Congress Commissions Ratings Study

As a compromise between the House wanting to abolish the mention of credit ratings in the Federal register, and the Senate, who tried to become MORE involved in the ratings process, Dodd-Frank (DONK) commissioned a study. The regulators have a year to study and report back to Congress about their use of NRSRO ratings.

We support Chairman Frank’s efforts to strike the reference and official use of ratings. Ratings can’t be corrupt and useless, AND be the source of regulatory measurement.

The study should model its answer on the NAIC solution to PMBS:

1. Ignore the rating
2. Find a reliable third party to price the assets
3.  Publish the results.

The NAIC has already solved the rating problem, and it works. Let’s just copy that.

Agencies Issue Advance Notice of Proposed Rulemaking… – Board of Governors of the Federal Reserve System, August 10, 2010

Buffett Testifies Before FCIC

Warren Buffett recently testified before the Financial Crisis Inquiry Commission (FCIC) alongside Raymond McDaniel, the CEO of Moody’s Corporation.

Apropos of the report that 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have now been downgraded below investment grade to junk status, the Commission asked Buffett what he thought of the provision in the bank reform bill that would regulate rating agencies.

Buffett responded that while he “hated” the current system, he wouldn’t go so far as to outright support the measure. “I don’t know the answer to that,” he said. “The wisdom of somebody picking out raters, is that going to be perfect? I don’t know.”

He added that, “When rating agencies come to Berkshire, they have me by the throat. I have no leverage whatsoever. If there were 10 agencies and I took the cheapest one, people would say ‘You took the cheapest, but they didn’t do the work,’ so it’s not an easy answer.”

Buffet’s testimony can be seen at: http://www.cspan.org/Watch/Media/2010/06/02/HP/A/33689/Financial+Crisis+Inquiry+Commission.aspx

Cuomo Suspects That Banks Lied to Ratings Agencies

On May 12, New York Attorney General Andrew Cuomo subpoenaed eight banks in an effort to discover whether they had intentionally misled rating agencies to inflate the grades of certain mortgage securities.

The banks involved are Goldman Sachs Group Inc., Morgan Stanley, UBS AG, Credit Suisse, Deutsche Bank AG, Citigroup Inc., Credit Agricole SA and Merrill Lynch & Co (recently acquired by Bank of America Corp.). The major ratings agencies, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, were also subpoenaed.

Since 2008, New York State and federal regulators have been looking into why the agencies gave top grades to subprime-mortgage backed securities and collateralized debt obligations that later fell dramatically in value.

Reportedly, Mr. Cuomo is also interested in learning why bank mortgage desks hired former rating agency analysts. He is examining whether the analysts’ experience and relationships at the rating agencies contribute to inflated ratings for these mortgage deals.

Data that banks provide to the ratings agencies to evaluate their securities is generally verified through third-party due diligence. It is not known whether these third parties will also be subpoenaed.

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?

Asian Ratings Agencies Suggested

Asian financial writers are challenging the new rating agency regulations being proposed by the Chairman of the Senate Banking Committee, Christopher Dodd (D-CT) and similar moves by European regulators. The writers argue that nothing is being done to address the fundamental conflict of interest inherent in the agencies’ business model.  The issuers of the bonds being rated also hire and pay the agencies.

They also note a second conflict of interest. The U.S. and other heavily indebted governments do not want to reform the credit rating agencies because of their own borrowing needs. They could be exposed to potentially expensive downgrades if “true” credit ratings become the industry standard.

Instead, given the vast U.S. and European government debt that is held by Japan, China, South Korea, India and other Asian countries, they argue that it is time that Asians created their own assessment of the true creditworthiness of Western nations.

This agency or agencies would effectively replace the existing three major American agencies.

The Asian countries have another worse option: Stop buying our bonds.

Taking the Road More Travelled

Shelby gives them a solution and they ignore it and report back in a year. So the Congressional solution to a regulatory failure is to let the same regulators study the problem and report back in a year if any changes need to be made.

Frank and Kanjorski had it right in the House version. De-recognize the NRSRO designation, strip the reference to ratings from the Federal Register, and let investors (and their advisors) bear the burden of due diligence.  If ratings are worthless without an NRSRO-mandated use, the ratings agencies will fold.

The capital markets are complicated and diverse. Millions of transactions a day defy static and specific rules. Let’s have less rules, more surveillance and prosecution. Enter the capital markets at your OWN RISK. If you expect the upside of an investment, you have to bear the downside. Ratings can’t be used as a substitute for personal due diligence.

House-Senate Talks Drop New Credit-Rating Rules – The New York Times, June 15, 2010

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

LeMieux Responds to Franken

The Al Franken amendment added more government involvement in the NRSRO space, and added a layer to getting a rating on a securitized asset. This will make credit more expensive and less available.

Thankfully there is  SA 3774, the LeMieux amendment that passed in the Senate,  which strips the references of ratings from the federal register. This mirrors the language in the House/Barney Frank Financial Reg. Reform bill, but should become effective now.

Completely removing reference like the House version helps, but then regulators shouldn’t hold financial institutions hostage to a discredited rating.

It is logically inconsistent for the ratings to be useless and the foundation of regulatory credit analysis.

[$$] The Credit Raters Brawl – WSJ.com, May 14, 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.

Greenspan: Rating Agencies Major Factor in Crisis

At a congressionally appointed panel investigating the causes of the financial crisis, Former Federal Reserve Chairman Alan Greenspan criticized credit rating agencies for doling out high marks to securitized subprime mortgages, inculpating them for their role in creating the current financial crisis.

“All I will say is what I can say for myself, [which] is that the ratings that were developed by the credit rating agencies were a major factor in the cause of the problems,” he told questioners.

Many fingers have been pointed at credit rating agencies for the top grades they assigned to securities based on subprime mortgages that then ran into repayment problems or defaulted.

However, this is a mistake. There were bad bonds and bad structures. But the rating system downgrades were driven by what the ratings measured: the first dollar cost. By the way, don’t investors bear some responsibility for their own investment decisions?

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