Shopping for Ratings

Good piece from the WSJ on how things have changed…or not…with regard to the conflict of interest that exists when the issuers are the ones that pay the fees of the rating agencies.  Whether ratings shopping, biases, etc. actually exist or not, the perception and possibility of this sort of behavior will always be present as long as the issuer pay system prevails.  A user pay system – where investors fit the bill for the ratings they use, not the issuer – removes all possibilities of this type of conduct. But is it viable as a commercial enterprise?

‘Ratings Shopping’ Lives as Congress Debates a Fix – Wall Street Journal, May 24, 2010

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.

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?

Corporate Scorecard Gets Green Light

Corporate Scorecard (CSC) has joined Australia’s credit ratings market after getting the official go-ahead from Australian Securities and Investment Commission (ASIC) to operate as a licensed credit rating agency.

The company joins Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as credit rating agencies licensed by ASIC. Says General Manager Brad Walters, “CSC has invested heavily in fulfilling all of the regulatory requirements and ongoing monitoring obligations.”

Corporate Scorecard is paid by clients such as governments, companies and investors to assess the risk of counterparties, rather than by issuers to rate the securities they are selling.

“Whether it’s a wholesale investor looking at a particular issuer, or a government department assessing a particular company, they are our client and so the remuneration line for us is direct to them,” said Walters. “Therefore, we don’t have that inherent conflict of interest of being paid by the issuer.”

CSC is the first Australian-owned credit rating agency to obtain an Australian Financial Services License to provide credit ratings. Operating at various levels within government and private sector, the company has been in business since 1987.

Hooray for the free market! A “new” rating agency, with a new pay model emerged from the wreckage. No government subsidy, legislation, government ownership was needed.

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

Ratings Agencies Take the Stand

Tune in to C-SPAN 2 to see the ratings agencies testify to the Financial Crisis Inquiry Commission.

Buffett wouldn’t voluntarily testify; he had to be subpoenaed.

With this many witnesses, expect lots of written/read testimony, some Congressional grandstanding and little discovery.

Here is the lineup (no pun intended):

Session 1: The Ratings Process

Eric Kolchinsky, Former Team Managing Director, U.S. Derivatives, Moody’s Investors Service

Jey Siegel, Former Team Managing Director, Moody’s Investors Service

Nicholas S. Weill, Group Managing Director, Moody’s Investors Service

Gary Witt, Former Team Managing Director, U.S. Derivatives, Moody’s Investors Service

Session 2: Credit Ratings and the Financial Crisis

Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway

(Mr. Buffett has elected to provide written testimony)

 Raymond W. McDaniel, Chairman and Chief Executive Officer, Moody’s Corporation

 Session 3: The Credit Rating Agency Business Model

Brian M. Clarkson, Former President and Chief Operating Officer, Moody’s Investors Service

Mark Froeba, Former Senior Vice President, U.S. Derivatives, Moody’s Investors Service

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

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