Credit Default Swap Spreads as Viable Substitutes for Credit Ratings
In response to the recent financial crisis, commentators have criticized certain credit rating agencies, known as Nationally Recognized Statistical Rating Organizations (NRSROs), and credit default swaps (CDSs). Regulators have proposed a range of reforms in both areas but have not considered the links between them. This Article considers one potential link: whether CDS markets could play a role in financial reform related to NRSROs.
More specifically, one set of proposals suggests that legislators and regulators reduce the dysfunctional incentives associated with overreliance on NRSRO credit ratings. Although there is support for this proposal in theory, one objection forestalling reform has been that, notwithstanding the problems associated with credit rating agencies, there do not appear to be viable substitutes for credit ratings. Indeed, ongoing skepticism and criticism about CDS markets has reinforced the objection. In simple terms, the objection is that regulators and investors should not replace one broken system (credit ratings) with another broken system (CDSs).
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Brian T. Fitzpatrick
Donald C. Langevoort