New Amendment Targets Rating Agencies

Senators Al Franken (D-MN), Charles Schumer (D-NY), Bill Nelson (D-FL) and Roger Wicker (R-MS) have proposed an amendment to dismantle the “issuer pays” model that rating agencies currently use. The amendment would establish a Credit Rating Agency Board that would arbitrarily choose which rating agency would rate an issuer’s debt.

Taking aim at what they call a “permanent conflict of interest,” proponents of the amendment argue that this would make it more impartial as well as open up competition to smaller firms. The bipartisan proposal has received widespread support, including the endorsement of the Consumers Union consumer advocate group.

The rating agencies have unanimously come out against the amendment. “We believe the benefits of the issuer-paid model, combined with appropriate regulation, can far outweigh any potential conflicts of interest,” said Standard & Poor’s spokesman Ed Sweeney.

This is a bad idea (how come every problem can be solved with more government?). The only guys in America who didn’t know or understand this conflict existed were Franken, Schumer, Wicker, and Nelson. The new Board name should be aligned with the usefulness of the idea: Credit Rating Agency Panel.

The Effects of Reform

So, after protecting ratings as a First Amendment opinion, Congress changed the 2300-page regulatory reform bill and exposed the raters to legal liability if the ratings don’t reflect an ultimate change in the price of the bonds, or a default (crank up the class action lawsuit machine…).

What does this mean? Can a bond holder sue an NRSRO if the market value of a bond declines after a downgrade?

It means that this chills the value of a rating, if it exposes the rater to monetary liability. It seems there is a loophole, however.

If the rating was not part of the submitted OS or documents submitted to the SEC, the rating would be legally exempted, since it was not officially part of the submitted deal documents.

This is a stupid, populist nod to the worst of Congressional impulses. AT BEST, it will raise the cost of credit, and make it less available. AT WORST, it will put lawyers in charge of credit allocation.

What’s next, broker/ dealer stock buy and sell ratings? Will realtors be subject to legal liability if a house depreciates after you buy it? Will Las Vegas odds makers be subject to legal action if the odds are wrong and you don’t win?

The only good news is municipal bonds would be exempt because they do not have to register with the SEC. 

Bond Sale? Don’t Quote Us, Request Credit Firms – WSJ.com, July 21, 2010

No New Business Model for Credit Rating Agencies

While both the House financial reform bill approved in December and the current Senate bill call for tighter regulation of credit rating agencies, critics are upset that neither improves on the “issuer pays” business model.

Because most of the agencies’ revenue comes from issuers of bonds and other debt that the agencies evaluate and rate, critics say this is an unacceptable conflict of interest — that ratings could too easily be tainted by business needs.

Congressional aides defended the bill, saying that the business model could not be changed without destroying the industry. The Senate bill is now on its way to the floor for debate and a final vote.

Let’s let the ratings agencies alone. You can’t legislate morality or virtue in a free market. If nobody trusts the NRSROs, the companies will cease to exist. Let’s let the market participants decide the usefulness of ratings, not Congressmen.

Financial Reform Bill May Skirt Debate

Senator Christopher Dodd (D-CT) is maneuvering the financial reform bill to go straight to a vote in late April without any floor debate. As the most ambitious financial reform proposal since the Great Depression, the move to ignore more than 400 proposed amendments has provoked criticism.

Republicans, who are traditional supporters of the free markets that would be adversely affected by many provisions in the bill, are in a difficult position. To fight the bill “on behalf of the banks” could result in voter backlash. There is widespread public support for strengthening banking regulations. To allow it to go forward without challenge would be to abandon their traditional supporters.

The bill is also open to opposition from some Democrats who don’t feel that new regulations are tough enough.

As for how the bill affects credit rating agencies, Senator Bob Corker (R-TN), a member of the Senate Banking Committee who has been working closely with Senator Dodd to craft the bill, commented that the proposed new regulations had not changed from Dodd’s original plan. He said that the bill placed a “pretty big liability burden” on the rating agencies. Generally, Republicans are opposed to this increased risk of litigation. They argue that it will result in frivolous and expensive lawsuits that would serve no good purpose. But the challenge remains:  How can they frame this debate without angering the voter base?

A History of Credit Ratings

Dennis Berman gets it right in today’s WSJ. We have institutionalized the use of credit ratings and mandated their use in regulation to the degree that it has been allowed to replace individual due diligence. It is convenient for individuals, fiduciaries and politicians to pile on the ratings agencies and attribute all sub optimal economic outcomes to the “incompetent” ratings agencies. Everybody has a scapegoat, and the power of the Federal government is bearing down hard on the NRSROs.

Berman makes a good case for knowing the history of ratings before we try and implement a solution.

We should also know what ratings measure. There is a huge gap between what a rating measures and what the general public (and Congress) thinks it measures. There is also a huge problem in using a single obligor ratings system in a multiple obligor security sector.

 We have two choices:

More government involvement (the Al Franken Plan): Otherwise known as the “how is that working out so far” solution…

Or

The  logical conclusion: De-certify the NRSRO designation, remove the references to ratings from the Federal statutes, and let caveat emptor rule.

If you don’t know what the credit “worthiness” of a bond of an asset is, don’t buy it. If you have an investment manager or a fiduciary representing your interests, it is their responsibility to understand underlying credit. This will let the market establish the usefulness of Credit Ratings Agencies and the concerns of ratings shopping without government involvement or any additional regulation.

We have to know the history of ratings, NRSROs and the mis-application of a ratings system architecture to a modern structured finance asset class. The Franken solution will raise the cost of capital and make it less available. The elimination of the NRSROs will let investors be responsible for their own decisions.

The Credit Raters: How We Got Here – Wall Street Journal, May 25, 2010

Standard & Poor’s Striving to Change Bill

McGraw-Hill, which owns Standard & Poor’s, wants to change language in a Senate financial overhaul bill. It believes the current language would put credit-rating companies at a disadvantage in court.

McGraw-Hill Executive Vice President Ted Smyth issued a statement Wednesday that said the bill “creates a discriminatory pleading standard for credit rating agencies, with many unintended consequences for the market.”

Smyth was referring specifically to the portion of the bill that would enable investors to take legal action against rating firms that “knowingly or recklessly” fail to conduct a reasonable investigation of a company when developing ratings.

Instead McGraw-Hill argues that a credit rating agency could be sued for failing to predict a bankruptcy, for example, that occurred without fraud while auditors, lawyers, bankers and equity analysts would have no liability. The firm wants the provision altered to remove with this discriminatory language and instead retain the agencies’ current liability standard that requires that fraud be present.

If we are trying to create a Full Employment Act for class action securities lawyers, this will do it. Can’t we just use a simple, elegant age-old solution? Fully disclose any conflicts of interest and then its caveat emptor.

Senator Reed Blasts Credit Rating Agencies

Bloomberg News obtained an email by a McGraw-Hill lobbyist urging Senators Bob Corker (R-TN) and Judd Gregg (R-NH) to come out against financial regulatory reform.

In response, Senate Banking Committee member Jack Reed (D-RI) said, “This cynical attempt by Wall Street lobbyists to kill Wall Street reform before it has a chance to see the light of day must be resoundingly rejected. Credit rating reform addresses one of the systemic failures that caused the financial crisis.”

High standards regarding negligence have until now protected rating agencies from lawsuits. But under Mr. Reed’s proposed “narrowly tailored” legislation, investors would be able to sue ratings agencies if they could prove they had “knowingly or recklessly failed to review key information in developing ratings.”

Current ‘reform’ measures for rating agencies will make the ratings worthless, as the rating opinion will be about the creditworthiness of the asset, and eluding legal liability. Ratings will all be warm, generic vanilla pudding.

Franken’s Progress?

The Franken amendment put the SEC in charge of assigning who rates what deal.

Is this progress?

Let’s use the system we have in place.

After all of the trouble and doubt we have been through, let’s have the investor be responsible for his investment decision. If the NRSROs are so corrupt, and the ratings so valueless, they will be out of business without government involvement.

This will guarantee a slowdown in credit creation and make it more expensive in the middle of a recession.

If we are trying to prevent “ratings shopping,” this isn’t the way to do it.

Is there any problem that can be solved without government intervention? ANY?

Senate Passes Plan Aimed at Eliminating Credit Rating Conflicts – Bloomberg, May 13, 2010

Trouble for NRSROs

Senate grandstanding by Levin aside, this does not help the NRSROs’ case.

The headline oversimplifies the story, but the truth is some NRSRO employees saw the conflict and worried about it, while some charged full steam ahead. This is ultimately a management problem. There are inherent potential conflicts of interest in a seller pays ratings model.

Everyone knows this. This horse has already left the barn.

It is impossible to legislate all capital market behavior. Regulation should be observational. We need to set up rules of conduct, keep a level playing field and referee the game, not become part of the game. It is bad public policy when government picks winners and losers.

This still does not address the completely under-reported part of the entire ratings debate: Doesn’t the buyer bear some responsibility for his own action? If you relied on the rating and didn’t do your own due diligence, who is to blame?

Lots of investors didn’t buy these complicated investments, despite the high yield and AAA rating.

Senate panel: Ratings agencies rolled over for Wall Street – McClatchy Newspapers, April 22, 2010

Chairman Frank Pledges Fix on NRSRO Language

NRSRO — the shorthand for credit rating agencies registered with the SEC — is currently in dispute, specifically with regards to the second letter. Until recently, the acronym stood for Nationally Recognized Statistical Rating Organization. But the Wall Street Reform and Consumer Protection Act, HR 4173, officially changed the second word from Recognized to Registered every place it appears in the Securities Act and Exchange Act.

Opponents of the change argue that it puts thousands of contracts in default and upsets many federal and state regulations.

Advocates, who include Chairman Barney Frank, support the change because they believe it prompts investors to employ a degree of judgment and not rely solely on ratings agencies.

Acknowledging that a considerable number of states and private institutions have the old language in their statues, Frank is meeting with various state and agencies to find a legislative fix.

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