Proposals Pending to Eliminate Ratings’ First Amendment Protection
The free speech provisions of the First Amendment currently protect rating agency opinions. Although in the past the agencies have been sued for ratings given to investments that did not meet stated objectives, the agencies have never been found liable. This is because the burden of proof is the same as for libel. The plaintiff must demonstrate malice. Suggested legislation, proposed rule changes by the SEC and pending court cases are challenging this protection.
By law, financial statements and disclosures must be factually accurate and complete. However, credit ratings have been exempt from this legal standard since 1981 by the SEC. Proponents of revoking this exception argue that the rating agencies should be held to the same standard and that liability will lead to more accurate ratings.
Opponents have four primary objections: First, the nature of the rating agency’s work is purely speculative and there will always be factors that are impossible to anticipate and will impact investment performance. Second, a rating is an opinion. A person has always been free to accept a rating or reject it. A prudent investor should use a rating as only one of several measures of risk.
Third, removing the protection would lead to extensive litigation that would place an undue burden on the ratings agencies. And finally, future ratings would be designed to avoid legal action and would likely be so indeterminate to pass legal review that they would be virtually useless.
S & P President’s Letter to the Editor
Interesting commentary from Deven Sharma, president of Standard and Poor’s. Say what you will about the rating agencies and their role in contributing to the credit crisis (we would agree with much of the finger pointing, although certainly not all of the blame goes to them), but he makes some good points about the REASON ratings should be used. More specifically, he makes the case that ratings should be used because the market finds value in them, not because government / regulatory language mandates it. Given the events of the past two years, institutions should be decreasing, not increasing, their reliance on ratings. And they should certainly have the choice to do so. Anything else, such as government mandated reliance on third-party ratings, presents a prime opportunity for poor assessment of the true value of securities (“market value” becomes misaligned with true economic value) – overstating market value when a security gets a “clean” bill of health and understating it when a security is downgraded to “junk” status. This again highlights the issue of why marking-to-market does not always represent true economic value for investors. Third-party ratings are a pervasive reason this misalignment exists! Check out some of the resources on this website to learn more about this disconnect and how third-party ratings contribute to it.
Why Rating Requirements Don’t Make Sense – StandardandPoors.com, January 19, 2010
Good News for Life Insurers
The insurance industry regulators have prevailed. The rule change is in effect and billions in capital has not been squandered. This common sense approach to capital measurements takes into account the economic value of a bond and its cost basis.
When determining the value of anything, isn’t what you paid for it important?
For example: If I paid $70 for a $100 face value bond, and I received $90 at maturity, is that good or bad? One correct answer is “it depends on what you were expecting….”
But the FACT that you received $20 more than you paid for it should count for something.
For Insurers, a $5 Billion Benefit – WSJ.com, January 15, 2010
NAIC Saves Capital
Well, they got it done.
The National Association of Insurance Commissioners saved an approximately $5B in industry capital by ignoring the NRSRO ratings and using a recognized 3rd party to evaluate mortgage backed securities. The NAIC understood that the rating only described the first dollar of loss, not the magnitude of loss, and that strict use of ratings would unnecessarily drain precious capital out of the industry at exactly when they could least afford it.
PIMCO was interviewed and hired, and they subsequently evaluated thousands of CUSIPs to make the MBS valuations for the industry before year end. This independent, third party, global, fixed income institution was employed to make valuations impartially and consistently across the industry.
Three cheers in the New Year for the NAIC. This is a textbook example of regulators using market resources to make regulation fair, appropriate and realistic.
Insurance Rule Adds Up to $5 Billion – WSJ.com, January 4, 2010
Is the Tide Turning?
While not directly related to ratings, which is the main topic of this blog, the article below discusses a key related issue: capital shortages at banks and their drag on lending. A revamp of the ratings system could actually help address this problem because a carefully crafted restructuring of the way securities are rated and a corresponding restructuring of how regulators use these ratings would increase regulatory capital at institutions. How? Under the current system, securities that are rated below investment grade are treated as entirely toxic and drain capital from the banks that own them. In many cases, only a small portion of these securities has been deemed uncollectible and therefore the entire security is not actually toxic. Designed correctly, a new ratings system and cohesive regulatory framework would treat only the portion of assets at risk of loss as “toxic” and therefore would not punish a bank’s capital levels for the collectible portion. The result would be a more accurate, reflective calculation of capital that would also increase capital at many banks as it relates to multi-obligor securities.
In the meantime, we can draw some solace from the fact that the White House is at least communicating that they are listening and are aware of the challenges imposed on banks that are keeping them from lending. The flipside is that at least up to this point it appears the White House has very little practical influence on regulators, who have a different point of view.
Obama Pledges Support for Small Banks to Spur Lending – Bloomberg.com, December 23, 2009
Will New Ratings Reforms Be Effective?
Filed under: The Rating Agencies, The Ratings System
The attached article talks about how the House recently made extensive progress towards eliminating all language from both laws and financial regulation rules that references rating agencies (NRSROs). The “system” will no longer depend on such agencies. These are the first steps of progress towards reform and are commendable. However, the real wood that needs to be chopped is determining what the new system will look like when it no longer relies on the agencies. This new system must consider many factors, but to ultimately be effective it must lead us to an economic value attached to the assets that are rated versus the simple “good” vs. “toxic” diagnosis that we currently have.
Here is the article:
One Cheer For Barney Frank – WSJ.com, December 23, 2009
A Good Idea
Representative Paul Kanjorski D-PA has proposed that the federal rule be dropped that requires credit ratings to determine what an asset is worth, and therefore determine capitalization. Representative Kanjorski’s intent is to distance the Federal Government from a de facto endorsement of ratings agencies’ work. In its own right, this is a worthy goal.
But dropping this rule, which dates from the Great Depression would have a far greater consequence. The unanswered question is: What will replace NRSRO ratings.
Although a good move, this rule change is still nibbling around the edges of the reform that’s needed at the ratings agencies. Until the business model is changed so securities issuers are no longer paying for their own ratings, the value of those ratings will be forever suspect.
It’s Time For Independence
The ratings agencies’ primary role is to serve as an independent and completely neutral evaluator of an investment’s risk. In the simplest sense, the agencies are the referees at the basketball game. And like the referees, their responsibility is to assure an honest and clean game for the thousands who have plunked down some hard earned cash and have “invested” in watching a game.
There are dozens of proposals being floated that are all meant to arrive at this independence without fundamentally changing the business model that has rating agencies being paid by the securities’ issuers. Possibly the most startling is a proposal to hold all ratings agencies jointly liable whenever any of them violate securities law—an effort to have them all police each other. It isn’t difficult to foresee the chaos—and litigation—that would quickly ensue.
Until you reverse the flow of money, until money flows from investors to the agencies — until the crowd or an independent third party pays the referees instead of the players — there can be no real confidence that this conflict of interest has been extinguished..
Don’t Put All Your Ratings in One Basket
Filed under: The Rating Agencies, The Ratings System
Regulatory over-reliance on ratings isn’t just a U.S. problem. As we have seen here in the U.S., using ratings as the ultimate measure of value is dangerous.
Ratings are too blunt a tool to measure economic value. It makes the ratings agencies the default arbiter of capital levels. The stakes are too high to use a single statistic measure.
ECB Must End Moody’s Veto on Greek Debt, Goldman Says – Bloomberg, December 18, 2009
Protection For Consumers Is Help For Us All
As much as we all hate bureaucracy and its associated expense, a “Consumer Financial Protection Agency” may be a good idea. Truth be told, there are many well-educated Americans who lack even a rudimentary understanding of finance. (A business executive was once overheard saying that he wasn’t going to refinance because he didn’t want to lose all that interest he had paid to his mortgage company). And there is a huge industry that is more than willing to exploit this lack of knowledge.
Unlike the FDA or the CPSC, however, the “CFPA” can do more than protect just consumers from dangerous products — or more often to protect consumers from themselves. By helping to assure upfront that debt instruments that eventually get packaged and sold as securities are solid, the CFPA will help us all.
Because the issuer rarely holds loans, we can no longer trust that the person writing the loan will thoroughly vet the applicant. These loan brokers have very little risk, so they have very little incentive to ensure the candidate is creditworthy. Instead they are more motivated to close as many loans as quickly as they can, regardless of quality.
Preventing the most dangerous loans from ever being made will help to ensure that the toxic loans that make regardless of quality us all sick never get into the system. Subsequently we can also have greater confidence in the rating agencies’ assessments. The consumer benefits directly, but we all benefit indirectly from a more reliable securities market.
