Because ratings now provided a regulatory license, they were especially valuable to issuers. Rating agencies monetized this regulatory power by charging issuers for ratings instead of selling them to investors.
The unintended consequence was the phenomenon of “ratings shopping” in which issuers pitted rating agencies against one another to win rating mandates through lower standards. This was exacerbated by a less obvious unintended consequence of regulation, which is that it stunted the growth of alternative credit analysis providers who found it more difficult to sell their services to fixed income investors, given the availability of issuer-paid credit ratings at no out-of-pocket cost. In other words, companies that might have provided more accurate ratings were crowded out by the regulatory privileges created by NRSRO status.
Far from protecting investors, the regulatory privileges given to NRSROs made it more difficult for investors to understand the true risks of bonds, with far-reaching consequences. This became apparent during the great financial crisis when it emerged that from the early 2000s NRSROs had assigned inflated ratings to thousands of Residential Mortgage Backed Securities (RMBS) as well as derivative instruments such as Collateralized Debt Obligations (CDOs). The lenient ratings attracted excessive mortgage finance capital that exacerbated a home price bubble—and a wider asset price bubble. It was the bursting of this bubble that triggered the Great Recession of 2007–2009.
Reason Foundation
February 27, 2018
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