Rating the Raters


New York—Rating agencies are under the gun again, and this time they will have difficulty dodging the bullet.  After Enron, ratings agencies were low on the list of culprits, and the ill effects on their operations were negligible.  Now, with the sub-prime meltdown, the ratings firms will be high on the legislative agenda.  And, given the global impact of the crisis, ratings agencies will be battling regulatory initiatives on three continents.

After the collapse of the tech bubble in 2000, the focus was on corporate governance (SarBox in 2002) and analyst conflicts (Global Research Settlement in 2003).  Rating agencies were an afterthought, yielding The Credit Rating Reform Act of 2006 in September of last year.  The legislation was intended to stimulate competition by lowering regulatory barriers to entry which the SEC had inadvertently created in its NRSRO regulation.  The markets greeted this legislation with a yawn, figuring that the formidable market barriers to entry—in the form of market share, global franchises and brand recognition—would make direct competition difficult.  Stock in Moody’s and McGraw-Hill (parent of Standard & Poor’s) sailed to new highs.

Less than prime ratings

What a difference a year makes.  The ratings agencies are now in the bright glare of the media for their role in facilitating the wide-spread securitization of sub-prime debt.  One of the more transparent areas of ratings agencies is the criteria they use to rate debt, and consequently there is an ‘audit trail’ on the standards they used to rate CDOs and other structures which incorporate sub-prime debt.  The WSJ examined in depth one facet, so called “piggyback mortgages” which effectively eliminate down payments by allowing borrowers to take out a second loan for the down payment at the same time they are getting a mortgage.  The ratings agency track record is not good—initially viewing piggyback mortgages as having a similar default risk to regular mortgages.  Worse, after finding in 2006 that piggybacks were 43% more likely to default (surprise!) they tightened their criteria for future CDOs in April 2006 but did not revise their ratings on existing CDOs previously rated under what was now flawed criteria.  Piggybacks are only part of the subprime story and as scrutiny increases, additional criteria issues will come out.

Over a year later after the revised criteria on piggybacks, on July 10, the ratings agencies acted.  And they acted in concert—an aspect which will also invite scrutiny.  Moody’s cut ratings on more than 400 securities that were based on subprime loans. S&P put 612 on review, and downgraded most two days later.   Unfortunately these downgrades are only a small fraction of the outstanding CDO debt, so further downgrades are likely.

Consequences in the US

The full consequences of the subprime crisis won’t be clear until the crisis fully plays out but the signs are not good for the ratings agencies.  In the US, both Senate Banking and House Financial Services have scheduled fall hearings.  Senator Chris Dodd (D-CT), chairman of Senate Banking (and presidential candidate), castigated the agencies in a press conference on Monday.  Barney Frank (D-MA) has scheduled hearings in October.  The hearings will be no picnic.  Even in June, during SEC Chairman Cox’s visits to the Hill, ratings agencies were the subject of pointed questions from democrats and republicans (such as Senator Richard Shelby (R-AL)).

The hearings will result in legislation.  There are different approaches under discussion.  One approach which would be to release the trial lawyer hounds on the ratings agencies by weakening or removing their liability protections.  This would appeal to Democrats.  Another approach that is being discussed is to roll back to the pre-1970 situation, when credit rating agencies were lowly independent research companies who sold subscription services rather than accepting payments from the firms that they rated.  A related reform that is being proposed is the removal of credit rating agencies from the regulatory treatment of institutional investors.  Neither of these latter approaches would be easy to implement, but they reflect depth of feelings within Congress.  Congressional staff on both sides of the aisle feel that previous legislation didn’t work (even though it is less than a year old) and something more serious is required.

And it’s no better outside the US…     

 The EU, which after the tech bubble allowed the ratings agencies to implement a voluntary code of conduct, is also likely to legislate.   The EU’s leading regulator, Internal Market Commissioner Charlie McCreevy, has swung into action.  McCreevy has reportedly invited securities regulators from across Europe to a meeting next month to discuss rating agencies and the recent problems.  He had said he wanted to give the voluntary code time to prove itself but the U.S. subprime meltdown has highlighted some weaknesses.  He’s expected to decide on whether to propose new legislation sometime in 2008.  European sentiment is also running strong.  The FT quotes an unnamed EU Commission official as saying, “If the rating agencies believe this is going to be business as usual, they are very wrong.”

Even India is in the act.  A recent article in the New Delhi Business Standard calls for legislation of ratings agencies: “[Rating agency] reforms are particularly pertinent in India, where it is now practically impossible to do a primary issue of a bond without the involvement of a credit rating agency. Fees to credit rating agencies have become akin to a tax. Infosys has zero debt, and its first Rs 1,000 crore bond issue should surely face a good market in a rational world without any credit rating. It is better to trust the processes of the competitive and speculative market, rather than trying to install a set of government-supported profit-making gatekeepers.”

The rating agencies have been regulatory Houdinis—managing to remain largely unregulated despite numerous attempts to impose regulation.  The subprime market may be the blow that brings them down, but, as with Houdini, the effect of the impact will have to play out a bit further.


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