Rating the raters

For years, the major credit rating agencies – Moody’s, Fitch and Standard & Poor’s – have been the quasi-official gatekeepers of high finance. In the wake of the subprime debacle, however, a growing number of investors and regulators on both sides of the Atlantic are arguing that someone should be keeping an eye on these gatekeepers.

Critics say the rating agencies significantly contributed to the existing credit crunch by ‘falling asleep at the wheel’ and giving AAA ratings denoting relative safety to packages of securitized home loans that were in fact very risky.

It wasn’t just high-flying financiers who lost money when those home loans went into foreclosure. Entities such as pension funds and insurance companies have long relied on the supposedly neutral ratings system to choose conservative investments. They lost billions during the crisis, and those losses spilled over to affect the regular man and woman on the street.

The hand-wringing that followed has shone the spotlight of media and regulatory attention on a previously obscure and little-understood area of the markets. Many investors do not like what they’re seeing. Complaints about the ratings industry range from a lack of competition – the three major agencies have long dominated the field – to concerns about transparency and even the very methods the agencies rely on to rate securities, but it is revelations over conflicts of interest that are generating perhaps the loudest outcry.

In many cases, the rating agencies were paid for their work by the very companies whose securities they were examining. In some cases, they were collecting lucrative consulting fees from these companies to advise them on the deals. They also had a stake in the growth of exotic securities: as the market for these vehicles ballooned in recent years, so too did the number of securities the rating agencies were paid to rate – and the profits they took home as a result.

A permanent shift in attitude

SEC chairman Christopher Cox said recently of the rating agencies controversy: ‘Events of recent months have galvanized regulators and policy-makers not only in this country but also around the world to reexamine every aspect of the regulatory framework governing credit rating agencies.’

In June the SEC unveiled a series of proposals aimed at increasing transparency, creating more competition among the rating agencies and encouraging investors to find alternate means to evaluate new security offerings. These proposals also would prohibit the agencies from consulting on deals they plan to evaluate, and would ban gifts worth more than $25 from clients.

Tougher rules ahead

Most notably, perhaps, the SEC is proposing to rewrite regulations that require the $3.4 trillion US money market industry to consider credit ratings when investing in short-term debt.

‘Credit ratings have become a crutch,’ SEC commissioner Paul Atkins says. ‘Credit ratings are opinions. They are not a substitute for investors making informed decisions.’

Many officials in Europe want solutions that go far beyond what the SEC is proposing, however. They want to license the agencies themselves and replace the EU’s traditional means of influencing the agencies – a voluntary code of conduct issued by the International Organization of Securities Commissions (IOSCO) – with mandatory rules. Under this plan, EU regulators would have the power to supervise the internal procedures of the companies themselves.

‘A regulatory solution at the European level is now necessary to deal with some of the core issues,’ the EU’s internal market commissioner, Charlie McCreevy of Ireland, said in Brussels last month, following the SEC meetings on the problem.

McCreevy promised to unveil proposals in October that would implement an ‘external oversight regime whereby the European regulators will supervise the policies and procedures.’

Some say the emerging proposals already highlight fundamental philosophical differences over the role governments should play in regulating markets. A battle is shaping up between regulators in the US and Britain on one side and EU regulators on the other, pushed by the French, the Germans and Italians.

Others say the SEC might also tinker with the way the rating agencies do their business, if congressional legislation expands their regulatory authority.

Whatever the case, few are denying one stark fact: regulators have failed to keep pace with the dramatic growth in clout and importance of the rating agencies in recent decades, and that failure lies at the core of the current credit crunch.

For his part, McCreevy has not yet laid out specific proposals to address the conflicts of interest. In a speech in June, however, he called for ‘robust firewalls’ between rating agency executives in charge of increasing earnings and those doing the ratings.

McCreevy dismissed the IOSCO code of conduct as a ‘toothless wonder,’ and said efforts by the agencies to regulate themselves were insufficient. ‘No supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up,’ he said.

Still, some critics contend neither solution will solve the problem unless the entire issuer-pays model is scrapped. Joshua Rosner, managing director of Graham Fisher & Company, a New York investment research firm, and one of the few to warn of the subprime debacle, says a company can simply cut off a rating agency if it feels an unfavorable opinion is about to be issued.

Just this past spring, for instance, Fitch appeared to be taking a more aggressive stance on both Ambac and MBIA. When MBIA (in early April) and Ambac (in June) found out Fitch was likely to downgrade them, they asked the company to stop their ratings. ‘Fitch had to return all the documents on which the ratings were based and the companies said they would provide no further information,’ Rosner says.

Encouraging competition

White contends the solution lies in loosening regulations on the books of insurance, pension, state and federal regulators requiring ratings. ‘Once we have the end of that outsourcing of decisions, the end of that mandated attention, the bond markets will make up their own mind,’ he says. ‘Who has a good track record? Who has a conflict of interest?’

The SEC took a step in that direction during its third meeting on the subject in June, continuing a trend toward increasing competition. 

The fallout for rating agencies after the collapse of Enron, caused because the three major agencies maintained investment-grade ratings on Enron’s bonds until less than a week before it filed for bankruptcy, led to a series of hearings on Capitol Hill. Congress began pressuring the SEC to increase competition by recognizing new rating agencies.

Since that scrutiny began, the SEC has expanded the number of licensed rating firms from just three to nine. In 2006 President George Bush signed a bill that directed the SEC to issue regulations on licensing new rating agencies. But the latest troubles have prompted the SEC to expand competition even further and to modify the rules that require certain institutions to rely on ratings. ‘Over the last three decades, we have embedded [the use] of credit ratings into our rule books,’ Atkins explained at one SEC meeting. ‘Recent events have awakened us to the unintended consequences of our behaviors.’

At the meeting, SEC staffers appearing before the commission said they had identified some 44 rules and forms referencing credit rating agencies and recommended eliminating any mention of those agencies in 11 of the rules, changing the wording to allow investors to seek alternative means of achieving due diligence requirements in 27 rules and leaving the language unchanged in just six.

Holding the board responsible

Among the most significant proposed changes is a measure that would allow US money market funds to buy short-term debt without considering the ratings, instead requiring a money market fund’s board of directors to determine that each security ‘presents minimal credit risks’ and is ‘sufficiently liquid to meet reasonably foreseeable redemptions.’ No more than 10 percent of investments could be held in illiquid securities.

Other regulations would allow, in some cases, investment advisers that are currently required to rely on ratings before green-lighting some transactions to make their own assessments of whether a security meets specific credit and liquidity requirements.

Jerome Fons, a former managing director of Moody’s Investor Service and principal at the investment consultancy Fons Risk Solutions of New York, was harshly critical of the SEC’s proposals to deal with conflicts of interest, telling reporters that he was ‘not convinced there is any real desire to drastically reform or remake the industry.’

After the competitive proposals, however, Fons says he was almost eating his words. ‘If they go through with these proposals, it’s the right direction,’ he asserts. ‘I think this will improve the competitive landscape, and if somebody with a better mousetrap comes along, the market will be the decider.’

Rosner maintains that increased competition cannot possibly solve the problem, however. Many investors, he believes, will continue to rely on the rating agencies, because ‘you have time constraints on whether to participate or not in a deal; investors don’t have time to look for reams of data.

‘It will take every country’s bank supervisors, every state’s insurance commissioners and every nation’s pension supervisors to achieve a global reduction in the use of ratings,’ Rosner says. ‘It’s an admirable goal, but I don’t think it can be achieved in the short term.’

What is really needed, according to Rosner, is legislation that would change the way the rating agencies operate. When the rating agencies find a structured finance model is not working, for instance, they change the model but do not go back and re-rate securities graded under the old models. ‘At this point there is no indication that the US is understanding the issue deeply enough,’ Rosner says.

McCreevy’s proposals might delve deeper, but Fons too is skeptical that the solutions currently under discussion will in fact solve the problems. ‘The most drastic thing anyone could do would be to outlaw the issuer-pays business model, but I don’t think anyone is doing this,’ he says. ‘That’s not even on the table.’