What roles do credit rating agencies typically play before the outbreak of a crisis?

That's an excellent question. Many people find rating agencies quite mysterious. Before financial crises (like the one in 2008), they weren't mere bystanders; they were deeply involved, playing several crucial, yet ultimately problematic, roles.

You can think of rating agencies as "financial product quality inspectors." For instance, if a bank bundles a large number of mortgages into a new product and sells it to you, you certainly can't research the quality of every single loan within it, right? That's where rating agencies come in. They "inspect" it for you and assign a rating to the product, such as AAA (the highest, representing extreme safety) or CCC (junk grade, indicating very high risk).

Before the crisis erupted, they primarily played the following roles:

1. "Gatekeepers" and "Passport Issuers"

Many large institutional investors, such as pension funds and insurance companies, had internal mandates to "only buy highly-rated products." In other words, if a financial product didn't have a high rating like AAA or AA, it simply couldn't enter the portfolios of these major investors.

Thus, rating agencies became the "gatekeepers." The high ratings they issued acted like a "golden passport," allowing complex financial products to be smoothly sold to the wealthiest and most conservative buyers in the market.

2. "Translators" of Complex Products

Financial innovation before the crisis spawned a dazzling array of products (like the infamous CDOs), whose structures were so complex that even their designers might not have fully understood them.

The role of rating agencies was to translate these "heavenly books" (unintelligible to ordinary people) into a simple letter grade. Investors would see, "Oh, it's AAA-rated, that must be the safest," and then confidently buy. They trusted that the rating agencies had already done the most difficult analytical work for them. This significantly lowered the barrier to investment and allowed these complex products to be sold in greater volumes and at a faster pace.

3. "Fueling Stations" under Conflict of Interest

This was the most critical issue. Who paid the rating agencies? Not the investors buying the products, but the banks that designed and issued these products (i.e., the "sellers").

This is akin to an athlete participating in a competition, and the referee's salary is paid by that very athlete. Do you think the referee would be more inclined to give him a high score?

Before the crisis, Wall Street banks needed good ratings from agencies to sell off their bundled loans. Rating agencies, vying for the business of these major clients (rating fees were substantial), also had an incentive to relax their standards and issue inflated ratings. This "issuer-pays" model led to severe conflicts of interest, transforming rating agencies from neutral "referees" into "cheerleaders" for risky assets.

4. "Amplifiers" of Market Euphoria

When the market was flooded with a large volume of AAA-rated products, it created an illusion for everyone that "all was well and risks were low."

• Investors thought: "With so many AAA-rated products, we can buy them with our eyes closed."
• Banks thought: "Since they sell so well, let's issue more loans and bundle more products."
• Regulators might also have lowered their guard as a result.

The high ratings issued by agencies were like adding fuel to the fire of market euphoria, causing the bubble to inflate further. They failed to act as a "brake" and instead became the "accelerator."

In summary:

Before the crisis, rating agencies were supposed to be honest and reliable "risk alarm bells." However, due to conflicts of interest in their business model and the overall market optimism, they effectively acted as "packagers" of risk, "salespeople" for complex products, and "catalysts" for market bubbles. Not only did they fail to detect and warn of risks in advance, but they largely contributed to creating the conditions for the crisis.