The big short
G: Alright, FrontPoint Partners, how can I help you?
VD: Well, we don't understand why the rating agencies haven't downgraded subprime bonds since the underlying loans are clearly deteriorating.
G: Well, the delinquency-rates do have people worried, but they're actually within our models.
MB: You're convinced the underlying mortgages in these bonds are solid loans?
G: That is our opinion, yeah.
VD: Oh, crack the tape! Have you looked at the loan-level data?
G: What you think we do here all day? […]
MB: If these mortgage-bonds are so stable, so solid, have you ever refused to rate any of these bonds upper-tranches AAA? […] Can you name one time in the past year where you checked the tape and you didn't give the banks the AAA-percentage they wanted?
G: If we don’t give them the ratings, they'll go right down the block. If we don't work with them they will go to our competitors. Not our fault, simply the way the world works.
In the movie The Big Short, the hedge fund manager Mark Baum (a role inspired by the true story of Steve Eisman) and his colleague Vinnie Daniel corner the credit risk analyst Georgia Hale, prompting her to admit that rating agencies were responsible for exacerbating the real estate bubble triggered by subprime mortgages. The bursting of the housing bubble would have caused the worst economic crisis in Western society. What about today? Has anything been done to avoid such a situation?
Who supervises Rating Agencies?
The foundation of ESMA
The year after Lehman Brother’s bankruptcy, G20 countries’ regulators convened on the Basel Committee.
Aim of the Committee was to improve banks’ resilience to financial shocks and to provide a common regulatory framework across all the European countries.
The agreements (Basel III) provided for a strengthening of bank’s capital requirements and for stricter regulation of rating agencies.
In 2011 ESMA, the European Securities and Markets Authority, was founded. ESMA contributes to safeguarding the stability of the EU financial system and is the direct supervisor of Credit Rating Agencies. It’s also responsible for the application of EU Regulation 1060/2009, also known as the CRA Regulation.
The adoption of the Regulation 1060/2009 was a turning point for Europe. Before 2009, only a few countries had specific legislation for Rating Agencies. The Regulation set out for the first time common requirements for operating as Credit Rating Agency on the European Union, promoting integrity, responsibility, good governance and independence of rating activities. As stated by the regulators:
“Credit rating agencies are considered to have failed, first, to reflect early enough in their credit ratings the worsening market conditions, and second, to adjust their credit ratings in time following the deepening market crisis. The most appropriate manner in which to correct those failures is by measures relating to conflicts of interest, the quality of the credit ratings, the transparency and internal governance of the credit rating agencies, and the surveillance of the activities of the credit rating agencies".
ESMA is entrusted for monitoring agencies’ compliance with these requirements.
The new regulation
According to the regulation, to operate in Europe Rating Agencies must be registered by ESMA as CRA and officially listed as ECAI.
CRA stands for Credit Rating Agency. The registration takes place after examination of the requirements set out in Regulation 1060/2009. Agencies are required to publish updated information on their independence and avoidance of conflicts of interest, as well as on the services they provide, on the rating publication’s policies and remuneration, and on the code of conduct adopted.
The authorization automatically grants the status of ECAI (External Credit Assessment Institutions), which defines the institutions, other than banks and insurance companies, authorized to issue credit ratings. The registration as ECAI entails the publication of the mapping on the website of the European Banking Authority (EBA) and the certification of unsolicited rating quality.
Mapping means comparing the credit assessment scale adopted by the Rating Agency to the Credit Quality Steps defined by the European Commission. The mapping allows the standardization of the assessment, enhancing rating transparency.
Rating Agencies that issue both solicited and unsolicited ratings must also ensure equal quality level for both the typologies. The reason is simple: unsolicited ratings are based on public information only, unlike solicited ratings which include in the evaluation also private data and documents provided by the subject itself.
Credit Rating Agencies are also required to draw up a transparency report every year and to validate or review the methodologies used in rating issuance. ESMA, on the other side, supervises the registered entities (i.e. by analyzing complaints received by market participants).
In the event of breach of the CRA Regulation, ESMA has also the power to take enforcement actions, which may range from the imposition of fines to the withdrawal of registration.
Today's financial system
Compared to ten years ago, the current situation looks far brighter. Steve Eisman himself recently stated that the economic and financial system is sound and he doesn’t expect another big short. Moreover, the new financial technologies have allowed to automate most of the analysis procedures, reducing external interferences and probability of error. modefinance has been a pioneer in this field, becoming the first Fintech Rating Agency in Europe. But that's another story for another time.