Congressional Hearing – Credit Rating Agency
Below is the summary and discussion draft for the Congressional hearing that will be held on September 30, 2009.
See section 7
Section-By-Section Credit Rating Agency Summary
Credit Rating Agency Discussion Draft
Goodbye, Ratings?
On CNBC two weeks ago, Congressman Barney Frank proposed to do away with bond ratings. At the time, it seemed like posturing.
Then it was announced that there will be a hearing for a Banking Sub-committee on September 30th. Among the listed discussion points are a full section on the removal of ratings from statutory references, as well as a draft bill.
The unintended consequences of this action are monumental. It seems impossible to “de-certify” NRSROs and remove ratings from the financial architecture altogether. Ratings are pervasive in the U.S. financial system from banking to insurance, from trust agreements to collateral agreements and investment policies. It is unimaginable to delete their usage.
Banking and Insurance regulators use ratings to evaluate credit quality. So my first question is, “What do the regulators think?”
I think trashing the ratings system seems extreme.
It seems to work for single-obligor securities.
Where the problem lies is in multi-obligor securities.
Let’s enhance and improve ratings for multi-obligor securities.
Let’s recognize what a rating reflects: the probability of default.
The rating is silent on the magnitude of loss.
The 100-year-old ratings system was never able to handle the multi-obligor nature of modern securitization. The inherent flaw in the system was only noticed when housing assets began to depreciate.
Securitization allows for the creation of credit, which enables our modern economy to function. We need to enhance ratings, not eliminate them. In the coming days, we’ll need to watch the hearings closely.
Please watch the video of Congressman Frank’s CNBC interview on 9-21-2009 where he initially put forth these projections:
The Government Is The Only Quick Way To Restore Faith
The implications of inaccurate bond ratings are enormous and will take decades, maybe generations to sort out. But the problem lies deeper than with the rating system.
Investors have lost faith in their paper. At the simplest level they agreed to loan money using a multi-obligor bond as a security. The investor does his due diligence and sees that the bond is rated as a safe investment by a credit risk agency. Then a while later the bond is downgraded and the investor is exposed to more risk than was agreed and a whole set of problems ensue for the investor: under-capitalization, devaluing of the bond, greater risk profile, etc.
But the worst is that the credibility of the issuer and the rating agency are made suspect. The fundamental trust upon which our financial system is based is compromised.
So how do we restore trust? The leap of faith that is integral to any business transaction now needs to be backed by a neutral third party.
Unfortunately the only entity large enough and with sufficient standing to back trillions in possibly toxic assets is the US government — not someone with whom you want to do business. But, do we have a choice?
One Bond, Many Obligors, So Where’s The Risk?
Intuitively you know that a multi-obligor security is a safer investment than a single-obligor. The risk of complete default is spread across hundreds of debtors, not just one. If one obligor fails, there are many others who are performing as agreed. Your loss is nominal.
Even if 15% of obligors flounder (which, on a nationwide average, is about the worst failure rate for home mortgages) you still have 85% performing. And in the case of bundled home mortgages or car loans, the foreclosed homes or reposed cars still have value. Not market value perhaps, but it is greater than zero. So in the worst case you haven’t even lost 15% of your investment.
So, why are multi-obligor securities being downgraded so ruthlessly?
It appears as though the issuers and ratings agencies have no clear idea what is in the multi-obligor bonds they respectively issued and rated. Hence they are downgrading the bonds to a point at which they are comfortable not knowing what is included in the multi-obligor bond. Their abundance of caution — now when it is too late — is causing a lot of pain for a lot of good people.
The Department of the Treasury Gets It
The Department of the Treasury released an 89-page “white paper” on June 30, which has since been updated on August 11. As we understand it, this is an administration paper. The section on regulatory reform is puzzling only because we are curious about who put it in there.
This section provides an exact and explicit distinction between single- and multiple-obligor securities. It tells credit ratings agencies to differentiate between single and multiple obligors, and fully disclose what the ratings mean/measure. It also instructs regulators to “reduce their use of credit ratings in regulations and supervisory practices” and to “recognize the potential differences in performance” between structured and unstructured products.
As you can imagine, we endorse the principles in this section.
Welcome to TheRatingsDebate.com
Performance Trust has spent the last 12 months working to educate various stakeholders in the legislative and executive branches of government about the practical implications of mark-to-market accounting. These efforts culminated in the public testimony by our CEO, Rich Berg before the House Banking Sub-Committee. Another significant effort has been directed towards the development of our blog, MarktoMarketDebate.com. Thanks to your participation, the blog has been a success, and has been used throughout the country to help the public understand the issues behind mark-to-market accounting. We applaud the new rules issued by the Financial Accounting Standards Board (FASB) that address the conflicts we presented in the blog and before Congress.
Today, the debate among financial institutions has shifted away from mark-to-market and toward use of ratings to assess risk. Currently, the House and Senate are reviewing proposed legislation that gives the Securities and Exchange Commission (SEC) more authority to oversee the NRSROs.
We believe the proper understanding of what ratings mean is an issue that needs similar attention.
In this blog, we will feature our perspectives on the ratings issue as well as related opinions and news. Most importantly, this site will invite debate and discussion from all quarters of our economy, and, ultimately, propose new solutions.
Want to help with solving the ratings issues? You can get this vitally important message out to others by TheRatingsDebate.com link on to all your legislative contacts and peers in banking and finance.
Together we can make a difference and help get our banking system and economy back on track.
Help us solve the inherent problems with the bond ratings infrastructure.
Search the site, watch the videos and read the opinions.
Get educated, and join the discussion.
Let the debate begin!
