Wednesday, the SEC continued its piecemeal approach to dealing with offshoots of 2008’s financial crisis, passing new rules on credit-ratings agencies in a 3-2 vote. In our view, this latest rater reform is a small positive, but it doesn’t really address the principal issues. It also isn’t the surefire safety device some claim. Talk of this rule “protecting investors” is likely as much puffery as the raters’ opinions themselves.
The raters, 10 firms technically called Nationally Recognized Statistical Ratings Organizations (NRSROs), letter-grade bonds based on the likelihood an issuer defaults.[i] Many might recognize them from recent hits like, “INSERT RATER HERE Cuts Argentina to CCC- on Supreme Court Decision.” Or, for those recalling 2011, “CERTAIN RATER Strips US of Top Credit Rating.” Or REDACTED RATER That Downgraded US Credit Rating Sued by US, But Certainly Not for Downgrading US, Says Government. Sovereign ratings grab most headlines, but they aren’t the lion’s share of raters’ business. Municipal, structured and corporate ratings dominate, and unlike most sovereigns, they pay NRSROs for their rating.
In the sovereign market, issuer ratings are usually considered “in the general public’s interest,” so they’re free (whee!). But corporations and municipalities pay the rater, creating a potential conflict of interest, since raters could theoretically compete on two major fronts:
The new rules are motivated by accusations raters often used option 2, boosting profits by luring more business. Pre-2008, that business happened to be bank-issued securitized debt. Inflated ratings make more of these assets investible for banks and other investors with ratings requirements. (More on that in a moment.) In seeking more businesses, some claim, the NRSROs played fast and loose with high grades.
Cue the reform efforts. Dodd-Frank correctly saw issues with raters and contained two separate (and conflicting) passages seeking to address them. Both mandated new rules varying in reach. A bipartisan effort separately sought to go further and create a government panel selecting the agencies that rate a new issue.[ii] Others have been, shall we say, less extreme? Wednesday’s rules likely make those folks fairly happy.
Here’s SEC Chair Mary Jo White:
This expansive package of reforms will strengthen the overall quality of credit ratings, enhance the transparency of credit-rating agencies and increase their accountability. Today’s reforms will help protect investors and markets against a repeat of the conduct and practices that were central to the financial crisis.
To some extent, we agree. Contained in the fact sheet’s 18 pages are 60 bullet points[iii] describing increased disclosure requirements for methodology and other matters, reporting to the government, oversight, training and education programs, and a rule requiring NRSROs to separate marketing and ratings analysis.[iv] They’re also supposed to install a look-back where they review their own work, giving themselves a gold star if they passed or smacking themselves on the wrists if conflicts of interest arose.
The good part? Disclosure requirements. Assuming they’re properly implemented (scheduled for January 1, 2015), investors may get a peek at how a rater determined a rating, and any potential conflicts. Disclosure is good for investors. The reporting may be too, but the jury is out. However the issuer-pays business model remains. And, as Fitch’s July press release on the parent company of a fellow NRSRO shows, that could lead to an upgrade! Hooray!
The industry needn’t operate this way. The moniker NRSRO is not just a snappy name the industry cooked up for marketing purposes, it’s a legal definition. Ratings agencies have a long history, with Moody’s and S&P dating back to the early 20th century. Then, they operated on an investor pays model. If investors valued a rating, they paid for it. In 1936, responding to bank failures the government blamed (wrongly) on speculative investing, regulators required banks to buy securities rated highly by one of these long existing bodies. The NRSRO designation followed in 1975, when these rules were expanded and formalized. Around the same time, the issuer-pays model took root.
It isn’t as though no one saw issues before 2008. After the Enron / Worldcom debacles in 2001 and 2002, many talked of reforming credit raters who’d completely missed these frauds, keeping them highly rated days before their demise. They were symbolically flogged in 2002’s Sarbanes-Oxley Act, which required an annual report on the industry to the SEC. 2006 brought the Credit Rating Agency Reform Act, seeking to eliminate conflicts of interest Congress believed caused these oversights (among other alleged things). It sought increased competition through the SEC expanding the ratings universe to include a couple more firms. Which seems to have worked smashingly.
To be clear, the raters were not the cause of 2008’s financial panic. Mark-to-market accounting and the government’s bizarre, unpredictable response did that. But they played a role, both by maintaining too-lofty ratings on securitized assets and eventually lowering them amid panic, forcing banks to fire-sell illiquid assets. In our view, however, history shows the fix is not necessarily adding bullet points to the regulatory code. But rather, pressing “delete” on the NRSRO designation and the issuer-pays model. What would remain? A model in which investors pay for ratings they value. Seem far-fetched? Look at stocks.
[i] There are technically 10, but we dare you to name more than three. Without googling! Or binging! (If that’s really a thing.)
[ii] It’s odd, in our view, that this bill only addresses Wall Street issuance. After all, umm, Enron? The raters didn’t catch them either. Even odder, the bill is titled, the Restore Integrity to Credit Ratings amendment. Which again, Enron.
[iv] Actually, this only applies to the big three raters, S&P, Moody’s and Fitch. The smaller seven needn’t separate even under the new rules. Finally, shouldn’t this have always been the case?