responsibilities further establishes the contentious nature of the debate and eventually resulted in
the reference to “recognized rating manuals” being removed from the regulations in 1938.44
Nevertheless, federal regulators had established the benefits of “investment grade” bonds without
answering the residual question of who would deem them such.
This marks the beginning of the lack of internal expertise for evaluating credit risk.
Furthermore, the public and private sector’s belief in a limited governmental role in the market
for asset information is clearly discussed. Based on public statements proffered by the OCC, it is
clear that they had no intention of stepping into the private sector and evaluating the riskiness of
assets. Whether that role was allocated to CRAs or the banks themselves, the federal government
had zero interest in operating in these sphere– establishing the foundation for a lack of internal
expertise within the federal government to carry out effective risk analysis. Furthermore, this
may help explain the eventual hesitancy of federal regulators to take on a larger role after Enron
42 O’Conner, “Address to California Bankers Association.” 43 Braddock Hickman, “Front Matter, Statistical Measures of Corporate Bond Financing Since 1900,” in Statistical Measures of Corporate Bond Financing Since 1900, ed. W. Braddock Hickman and Elizabeth T. Simpson (New Jersey, Princeton University Press, 1960). http://www.nber.org/chapters/c2463.pdf. 44 White, “Credit Rating Agencies: An Overview.”
28
and the financial crisis of 2008. The OCC’s decision to stay out of the way of financial
institutions and the operations of CRAs set precedent that will be further enforced in the next
historical juncture.
C) Regulatory Outsourcing Throughout Multiple Policy Spheres
Though the regulatory decision to empower CRAs to evaluate the safeness of assets on
the market was rolled back by the OCC seven years after initiation – the impact was swift and
widely felt. Overnight, the OCC had effectively slashed in half the bonds that were viable
investments for banks.45 Furthermore, allocating regulatory policy responsibilities to CRAs had
immediate effects on the prudential regulation of other areas of financial activity. When state
regulators were faced with similar regulatory challenges – they followed suit. Frank H. Johnson,
Superintendent of Banks for Montana, stated “we depend upon the ratings for our guidance,
assuming that they are reliable and honest.”46 Statements of a similar nature by Bank
Superintendents of Mississippi, Alabama, and Oregon can be found – analysis provided by
CRAs were “a fair valuation,” “very helpful,” and “generally accepted.”47 State regulators also
adopted this system to evaluate life insurance providers and the capital they needed to keep in
safe investments. Between 1936-1974, 48 state regulators folded CRAs into their regulatory
practices, establishing minimum capital requirements for banks that corresponded to the riskiness
of the bonds held in their portfolios, with risk being measured by CRA ratings.48 Additionally, in
45 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 31. 46 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 27. 47 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 28. 48 Lawrence J. White, “Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response.” Journal of International Banking Law and Regulation.
29
1951, the National Association of Insurance Commissioners instituted higher capital
requirements on insurers, as measured by the ratings produced by CRAs.49
Table 1: Federal Regulatory Dependence on CRAs50
It is important to note that every additional inclusion of CRAs in the regulatory process
increased the cost of designing an alternative regulatory system. CRA dependence spread to the
state level and to insurance markets as the go-to source for credit risk analysis, developing entire
regulatory systems around this dependence. Emerging from the Great Depression, the evidence
indicates that regulatory bodies at the state and federal level were looking for mechanisms to
better oversee the financial system. CRAs provided a quick and potentially easy solution to this
challenge by ensuring that financial institutions would only hold “safe” assets. This logic
permeated a host of regulatory spheres, imbedding this principle in multiple areas of policy at the
state and federal level and further entrenching this policy design. This initial spread established
49 Timothy Sinclair, The New Masters of Capita: American Bond Rating Agencies and the Politics of Creditworthiness (New York, Cornell University Press, 2008), 43. 50 Sinclair, “New Masters of Capital,” 43.
30
the foundation for future reliance on CRAs in other policy sectors that eventually limited the
scope of potential reform by increasing the cost of alternative policy designs in 2006 and 2010.
Furthermore, writers and economists at the time recognized the growing strength of
CRAs and the role of government policy in establishing that strength. According to Gilbert
Harold’s landmark book on the subject in 1938, “it is unanimously asserted by the rating
agencies that the use of bond ratings today is greater than ever before and that the use of and
reliance on the ratings is growing year by year.”51 Furthermore, Harold stated that,
“governmental supervisory commissions, the office of the Comptroller of the Currency, and the
Federal Reserve banks employ bond ratings in examining the portfolios of banks under their
jurisdiction. Indeed their use in this connection by bank (and insurance) commissions of most of
the states as well as by the federal government is perhaps the most important assignment which
the ratings have been given.”52 According to writers at the time, government recognition of
CRAs through federal policy at the time was the single most important factor in solidifying their
role in the market economy.
D) Conclusion
The first historical juncture matches the criteria identified by Pierson as indicative of
increasing returns. First, there were multiple potential equilibriums in 1936 when the federal
government decided to rely on credit rating agencies. Alternatively, they could have developed
internal metrics for credit analysis but instead opted to outsource this task to CRAs or to bank’s
to conduct internally. Second, the small and seemingly inconsequential decision to rely on
“recognized rating manuals” set the tone for how other regulators would look to evaluate the
51 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 34. 52 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 212.
31
riskiness of financial assets. Whether federal regulators recognized it or not, every financial
regulatory body was determining a method for evaluating the safeness of assets, and the decision
to be a first-mover in allocating this responsibility to CRAs was of immense consequence.
Additionally, timing is crucial, as the decision to outsource this responsibility came as the
country was emerging from the Great Depression and trying to develop systemic ways to limit
financial risk. Lastly, the policy choice to allocate risk-assessment to CRAs begins in this period
and sets the stage for future growth in the policy design during the second critical juncture.
In this section, methodologically, I have been able to produce straw in the wind
arguments on behalf of the initial hypothesis. Though the quick succession of identical
regulatory structures that outsourced credit evaluation to CRAs is striking, it only supports that
argument that these decisions illustrate a lack of internal expertise within federal regulatory
agencies during the time period in addition to preliminary regulatory outsourcing across multiple
policy arenas. This historical juncture neither rejects alternative hypothesis nor gives clear
barriers that the hypothesis must overcome, but nevertheless provides basic foundational
evidence to support the argument for a path dependence model. Similarly, this fact pattern is
neither necessary nor sufficient to prove my hypothesis that the historical regulatory outsourcing
limited the scope of potential reform in 2006 and 2010. This foundational set of facts provides
the bedrock of the argument that future policy developments were developed in the context of
this initial codification of regulatory dependence. Further evidence will either confirm or deny
that this initial policy decision played an important role in future decisions pertaining to CRAs in
the regulatory process.
32
III) Legitimizing Regulatory Dependence: 1975-1985
In 1975, the SEC took the next step in codifying the regulatory role of CRAs through the
creation of NRSROs. This produces the second critical juncture where dependence on CRAs was
legitimized and strengthened. When the SEC faced the regulatory challenge of analyzing the
safety of the bond portfolios held by broker dealers, they relied on a similar outsourcing process
as other prudential regulators and took that process a step further through the codification of
NRSROs. This historical period also demonstrates clear signs of a lack of internal expertise to
evaluate the safety of assets at the federal level in addition to evidence that regulatory
outsourcing to CRAs was continuing to spread. In this section, both the causes of the regulatory
decision to further entrench CRAs and the consequences of that decision are important in both
illustrating the continuity of the path dependence model and establishing the binding effects that
this juncture had on the scope of potential reform in 2006 and 2010.
Just as previous regulatory decisions to allocate responsibilities to CRAs came at the end of
financial uncertainty (The Great Depression, bank failures of the late 1920’s), New York City’s
brush with financial hardship also sent ripple effects throughout the regulatory community. In
1975, New York City was essentially out of funds after continuing to maintain a robust social
welfare system in the context of dramatically declining revenues.53 During the same time period,
CRAs completely failed to adjust the city’s debt ratings. At the onset of the financial collapse,
New York’s debt was still rated an A despite fundamental problems in the city’s ability to pay
back the debt it had accumulated.54 Though the state and federal government stepped in and
eased the transition, the threat of default for one of the most prominent cities in the country, and
the inability of CRAs to inform investors of this possibility, was highly alarming to the SEC. In
53 Roger Dunstan. “Overview of New York City’s Fiscal Crisis.” California Research Bureau, California State Library, Vol. 3, No. 1, (1995). 54 Dunstan, “Overview of New York City’s Fiscal Crisis.”
33
an exhaustive report published in August of 1977, the SEC voiced their discontent with the
quality of the analysis conducted by CRAs: “Based upon the record of this investigation, it
appears that both Moody’s and S&P failed, in a number of respects, to make either diligent
inquiry into data which called for further investigation, or to adjust their ratings of the City’s
securities based on known data in a manner consistent with standards upon which prior ratings
had been based.”55
A) Regulatory Outsourcing and the Lack of Internal Expertise
First, it is important to note whether recent economic events had shifted the conversation for
the OCC and other federal regulators regarding the role and prominence of CRAs in the
regulatory process. During a 1967 Senate hearing in the Subcommittee on Financial Institutions;
Committee on Banking and Currency, the OCC maintained their deference to CRAs as the only
legitimate actors for the analysis of financial instruments. When asked how many analysts he had
on hand to assess the risk of portfolios owned by institutions, William Camp, head of the OCC,
stated: “Well, there are a number of rating services throughout the country, Standard & Poor’s,
Moody’s, any number of them.”56 This aligns with previous statements by the head of the OCC
that CRAs were the best equipped to evaluate asset risk and the soundness of bonds. When asked
how many analysts the OCC had on staff to conduct the kind of analysis produced by CRAs,
Camp stated, “I would say at least 10 people…”57 Thus, the head of the principle regulatory body
charged with potentially overseeing CRAs felt that these institutions were fully capable of
55 U.S. House. Committee on Banking, Finance, and Urban Affairs. Securities and Exchange Commission Staff Report on Transactions in Securities of the City of New York, 1997. https://www.sec.gov/info/municipal/staffreport0877.pdf 56 U.S. Senate. Subcommittee on Financial Institutions; Committee on Banking and Currency. “Bank Underwriting of Revenue Bonds.” August 28-30, September 12, 1967. Available from: ProQuest Congressional Search. HRG-1967-BCS-0027. 57 HRG-1967-BCS-0027.
34
replacing federal regulators in measuring the safeness of the investments held by financial
institutions, maintaining consistency with previous statements by the OCC in the 1930’s.
The SEC, however, seemed more critical of the now prominent role of CRAs. In a “Report of
Special Study of Securities Markets” to the House Committee on Interstate and Foreign
Commerce in 1963, the SEC noted: “Analyst’s research which is limited to the data set forth in
the services may be superficial since the services’ data are not necessarily complete.”58
Furthermore, the report discussed the failure of CRAs in analyzing Atlantic Research Corp.,
detailing how CRAs inflated ratings dramatically above what the SEC’s own analysis indicated.
In contrast to the OCC’s capacity to complete this kind of analysis, SEC researchers noted that
“Standard & Poor’s had the largest research staff, consisting of 27 analysts, 12 assistant analysts,
15 field representatives, and 8 statisticians.”59 Despite the SEC’s concerns and findings, only 10
OCC staff members, with no experience or special training in the field, were tasked with
understanding and assessing the deals and analysis conducted by all of the CRAs in the market.
This demonstrates that federal regulators lacked the capacity, funding, and skillset necessary to
conduct risk analysis on par with CRAs. The OCC’s previous decisions to rely on CRAs for risk
analysis was directly showcased by the absence of staff dedicated to the task of evaluating
CRAs.
During this period, the SEC was considering the “net capital rule” for broker dealers that
would establish looser capital restrictions for institutions that held investment grade bonds. The
rule was eventually established in 1975.60 Similar to the OCC, the SEC had to design a system
for evaluating what bonds would be considered “investment grade” and how best to determine
58 U.S. House. Committee on Interstate and Foreign Commerce. “Special Study of Securities Markets, Pt. 1.” April 3, 1963. Available from: ProQuest Congressional Search. 12576 H.doc.95. 59 12576 H.doc.95 60 See 17 CFR 240.15c3-1 – Net Capital Requirements for Brokers or Dealers.
35
the stability of assets. Again, the SEC had three policy alternatives: evaluate the safeness of
assets internally, allow the banks to conduct this analysis themselves, or rely on CRAs to fulfill
this function. In November of 1977, the SEC seemed to view CRAs more favorably in
comparison to their previously critical report in 1963, stating in their November address,
“corporate security ratings are considered useful by many members of the investment community
and that currently such ratings are widespread in the securities markets and frequently are relied
on in investment and other processes.”61 It is hard to determine what happened in the 14 years
between the SEC’s investigation of Atlantic Research Corp. and the 1977 statement by the SEC,
but it is clear that the SEC’s views on CRAs dramatically shifted.
The SEC, however, was concerned with putting the trust of federal regulatory policy in the
hands of any institution that claimed to be a CRA. Instead, they opted to create NRSROs:
officially recognized CRAs that would be statutorily enabled to analyze asset risk for the purpose
of SEC regulations. The designation of NRSROs was a crucial decision: it established that there
would only be a few select CRAs that the government would entrust, producing a barrier to entry
for other CRAs in the market. The top three firms, Moody’s, S&P, and Fitch, were all
grandfathered in as NRSROs.62 The rational behind this codification was paradoxical: because
CRAs already played a crucial role in the regulatory process, their role should be further
solidified so as to ensure some level of quality control. This gives further credence towards the
path dependence model in that the decision to further enmesh CRAs into regulatory policy
stemmed in part from their already embedded role in the sector.
With the creation of NRSRO’s, prudential regulators would now rely on the ratings produced
by selected CRAs when evaluating capital requirements and the safety of assets held by
61 Paul Dykstra. “Disclosure of Security Ratings in SEC Filings.” 78 Det. C.L. Rev. 545 (1978). 62 Emily Ekins and Mark Calabria, “Regulation, Market Structure, and Role of the Credit Rating Agencies.” Policy Analysis, No. 704, (2012).
36
institutions under their purview. For the SEC, this was codified in 17 CFR 240.15c3-1 which
established that commercial paper, nonconvertible debt securities, and convertible debt securities
would all be scrutinized based on the ratings established by the NRSRO’s. If a security received
“one of the four highest ratings by at least two of the nationally recognized statistical rating
organizations…” than less collateral would be permissible.63 Importantly, these rules did not
mandate that the SEC play any role in overseeing the methodology of CRAs or the functioning
of their operations.
Furthermore, no clear application process or methodology for becoming a NRSRO was
created. For a firm to gain NRSRO status, they would have to send in an application and wait for
a response at the convenience of the SEC. If granted, the firm would “receive a 'no action’ letter
from the staff; the letter promised that the Division of Market Regulation would not recommend
enforcement action against any broker-dealer that used the applicant’s ratings for determining its
capital requirements. The SEC did not even issue a press release at these times (and additionally
insisted in the no-action letter that the applicant not market itself as an NRSRO).”64 Given that
there was no clear rational or methodology for choosing NRSROs, let alone critiquing their
analytical process for evaluating the safeness of assets, the SEC had a limited to non-existent role
in evaluating credit risk or supervising the practices of NRSROs. This strengthens the argument
that the SEC did not have the skillset or experience necessary to play a large role in this
regulatory sphere.
The evidence seems to indicate that neither the OCC nor SEC had the desire or capacity to
evaluate credit risk. First, the OCC explicitly stated in testimony to the Senate that they relied on
CRAs to effectively evaluate credit risk. This was entirely consistent with previous statements by
63 See 17 CFR 240.15c3-1 – Net Capital Requirements for Brokers or Dealers. 64 Lawrence White. “A New Law for the Bond Rating Industry.” Regulation, (2007).
37
the OCC indicating a deep hesitancy to get involved in supervising CRAs or the investment
practices of financial institutions. While the SEC was initially more critical of CRAs, they also
conceded that CRAs were the best staffed and prepared to carry out risk analysis in the market,
and in this analysis of the rule-making and legislative record, never suggested that they should be
involved in carrying out this work internally. Furthermore, the SEC did not establish a role in
overseeing the evaluation process of CRAs. Thus, there is evidence to suggest that there was no
internal expertise or mechanisms to carry out the role that CRAs were playing in the market,
despite examples of their failure to do so throughout the time-period.
B) Regulatory Outsourcing Throughout Multiple Policy Spheres
The creation of NRSROs had a huge impact on the proliferation of systemic dependence on
CRAs that eventually constrained decision-making in 2006 and 2010. After the SEC decision to
create NRSROs, codified dependence on CRAs spread to a multitude of policy sectors at the
federal and state level. This proliferation increased the entrenched nature of regulatory
dependence on CRAs, and thus the cost of potential alternative systems of regulation.
Additionally, the creation of NRSROs was inherently shaped by previous regulatory decisions in
that the policy design mimicked previous dependence on CRAs by the OCC. Thought it is
possible that this design was conceived completely independently, it is hard to imagine that the
SEC did not consider the OCC’s strategy for risk assessment when developing the Net Capital
Rules. In 1994, the SEC went on to state: “the utilization of NRSRO ratings, therefore, is an
important component of the Commission’s regulatory program.”65
65 Securities and Exchange Commission. “Concept Release: Nationally Recognized Statistical Rating Organizations.” Release Nos. 33-7085; 34-34616; IC-20508. August 31, 1994. http://www.sec.gov/rules/concept/34-34616.pdf
38
In a January 2003 Report by the SEC on the role of CRAs in securities markets, the
proliferation of regulatory dependence on CRAs after the creation of NRSROs was documented
at length. First, the SEC had included NRSROs into regulations and rules connected to the
Securities Act of 1933, The Exchange Act, and the Investment Company Act of 1940,
influencing rules and regulations regarding money market funds, non-convertible debt, preferred
securities, and asset-backed securities.66 Congress also participated in this proliferation,
incorporating NRSROs into the Secondary Mortgage Market Enhancement Act of 1984 and
amendments to the 1950 Federal Deposit Insurance Act.
At the state level, the trend of regulatory dependence continued at a breakneck pace. For
example, California Insurance Code in 2003 relied on NRSRO ratings in regards to the
investments that incorporated insurers could make.67 Texas and New Jersey insurance codes
featured similar levels of dependence, mandating that insurance providers only invest extra funds
in assets given high levels of safety by NRSROs. An analysis conducted by Emily McClintock
Ekins and Mark A. Calabria found that by June of 2005, “8 federal statutes, 47 federal rules, and
100 state laws referenced credit ratings issued by NRSRO CRAs.68 The following table
combines their analysis with a list of regulations compiled by Timothy Sinclair to provide a
robust list of federal laws that built CRAs into the regulatory process. Combined with the
widespread dependence created in state law, this historical juncture witnessed an immense
increase in statutory inclusion of CRAs.
As will be further described in the next chapter, the proliferation of regulatory inclusion
of CRAs limited the scope of potential reform by increasing the complexity and cost of
66 Securities and Exchange Commission. “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Market As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002.” (2003). 67 See California Insurance Code § 1192.10 (2003). 68 Ekins and Calabria, “Regulation, Market Structure, and Role of the Credit Rating Agencies.”
39
switching to a larger regulatory role for the federal government. When faced with the failure of
the current regulatory system, the daunting economic task of unwinding years of regulatory
policy limited the scope of potential reform and biased the regulatory outcome towards
maintaining the status quo.
40
Table 2: Federal Rules Referring to NRSROs 69
69 Regulations aggregated from Ekins and Calabria, “Regulations, Market Structure, and the Role of Credit Rating Agencies,” and Sinclair, “New Masters of Capital,” 43.
41
C) Conclusion
This critical juncture further illustrates the path dependence model through the lack of
internal expertise and the growth in dependence on CRAs throughout multiple policy spheres.
The SEC’s decision to create NRSROs further entrenched CRAs into the regulatory framework
and resulted in a mass proliferation of dependence in other regulations throughout the financial
system. Furthermore, testimony and research by the OCC and SEC confirm that both actors,
based on the evidence available, still viewed CRAs as the most capable to evaluate the riskiness
of market assets.
Again, we must reevaluate this development through the increasing returns model. Through
this critical juncture, we find that the equilibrium presented in the first critical juncture not only
persisted, but also seems to gain higher levels of inertia. From 1975-2001, several new areas of
financial products were folded under the outsourced regulatory authority of CRAs. Additionally,
the SEC formalized the role of CRAs at the risk of having unchecked organizations so heavily
involved in prudential regulation. Thus, the decision to codify the role of CRAs was driven by
their already entrenched role in the regulatory process. Faced with high switching costs, the
SEC maintained and expanded the regulatory structure around CRAs, further entrenching these
institutions in the regulatory process.
Furthermore, this juncture produces stronger evidence towards a path dependence model.
The decision by the SEC to build on the previous regulatory model arguably forms a hoop test or
potentially a smoking gun test. If the historical regulatory structure did not influence SEC
decision-making, it is difficult to explain how they arrived at an essentially identical structure of
regulatory outsourcing as the OCC developed in the 1930s. Though the system was different
with the implementation of NRSROs, it would be hard to argue that this system was derived
42
independently of the historical context, and the high level of alignment provides strong evidence
towards a path dependence model. The clear parallels between the regulatory system developed
by the OCC in the 1930s and the NRSRO model developed by the SEC in the 1970s are
necessary pieces of evidence in supporting my hypothesis of a path dependence model that
restricted future regulatory decisions and are strongly sufficient in demonstrating that regulatory
policy in the 1930s helped shape policy decisions in the 1970s.
This body of evidence also forms straw in the wind arguments on behalf of the initial
hypothesis. Despite evidence in of the repeated shortcomings of CRAs, the historical equilibrium
built on previous policy decisions held. These factors support my hypothesis that a path
dependence model that began in the 1930’s eventually shaped the legislative outcomes in 2006
and 2010. If federal regulators were not constrained by the lack of skills for credit analysis at the
federal level and the imbedded nature of CRAs, the SEC and OCC would arguably have created
a new regulatory system in light of the many demonstrated failures by CRAs. The previous
sequence of regulatory allocation, however, proved binding to future policy decisions, creating a
continued path dependent process.
43
Chapter IV: The Failure of Reform
A) Introduction
In this section, I seek to illustrate how the path dependence model, anchored by the two
historical junctures described previously, limited the scope of potential reform in both the
Reform Act of 2006 and Dodd-Frank. The evidence will show that the scope of these reforms
was limited by the lack of internal expertise by federal regulators and the mass proliferation of
regulatory dependence that generated high levels of inertia. The lack of internal expertise lead to
both private and public actors expressing clear doubts about whether the federal government
could take on a more expansive regulatory role. The increased cost of unwinding CRAs from the
regulatory process will be discussed throughout the legislative record in terms of the cost and
complexity of undoing dependence on CRAs. Both of these mechanisms are apparent throughout
the legislative and rule-making debate surrounding the role of CRAs in financial regulation. The
evidence will support my hypothesis that historical dependence on CRAs played a primary role
in shaping the regulatory outcome, though does not directly disprove alternative explanations
that CRAs or Wall Street had captured federal regulators. Furthermore, Lindblom’s argument
that CRAs potentially held a privileged position also finds some support in the legislative record.
In this section, I seek to understand the causes of the regulatory outcome and to assess the degree
to which they are grounded and connected to the path dependence model outlined previously. To
illustrate these points, I will utilize Congressional testimony and debates to assess the thought
process and rational behind the eventual laws passed in 2006 and 2010.
44
B) 2006 Credit Rating Agency Reform Act
a. Background
Before evaluating the law, it is important to note a few important trends in the financial
sector and the structure of the credit rating business. In the period between 1985-2006, financial
markets grew in size and complexity, drastically increasing the potential risk of regulatory
outsourcing to CRAs. CRAs became responsible for evaluating highly complex assets – gaining
technical expertise and further increasing regulatory switching costs. Also, during this time
period, CRAs came under increasing scrutiny as the NRSRO process reduced competition in the
field and gave rise to concerns that an arbitrary oligopoly had been forming through codified
regulatory outsourcing. This development raised widespread critiques of maintaining the current
regulatory framework. Nevertheless, the equilibrium system of regulatory dependence held,
continuing the path dependence model.
First, financial markets underwent substantial legislative changes during the period in
question. Under the Carter administration, the Depository Institutions Deregulation and
Monetary Control Act slowly abolished limits on interest rates and incentivized greater
investment in insurance markets. Second, the Reagan administration’s passage of the Garn-St.
Germaine Depository Institutions Act eased limits on real estate and borrower lending,
contributing significantly to the weakness of mortgage loans that defaulted during the crisis of
2008. Under the Clinton administration, the Gramm-Leach-Bliley Act allowed previously illegal
banking conglomerates that combined insurance, investment, and deposit holding practices.
Furthermore, the whole period featured high levels of consolidation as rules barring the
combination of banks across state lines under the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 were slowly overturned. In 1992, SEC Commissioner Richard Roberts
45
noted, “…Rating agencies, despite their importance and influence, remained the only participants
in the securities markets without any real regulation.”70
Second, CRAs fundamentally shifted their business model during this period to an issuer pay
system of revenue generation. Under the original investor pay model, an investor seeking
information on the credit-worthiness of an asset or borrower would purchase the information
collected by the credit rating organization or pay a subscription fee to gain access. The issuer pay
model features companies looking to issue a security, bond, or debt instrument paying for a
rating to bolster the price at which that instrument can then be sold on the market based on the
perceived stability that the rating indicates.
With increasing deregulation came increasing dependence on CRAs. As a direct result of
deregulation, banks began to create “a range of highly-rated asset-backed transactions and
collateralized bond obligations, as well as derivative product companies, financial guarantor
transactions...”71 These assets, in turn, required regulatory approval that manifested itself in the
form of requiring high ratings from NRSROs. As financial products increased in complexity and
as collateralized debt and bond obligations became increasingly distant from the underlying
assets, investors and regulators alike relied on NRSRO’s to evaluate the safety of the underlying
assets. Furthermore, the proliferation of these complex assets underwent explosive growth, with
financial derivatives growing at a rate of 36% a year starting in 1986 to reach $3.5 trillion at the
end of 199172 and the MBS market growing from $500 million in 1996 to $3.2 trillion in 2003.73
70 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services. “Rating the Rating Agencies: The State of Transparency and Competition.” April 2, 2003. HRG-2003-HFS-0054. 71 Frank Partnoy, “Overdependence on Credit Ratings Was a Primary Cause of the Crisis.” Eleventh Annual International Banking Conference: The Federal Reserve Bank of Chicago and the European Central Bank Credit Market Turmoil of 2007-08: Implications for Public Policy. http://www.law.yale.edu/documents/pdf/cbl/Partnoy_Overdependence_Credit.pdf 72 Eli M. Remolana, “The Recent Growth of Financial Derivative Markets” New York Federal Reserve, Quarterly Review. Vol. 17, 14, (1992).
46
The confluence of these massive changes in the financial markets and the increasing role of
CRAs erupted in the Enron scandal of 2001. In one of the biggest corporate meltdowns in recent
history, Moody’s, Standard & Poor’s, and Fitch all rated Enron investment grade up until four
days before the company went bankrupt.74
After Enron, government officials and economists were very much aware of and discussing
the potential impacts of regulatory outsourcing to CRAs. First, there were a plethora of critiques
related to how NRSROs received national designation and the selection process for achieving
that status. The SEC established no clear guidelines for attaining NRSRO status, instead
publishing a public “no-action” letter that any financial institution could use the listed CRA to be
in compliance with SEC laws. The only factor that the SEC discussed as a central criterion is that
the CRA had widespread reputation and was nationally trusted. However, this created a self-
fulfilling prophecy, as new CRAs that wanted to gain national acceptance could not do so
without NRSRO status, while they could not receive NRSRO status due to the fact that they were
not nationally accepted. In 2001, only Moody’s, Standard & Poor’s, and Fitch were listed as
acceptable CRAs for the purpose of regulatory policy.75
As discussed by Partnoy, there was intense skepticism of the current “regulatory license”
model that had developed.76 During the time period, economists also debated whether CRAs
were actually adding value and providing information to the markets as opposed to reactively
73 John J. McConnell and Stephen Buser. “The Origins and Evolution of the Market for Mortgage Backed Securities.” Annual Review of Financial Economics, Vol. 3. 173-192. (2011). 74 Claire A. Hill, Why Did Anyone Listen to the Rating Agencies After Enron?” Journal of Business and Technology. 283, (2009). http://digitalcommons.law.umaryland.edu/jbtl/vol4/iss2/3. 75 Richard Johnson. “An Examination of Rating Agencies’ Action Around the Investment-Grade Boundary.” Federal Reserve Bank of Kansas City. (2003). 76 Frank Partnoy, “Two Thumbs Down for the Credit Rating Agencies.” Washington University Law Quarterly, Vol. 77, (1999), 619-712. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=167412.
47
assigning ratings after public events altered the riskiness of a given asset.77 Additionally, debates
also centered on the methodologies employed by CRAs, with one study concluding that 75% of
CRA analysis was conducted based on data and 25% relied on subjective interpretations by the
rating institution.78 There was also significant discussion of how financial institutions were
engineering complex derivative products that purposefully manipulated CRA rating models to
produce high ratings despite elevated levels of potential risk.79 All of these complaints centered
on the same fundamental topic: serious concerns existed as to the whether CRAs were equipped
to serve as a vital part of the government regulatory structure given a wide breadth of critiques
related to their ability to accurately measure risk. Increasing the government role in evaluating
the safeness of assets seemed likely to produce higher levels of security. First, the federal
government would not have the profit motive to inflate ratings that was currently being discussed
as plaguing the effectiveness of CRAs in the market. Second, federal regulators had stronger
tools to gather information from companies seeking ratings as opposed to CRAs that were forced
to work with whatever data was provided by the institution seeking the rating. Nevertheless, the
possibility that the federal government would also fail at this task was still a lingering concern.
b) Legislative Analysis
The Reform Act of 2006 was the first legislative attempt to reform the market for credit
ratings. This law, however, did very little, if anything, to reform the structural regulatory
dependence on CRAs. During the rule-making process, thought was given to whether the federal
government should continue to rely on CRAs to provide this crucial function. Throughout the
77 James Van Horne. Financial Markets Rates and Flows, 4th Edition (Englewood Cliffs, N.J.: Prentice Hall 1994), 181. 78 Lyn Perlmuth. “Is Turnabout Fair Play?” Institutional Investor, (1995), 34. 79 Partnoy, “The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies.”
48
hearings and debate surrounding the law – both mechanisms of the path dependence model
manifest itself as the SEC and other federal actors demonstrated a clear lack of internal expertise.
Furthermore, the entrenched nature of CRAs in the regulatory processes and the financial world
at large was widely discussed as hindering potential reform. The legislative record of the 2006
law highlights how these two factors bound the scope of potential reforms through the law.
Furthermore, the fact that the law was overwhelmingly focused on changing the NRSRO process
to ensure competitiveness as opposed to decreasing the government’s dependence on CRAs
helps illustrate the path dependence model.
To address the myriad of concerns related to the role of CRAs in government regulation and
the financial markets, the 108th Congress began a set of hearings on the subject in 2003.
Furthermore, the Sarbanes-Oxley Act of 2002 mandated a study of the role of CRAs in
regulatory policy. The first of such hearings, on April 2nd of 2003 had ambitious goals, as
described by Chairman Richard Baker: “It is my hope that we can examine in some detail the
manner by which these organizations are designated, the adequacy of our current regulatory
oversight methodologies and the basis for which such organization is either to be given approval
or the methodology for revocation of such authority.”80 Interestingly, this list of potential goals
relates to how the federal government oversees and selects NRSROs, and not whether such a
regulatory outsourcing should exist in the first place. Throughout the legislative hearings – the
focus of the debate was around fostering competition in the field of credit analysis and conflicts
of interest in the market, though the issue of government regulatory outsourcing was discussed to
some degree. During this hearing, Chairwomen Nazareth of the SEC noted that the oversight
80 HRG-2003-HFS-0054
49
capabilities of the SEC were “very limited” citing the lack of legislative authority granted to the
SEC to oversee how NRSROs conducted their business.81
i) Regulatory Outsourcing and the Lack of Internal Expertise
The lack of internal expertise by the SEC to handle the role that CRAs played in the financial
markets was clear and repeatedly demonstrated. This idea was perhaps best captured by Nazareth
during the first hearing on the subject of CRA reform: “But I can say that, in general what makes
this area so difficult and the reason that we never seem to come to closure on how to address
these issues is that, fundamentally what is occurring here is financial analysis.”82 The SEC’s
clear discomfort with critiquing or overseeing any sort of “financial analysis” in the private
sector may have stemmed in part from a lack of actual or perceived expertise to carry out this
role. In fact, the only individual in the first hearing that suggested that the federal government
carry out the role of analyzing the riskiness of assets was Professor Lawrence White from New
York University, stating that “the first and best [path] is to have the financial regulators withdraw
those safety delegations and to make the safety judgments themselves.”83 This comes in sharp
contrast to the SEC’s testimony that never even hinted at the idea of having the federal
government step in and come up with their own system of evaluating risk for the purposes of
federal and state law.
Private CRAs in the marketplace that were looking to compete with Moody’s and Standard &
Poor’s also voiced an incredulous view that the SEC could perform this role. Sean Egan, head of
Egan-Jones, stating, “ I question whether bank regulators would be able to catch Enron or
81 HRG-2003-HFS-0054 82 HRG-2003-HFS-0054 83 HRG-2003-HFS-0054
50
Worldcom or Genuity. I do not think they have the training, the incentives, the tools to do it.”84
Egan’s perspective on how to improve the market for asset information was to statutorily
mandate an investor-pay model, and his firm positioned themselves as the only CRA providing
quality information to investors as opposed to the practices of the major actors in the market that
boosted ratings to enhance profits and their client base.
A consistent theme throughout the hearings for the Reform Act of 20006 was an
overwhelming reluctance by the SEC to take any firm stance on a regulatory structure for
NRSROs and deep resistance to further inclusion in conducting the risk analysis that they had
previous outsourced to the NRSROs. The SEC had never performed this role and was hesitant to
engage in a new and potentially risky area of regulatory oversight, which compounded the
private sector’s distrust of having the SEC play a larger regulatory role in the field.
ii) Regulatory Inertia and the Entrenchment of CRAs
Throughout the debate surrounding the 2006 law – the entrenched nature of CRAs in the
regulatory process was frequently discussed. First, in an April hearing, Raymond McDaniel,
President of Moody’s, highlighted that “…the interaction of regulation with the rating agency
industry as a practical matter, has become very broad and deep and it would be difficult to
reverse that process.”85 Congressman Paul Kanjorski, reflecting on White’s proposal of having
the government end the outsourcing of regulatory responsibility, stated “but then we would have
to back up and change a lot of prior regulation that used that standard,” indicating an explicit
recognition of the costs of transition and the entrenched nature of CRAs in the regulatory
84 HRG-2003-HFS-0054 85 HRG-2003-HFS-0054
51
process.86 Even academics participating in the hearings noted, “there is a very large, very
complex interlocking web of regulations and statutes, both at the federal and state level…How to
move forward with a market solution when faced with this interlocking web – or to change the
metaphor, a Gordian Knot, - of regulation and rules did puzzle me.”87 Numerous references to
the constraints posed by the lengthy regulatory history illustrate the pervasive impact of
regulatory entrenchment.
The highly imbedded nature of regulatory outsourcing to CRAs in a multitude of policy
sectors at the state and federal level also played a role in the conversation regarding the removal
of NRSRO status altogether to foster greater competition. James Kaitz, President and Chief
Executive Officer for the Association for Financial Professionals, stated, “I would suggest if you
do that, you have eliminated an artificial barrier to competition, and you have erected a
permanent barrier to competition. As we have all discussed, the ratings are embedded in banking
law, insurance, mutual funds, and potentially into the pension area. So that would create a
permanent barrier to competition from any other organizations.”88 Due to the advantages given
through NRSRO status for so long, removing the status without promoting competition in some
other fashion would handicap potential market participants. When the SEC held a public
comment period on various areas of interest regarding the role of CRAs and asked whether or not
industry participants would support the removal of the NRSRO status – 42 of the 46 recipients
said they would not be in favor, many citing that the process of unwinding the regulatory system
would be costly and complicated.89
86 HRG-2003-HFS-0054 87 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Reforming Credit Rating Agencies: The SEC’s Need for Statutory Authority.” April 12, 2005. HRG-2005-HFS-0064. 88 HRG-2005-HFS-0064 89 HRG-2005-HFS-0064.
52
The debate between Congressman Kanjorski and Jim Kaitz, head of the Association for
Financial Professionals, sums up the nature of this debate quite succinctly:
“Mr. KAITZ. It might be a nice way to think about it, but it is totally unrealistic. You have to undo legislation and regulation and all those regulated portfolios to do away with the NRSRO - Mr. KANJORSKI. Congress doesn't have to do anything? Mr. KAITZ. It is embedded in insurance, mutual fund, banking regulation. You would have to then address each one of those separate pieces of legislation. Mr. KANJORSK. We have created a monster. Now we have to dress that monster?”90 There was clear recognition and consideration of the fact that the proliferation of dependence on
CRAs had a binding effect on the potential for reform. Any potential changes would have to be
reconciled with the fact that years of state and federal dependence would be incredibly costly to
undue – limiting the ability for federal actors to remove the NRSRO language and to shift
responsibility back to federal regulators.
c) Conclusion
The legislative records and hearings surrounding the Reform Act of 2006 provide strong
support for the path dependence model and the mechanisms previously identified. First, the lack
of internal expertise was clearly described by both the SEC and private actors who all argued that
the SEC was not equipped to play such a large regulatory role. Second, the entrenched nature of
NRSROs was frequently discussed in the context of potential reform, indicating that regulatory
entrenchment constrained the set of policy options available to Congress when reform was
considered. These factors resulted in the Reform Act of 2006 being limited to just codifying a
selection process for CRAs to become registered with the SEC. Furthermore, many critics
contended that the criteria established for registering with the SEC were anti-competitive,
90 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Legislative Solutions for the Rating Agency Duopoly.” June 29, 2005. HRG-2005-HFS-0051.
53
resulting in minimal changes to the competitive landscape of the industry.91 The Reform Act of
2006 did not in any way alter the fact that the federal government was still highly dependent on
the quality of the ratings produced by NRSROs in a host of regulatory fields without any direct
process for ensuring the effectiveness of those ratings.
C) 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act
Dodd-Frank also features both of the mechanisms of path dependence featured previously,
strengthening the hypothesis and path dependent model. Throughout the legislative process, the
SEC and other federal regulators expressed an inability to perform the role of CRAs while
regulatory entrenchment continued to bind potential policy reform. These forces culminated in
preventing substantial legislative intervention. Since the background, setting, and impact of the
financial crisis were already described previously, I will begin my analysis of the legislation and
the evidence of the two mechanisms of the path dependent model in the hearing process leading
up to the final regulations and rules.
a) Legislative Analysis
Throughout the legislative record, both the lack of expertise at the federal level and the cost
of removing CRAs from the regulatory process are discussed at length, with both factors limiting
the scope of potential reform. First, it is important to note that the widespread failure of CRAs
91 Greg Gordon. “Industry Wrote Provision that Undercuts Credit-Rating Overhaul.” McClatchy. August 7, 2013. http://www.mcclatchydc.com/2013/08/07/198739/industry-wrote-provision-that.html
54
during the crisis initially emboldened Congress to take a holistic view of the role of CRAs in the
financial markets. Most notably, Senator Richard Shelby asked during a Senate hearing in
September of 2007 to Chairman Cox of the SEC, “if you were to create a new system would you
design it differently? And if so, how so? Obviously, the system is flawed.”92 Thus, on the onset,
a wide range of policy alternatives was at least being considered. Over time, however, as the
system of dependence on CRAs was explored, the policy alternatives reduced to a more practical
set of outcomes, demonstrating the binding effects of past regulatory decisions.
i) Regulatory Outsourcing and the Lack of Expertise
The hearings for Dodd-Frank support the hypothesis that both private and public actors
did not trust the SEC to produce accurate assessments of the safeness of assets. This view was
championed by Robert Auwaerter of Vanguard (an American investment firm) stating, “I
question whether they have the resources to do it right now, to go out to the agencies and
determine that the processes are working right.”93 This was also agreed upon by Represenative
Scott Garrett from New Jersey, who stated “So two things I do not think Congress of the SEC
should do…prescribe exact analytics that NRSROs must use.”94 Both of these statements echoed
the deep distrust that both public and private actors towards the SEC’s ability to be an effective
regulator of CRAs and the complex analysis they were now carrying out in the market.
Furthermore, think-tanks weighed in on the conversation, with Alex J. Pollock of the American
Enterprise Institute rebuking the proposals to increase the SEC’s role: “The worst case would be
to turn the SEC, through the regulation of ratings process, which could easily turn into regulating
92 HRG-2007-BHU-0027 93 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Approaches to Improving Credit Rating Agency Regulation.” May 19, 2009. HRG-2009-HFS-0032. 94 HRG-2009-HFS-0032.
55
ratings, into a monopoly rater, which would also suffer from the same lack of ability to predict
the future.”95 Interestingly, proponents of less government intervention framed the work of
CRAs as trying to “predict the future.” The contrast between this seemingly speculative task and
the vast importance of this role in determining policy surrounding the safety of assets is striking.
Though there was discussion of having the federal government play a larger role in the
regulatory sphere, such discussions were always coupled with a pervasive sense of frustration
with the glacial pace of change by the SEC. Congressional and private actors simultaneously
critiqued the SEC with Congress lamenting the slow pace of reform since 2006 and the private
sector representatives arguing that the regulatory body didn’t have the capacity do effectively
oversee the system. This lack of trust, and implicitly the lack of expertise, was a consistently
cited in the legislative record and informed the final results of Dodd-Frank. On net, Dodd-Frank
did increase the regulatory role of the SEC, but stopped short of giving the agency any direct role
over the analytical processes conducted by CRAs.
ii) Regulatory Inertia and the Entrenchment of CRAs
On the onset of Senate hearings regarding the immense failures of CRAs during the
financial crisis, the experts called in to testify on potential remedies to the problems seen in the
market were clear: the government needed to play a greater role in evaluating the riskiness of
assets. According to John Coffee, Adolf A. Berle Professor of Law at Columbia Law School,
“…the SEC should compute the default rates using its own criteria, not letting the agencies do it
themselves because they will use different criteria.”96 Chairman of the SEC Christopher Cox
concurred with this idea, opining, “Professor Coffee’s proposals in that respect are very
95 HRG-2009-HFS-0032. 96 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Role and Impact of Credit Rating Agencies on the Subprime Credit Markets.” September 26, 2007. HRG-2007-BHU-0027.
56
consonant with at least what I am thinking and I believe what the Commission staff and perhaps
the other Commissioners are thinking.”97
Alternatively, if the federal government was going to continue to depend on CRAs,
Coffee argued for a harsher set of punishments: “But I do not think absent some kind of either
liability risk of possibility of suspension or forfeiture that we are going to have the same
governmental oversight powers over the rating agencies that we have over the accounting
profession or the securities analysts.”98 Furthermore, a very promising model was introduced
where the SEC would approve a pool of CRAs, a company would request a rating from the SEC,
and the SEC would assign the task at random to one of the approved CRAs. Thus, the incentive
problems for bad ratings would be addressed in addition to randomizing the process to ensure
high-quality work product.99 Another important proposal repeatedly discussed was the idea that
any information shared with a given CRA must be proliferated to other CRAs to ensure a larger
amount of analysis being conducted in the market and a more fruitful level of competition.100
Thus, the inclusion of a broad role for government involvement for assessing the safety
of assets and making those results public was on the table for inclusion in the legislative process.
Furthermore, Professor Coffee suggested that CRAs that consistently produced faulty ratings
should lose NRSRO status, and that information shared with NRSROs during the rating
generation process should be shared with other CRAs that wish to conduct an analysis and check
the results of their competitors. All of these suggestions produced bold, robust changes to the
regulatory framework for CRAs.
97 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Turmoil in U.S. Credit Markets: The Role of Credit Rating Agencies.” April 22, 2008. HRG-2008-BHU-0025. 98 HRG-2008-BHU-0025 99 HRG-2009-HFS-0032 100 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Examining Proposals to Enhance the Regulation of Credit Rating Agencies.” August 5, 2009. HRG-2008-BHU-0052.
57
These broader goals, however, were stifled by the realities of regulatory entrenchment.
When asked about the SEC’s codified dependence on CRAs through their rules and regulations,
Chairman Cox definitively stated, “…we will not be able to purge, by any means, our rules of
reference to ratings.”101 Furthermore, according to many industry participants, the damage was
already done. According to Sean Egan, the historical dependence on specific CRAs, “In that time
period, what has happened is that because the government only recognized those few rating firms
and continued this unsound business model, it enabled the issuer-compensated rating firms to
grow much faster, much further, and have a more consolidated industry than it would be
otherwise.”102 Nevertheless, as noted by Stephen Joynt, President of Fitch, “…without
designating anyone, the present incumbents would be more likely to be used by investors for the
good reasons that they're used right now, in referencing ratings, and I think it might inhibit
competition and diversity of opinion.”103 Thus, unraveling the regulatory license system already
in place may have had little effect on the actual quality of ratings and competition in the markets.
Essentially, years of regulatory entrenchment had given the top CRAs a complete dominance of
the market and unbeatable head start that small challengers could not hope to overcome, stifling
the possibility of broad scale reform. As bemoaned by Senator Chuck Schumer, “so the ratings
are too much a part of our financial system to abandon them, but it is clear the system as it exists
is broken.”104
iii) Conclusion
101 HRG-2008-BHU-0025 102 U.S. House. Committee on Oversight and Government Reform. “Credit Rating Agencies and the Financial Crisis.” October 22, 2008. HRG-2008-CGR-0079. 103 HRG-2009-HFS-0032 104 HRG-2009-BHU-0052.
58
First, it is important to note what changes were actually codified in Dodd-Frank in
regards to reigning in abuses in the market for credit information. Dodd-Frank did successfully
remove references to NRSROs across a wide set of federal regulations, raise the liability for
CRAs, and lower the bar for the SEC to pursue enforcement action. Broader reform, however,
such as the creation of a new oversight system or the random assignment of CRAs to the analysis
of a deal, was lost in the legislative process. Based on the evidence available, the lack of
expertise within the SEC and the entrenchment of CRAs in the regulatory process rendered
widespread reform unattainable. The SEC’s relatively new role in the regulatory space was
evident in the fact that they barely had created a group within the agency to study CRAs after the
financial crisis of 2008. Furthermore, the substantially entrenched role of CRAs in the regulatory
process made broader ideas of reform far more complicated than Congress was prepared to
tackle. Though House and Senate members hypothesized bold changes, they were often greeted
with a highly entrenched system. Regardless of whether the NRSRO system was maintained or
removed – there was a feeling that regulatory intervention was too late. The top firms had
already cemented their market share, and regulators could only hope to potentially instill greater
quality ratings in the midst of a sub-optimal regulatory framework.
Chapter V: Conclusion
In this paper, I have sought to establish one primary claim: to understand the regulatory
aftermath of credit rating agency reform, history matters. More specifically, turning points in
regulatory decision making in the 1930’s and 1970’s codified pervasive dependence on private
59
CRAs, generating a path dependence model that restricted future legislative choice despite two
major attempts at reform. This path dependence model manifested itself through two central
mechanisms. First, by outsourcing regulatory responsibility to private CRAs, the SEC and other
regulators never developed the capacity to carry out this work internally while high levels of
proficiency and market reputation consolidated in the private sector, specifically among Standard
and Poor’s, Moody’s, and Fitch. This lead public and private actors to protest against any
increase in federal oversight over CRAs and credit analysis. Second, the decision to outsource
regulatory responsibility at the federal level spread rapidly among different federal laws and
statutes, state laws and statutes, and various other regulatory policy spheres, increasing the cost
of alternative policy solutions and biasing regulatory reform towards maintaining the status quo.
The combined effect of both phenomena was the reduction and restriction of regulatory
options when reform was pursued during 2006 and 2010. Though regulators sought a variety of
mechanisms to reform systemic flaws in the market for credit information, proposals to
dramatically enhance the government’s role in evaluating credit risk internally failed. First, the
lack of expertise at the federal level and the absence of a historical track-record of successful
regulation in the field lead to a lack of support for a larger regulatory role for the SEC by both
public and private actors. Second, the entrenched nature of CRAs in the regulatory process was
consistently mentioned as increasing the cost of effective reform. Alternative modes of oversight
were all forsaken in favor of smaller scale changes to disclosure and liability rules.
Though the evidence outlined provides strong support for the idea that the historical
trajectory of regulatory policy limited the scope of legislative reform, it does not authoritatively
reject alternative hypothesis that the politics or threats posed by CRAs were the main drivers of
the lack of reform. Though those aspects cannot be proven wrong, the prominence of those
60
processes in driving the regulatory outcome are suspect in light of the robust evidence that
connects the historical policy path to the current set of outcomes observed. On net, this analysis
strengthens the argument that the historical path influenced the final policy outcome observed.
If regulatory bodies in the 1930’s and 1970’s had designed an internal system for
measuring asset risk as opposed to regulatory outsourcing, it is possible that more effective
measurement strategies could have been developed within the federal government that may have
better detected issues in the financial sector leading up to the crisis of 2008. This view, however,
is arguably naïve. A common thread among economists is that the high levels of complexity in
the markets for assets such as mortgage-backed securities posed a new threat to understanding
the safeness of assets. If the federal government, as opposed to private CRAs, was able to apply
scrutiny to these practices, however, they may have been able to detect this worrisome trend
earlier and could have potentially reduced the economic and social cost of the 2008 recession.
The reforms created by both the 2006 and 2010 laws, ultimately, have had little impact
on the market for asset information. If these reforms were having the kind of impact that
legislators hoped, we would hypothetically have seen a higher level of competition in the market
for asset information. Net revenues and stock prices from both S&P and Moody’s, however,
paint a different story. All in all, financial indicators show that both companies continue to enjoy
high levels of revenue and increasing stock prices, indicating a complete absence of regulatory
enhanced competition.
61
Table 3: S&P’s and Moody’s Net Revenues Post Crisis105
Table 3: McGraw Hill Financial Inc. Adjusted Closing Price: 1985-201
105 Revenue data provided by YCharts. https://ycharts.com/.
MCO: Moody’s Corporation MHFI: McGraw Hill Financial Inc. (owners of Standard and Poor’s)
62
Table 4: Moody’s Adjusted Closing Prices: 1994-2014106
Table 5: Standard and Poor’s Closing Prices: 1994-2014107
106 Yahoo Finance Data: Moody’s Corporation (MCO). Accessed May 4, 2015. 107 Yahoo Finance Data: McGraw Hill Financial, Inc. (MHFI). Accessed May 4, 2015.
63
According to Raymond McDaniels, CEO of Moody’s, CRAs suffered from “serious
reputational damage” after the financial crisis.108 In contrast, the data paints the picture of a
sector that remains highly consolidated, profitable, and unshaken by the lessons of widespread
financial hardship. Despite two major efforts at regulatory reform, Moody’s and Standard and
Poor’s are still on top. In this paper, I argue that the historical dependence on these institutions to
carry out a central regulatory role proved too much to overcome. Years of dependence created a
web of regulation that, in the end, stood the test of time despite widespread evidence that the
system was simply not working.
There are, however, several limitations in this study. First, this analysis has not fully
disproved the alternative hypothesis. Capture arguments may still be applicable, and
understanding the nature and scope of the political battles being waged during the financial crisis
requires in-depth interviews with the participating parties to understand the relationship between
CRAs, Wall Street, Congress, and the SEC. These arguments are less persuasive, though, in the
context of minimal lobbying expenditures by CRAs. Furthermore, Lindblom’s analysis of
privileged positions may also apply in that the historical dependence allowed CRAs to utilize the
“punishment” that changes to the CRA model would cause massive disruptions in the market.
This argument, though, is also suspect given that the country was emerging from one of the
worst financial crises on record. Given that CRAs had failed so dramatically, the threat that their
ratings could send the country back into recession does not come across as plausible.
Additionally, unlike the fields of defense spending and the major financial institutions on Wall
Street, government dependence on these CRAs to preserve the health of the economy is much
108 HRG-2008-CGR-0079
64
more indirect. Finally, this study is a rhetorical analysis of statements made during both
historical junctures and the legislative record before the passage of the Reform Act of 2006 and
Dodd-Frank. These anecdotes can never fully capture the thoughts, attitudes, and beliefs of the
market and government participants at the time of rule making and legislation and is limited in
that respect.
Looking forward, there are a variety of areas of potential research. First, more empirical
measures of the effectiveness of CRAs post crisis will be crucial. It is entirely possible that the
2006 and 2010 reforms will bring about more accurate ratings as measured by lower downgrades
or other market measures over time, and sustained empirical research on this phenomenon will
be essential to further understanding the effects of reform. Furthermore, this analysis is severely
limited by timing: Dodd-Frank is a recent piece of complex legislation that may take many years
to implement and take effect. Perhaps the necessary seeds to introduce competition have been
planted and will come to fruition as the competition matures and market actors fully internalize
the fact that they no longer need to rely on NRSROs for regulatory purposes. Lastly, a more
thorough understanding of the politics of the relationship between the SEC, Congress, and CRAs
would lead to a more holistic understanding of the dynamics of reform. Arguments surrounding
concepts such as capture, though immensely important, are limited by the lack of geographic and
interpersonal access that I had in carrying out and implementing this research. Individuals in a
position to engage some of the “insiders” involved in the rule-making, testimonies, and back
room deals that eventually shaped the legislative outcome would more fruitfully explore
approaches such as capture that seek to understand the interpersonal and cultural elements of the
legislative process.
65
This paper seeks to add to the body of work on path dependence and the role that historical
analysis can play in political science. Qualitative evidence and purposeful process tracing still
provide important tools for understanding the evolution of regulatory development, helping
anchor recent shifts in the underlying trends that shape the outcomes observed. Path dependence
provides the most robust mechanism for understanding the substantial limits placed on potential
credit rating agency reform. Moving forward, hopefully Congress will be able to overcome the
specter of this path dependence and adopt bold reforms that remove the myriad of issues
identified in the market for asset information. Furthermore, this paper helps put into context the
many tradeoffs associated with outsourcing key regulatory decisions to the private sector.
Though doing so may be efficient in the short-run, long-term changes in the regulated market
might create serious incentive and governance problems that lead to widespread distress.
Government actors should heed the example of CRAs with caution when approaching future
regulatory outsourcing decisions.
66
Work Cited
Alessi, Christopher, "The Credit Rating Controversy," Council on Foreign Relations, February 19, 2015, http://www.cfr.org/financial-crises/credit-rating-controversy/p22328. Benmelech, Efraim and Jennifer Dlugosz, “The Credit Rating Crisis,” NBER Macroeconomics Annual 2009, Volume 24 (2010), 161. http://www.nber.org/chapters/c11794.pdf Bennett, Andrew and Jeffrey T. Checkel, “Process Tracing: From Philosophical Roots to Best Practices,” in Process Tracing in the Social Sciences: From Metaphor to Analytic Tool, ed. Andrew Bennett and Jeffrey Checkel, (Cambridge University Press, 2012), 1. Bernanke, Ben, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.” National Bureau of Economic Research, No. 1054, (1983). http://www.nber.org/papers/w1054.pdf. Bricker, Jesse, 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. Bureau of Labor Statistics, U.S. Department of Labor, 3/1/2015, http://data.bls.gov/timeseries/LNS14000000. Carpenter, Daniel and David A. Moss, Preventing Regulatory Capture: Special Interest Influence and How to Limit It (Cambridge: Cambridge University Press, 2014), 1-22 and 451-66. Center for Responsive Politics, Open Secrets, Lobbying expenditures by the Securities Industry, (2013): https://www.opensecrets.org/lobby/indusclient.php?id=F07&year=2013. Lobbying Expenditures by Moody’s, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000043203&year=2013. Lobbying Expenditures by S&P, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000035733&year=2013. Lobbying Expenditures by Fitch, (2013): http://www.opensecrets.org/lobby/clientsum.php?id=D000050935&year=2013. Federal Reserve System Publication Committee, “The Federal Reserve System: Purposes and Functions,” (2005), http://www.federalreserve.gov/pf/pdf/pf_complete.pdf. Collier, David. ‘‘Understanding Process Tracing.’’ PS: Political Science and Politics 44:823-30, (2011). http://polisci.berkeley.edu/sites/default/files/people/u3827/Understanding%20Process%20Tracing.pdf. Dunstan, Dunstan. “Overview of New York City’s Fiscal Crisis.” California Research Bureau, California State Library, Vol. 3, No. 1, (1995). Dykstra, Paul. “Disclosure of Security Ratings in SEC Filings.” 78 Det. C.L. Rev. 545 (1978). Ekins, Emily and Mark Calabria. “Regulation, Market Structure, and Role of the Credit Rating Agencies.” Policy Analysis, No. 704, (2012). Fons, Jerome S. “Policy Issues Facing Rating Agencies,” in Ratings, Rating Agencies and the Global Financial System, ed. Richard M. Levich, Giovanni Majnoni, and Carmen Reinhart. (New York: Kluwer Academic Publishers, 2012), 343. Gordon, Greg. “Industry Wrote Provision that Undercuts Credit-Rating Overhaul.” McClatchy. August 7, 2013. http://www.mcclatchydc.com/2013/08/07/198739/industry-wrote-provision-that.html. Harold, Gilbert, Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness (New York, Ronald Press, 1938).
67
Hickman, Braddock. “Front Matter, Statistical Measures of Corporate Bond Financing Since 1900,” in Statistical Measures of Corporate Bond Financing Since 1900, ed. W. Braddock Hickman and Elizabeth T. Simpson (New Jersey, Princeton University Press, 1960). http://www.nber.org/chapters/c2463.pdf. Hickman, Braddock. “Introduction and Summary of Findings to ‘Corporate Bond Quality and Investor Experience,” in Corporate Bond Quality and Investor Experience (New Jersey, Princeton University Press, 1958), 3-27. Hill, Claire A. “Why Did Anyone Listen to the Rating Agencies After Enron?” Journal of Business and Technology. 283, (2009). http://digitalcommons.law.umaryland.edu/jbtl/vol4/iss2/3. Johnson, Richard. “An Examination of Rating Agencies’ Action Around the Investment-Grade Boundary.” Federal Reserve Bank of Kansas City. (2003). Katz, Jonathan, 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 Kruck, Andreas. Private Ratings, Public Regulations: Credit Rating Agencies and Global Financial Governance (London, Palgrave MacMillan, 2011), 85. Kuschnik, Bernhard, “The Sarbarnes Oxley Act: ‘Big Brother is Watching You’ or Adequate Measures of Corporate Governance Regulation?” Rutgers Business Law Journal, (2008), http://businesslaw.newark.rutgers.edu/RBLJ_vol5_no1_kuschnik.pdf Kwak, James, “Cultural Capture and the Financial Crisis.” In Preventing Regulatory Capture: Special Interest Influence and How to Limit it, ed. Daniel Carpenter and James A. Moss, (Cambridge: Cambridge University Press: 2013). Lindblom. Charles. “The Markets as Prison.” The Journal of Politics, Vol. 44, No. 2, (1982). http://www.jstor.org/stable/2130588?seq=1#page_scan_tab_contents McConnell, John J. and Stephen Buser. “The Origins and Evolution of the Market for Mortgage Backed Securities.” Annual Review of Financial Economics, Vol. 3, (2011), 173-192. McLaughlin, David “S&P Analyst Joked of Bringing Down the House Before the Crash,” BloombergBusiness, February 5, 2013, http://www.bloomberg.com/news/articles/2013-02-05/s-p-analyst-joked-of-bringing-down-the-house-ahead-of-collapse. Morgenson, Gretchen, “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 Murphy, Edward. “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets.” Congressional Research Services, (2013), http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=2154&context=key_workplace. O’Connor, J.F.T. Comptroller of the Currency, “Address at a convention of the California Bankers Association, Sacramento, California,” May 22, 1936. Paletta, Damien and Matt Phillips, “S&P Strips U.S. of Top Credit Rating,” The Wall Street Journal, August, 6 2011. http://www.wsj.com/articles/SB10001424053111903366504576490841235575386 Partnoy, Frank. “Overdependence on Credit Ratings Was a Primary Cause of the Crisis.” Eleventh Annual International Banking Conference: The Federal Reserve Bank of Chicago and the European Central Bank Credit Market Turmoil of 2007-08: Implications for Public Policy. http://www.law.yale.edu/documents/pdf/cbl/Partnoy_Overdependence_Credit.pdf
68
Partnoy, Frank, “The Paradox of Credit Ratings,” University of San Diego Law & Economics Research Paper No. 20, (2001). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=285162. Partnoy, Frank. “Two Thumbs Down for the Credit Rating Agencies.” Washington University Law Quarterly, Vol. 77, (1999), 619-712. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=167412. Perlmuth, Lyn. “Is Turnabout Fair Play?” Institutional Investor, (1995), 34. Pierson, Paul, “Increasing Returns, Path Dependence, and the Study of Politics,” The American Political Science Review, Vol. 94, No. 2 (2000), 251-267, http://www.unc.edu/~fbaum/teaching/PLSC541_Fall06/Pierson%20APSR%202000.pdf. Remolana, Eli M. “The Recent Growth of Financial Derivative Markets” New York Federal Reserve, Quarterly Review. Vol. 17, 14, (1992). Resolution of the Missouri Bankers Association at its 46th annual convention, Kansas City, Mo., May 5, 1936. Securities and Exchange Commission. “Concept Release: Nationally Recognized Statistical Rating Organizations.” Release Nos. 33-7085; 34-34616; IC-20508. August 31, 1994. http://www.sec.gov/rules/concept/34-34616.pdf Securities and Exchange Commission. “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Market As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002.” (2003). Sinclair, Timothy, The New Masters of Capita: American Bond Rating Agencies and the Politics of Creditworthiness (New York, Cornell University Press, 2008). 4-100. Sylla, Richard, “A Historical Primer on the Business of Credit Ratings.” The World Bank, Washington, DC, (2001), http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf. U.S. House. Committee on Banking, Finance, and Urban Affairs. Securities and Exchange Commission Staff Report on Transactions in Securities of the City of New York, 1997. https://www.sec.gov/info/municipal/staffreport0877.pdf U.S. House. Committee on Interstate and Foreign Commerce. “Special Study of Securities Markets, Pt. 1.” April 3, 1963. Available from: ProQuest Congressional Search. 12576 H.doc.95. U.S. House. Committee on Oversight and Government Reform. “Credit Rating Agencies and the Financial Crisis.” October 22, 2008. Available from: ProQuest Congressional Search. HRG-2008-CGR-0079. U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Approaches to Improving Credit Rating Agency Regulation.” May 19, 2009. Available from: ProQuest Congressional Search. HRG-2009-HFS-0032. U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services. “Rating the Rating Agencies: The State of Transparency and Competition.” April 2, 2003. Available from: ProQuest Congressional Search. HRG-2003-HFS-0054. U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Legislative Solutions for the Rating Agency Duopoly.” June 29, 2005. Available from: ProQuest Congressional Search. HRG-2005-HFS-0051. U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Reforming Credit Rating Agencies: The SEC’s Need for Statutory Authority.” April 12, 2005. Available from: ProQuest Congressional Search. HRG-2005-HFS-0064.
69
U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Examining Proposals to Enhance the Regulation of Credit Rating Agencies.” August 5, 2009. Available from: ProQuest Congressional Search. HRG-2009-BHU-0052. U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Role and Impact of Credit Rating Agencies on the Subprime Credit Markets.” September 26, 2007. Available from: ProQuest Congressional Search. HRG-2007-BHU-0027. U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Turmoil in U.S. Credit Markets: The Role of Credit Rating Agencies.” April 22, 2008. Available from: ProQuest Congressional Search. HRG-2008-BHU-0025. U.S. Senate Subcommittee on Financial Institutions; Committee on Banking and Currency. “Bank Underwriting of Revenue Bonds.” August 28-30, September 12, 1967. Available from: ProQuest Congressional Search. HRG-1967-BCS-0027 Van Horne, James. Financial Markets Rates and Flows, 4th Edition (Englewood Cliffs, N.J.: Prentice Hall 1994), 181. Wall Street Journal. September 12, 1931. White, Lawrence J. “A New Law for the Bond Rating Industry.” Regulation, (2007). White, Lawrence J. “Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response.” Journal of International Banking Law and Regulation. White, Lawrence J. “Credit Rating Agencies: An Overview” Annual Review of Financial. Economics, Vol. 5, (2013). World Trade Organization. “World Trade Organization Annual Report 2009,” (2009), https://www.wto.org/english/res_e/publications_e/anrep09_e.htm. World Trade Organization. “World Trade Organization Annual Report 2010,” (2010), https://www.wto.org/english/res_e/publications_e/anrep10_e.htm.
top related