EU Moves to Regulate the Rating Agencies; SEC Should Follow Suit

It’s about time. European regulators have at last proposed rules to prevent the rating agencies (perhaps the biggest villains of this whole credit crackup, in my view) from ever again helping drive the global financial system into the abyss. Not a moment too soon! The rules aren’t perfect, but they’re a good start.   

Under the plan, ratings agencies will fall under the direct supervision of EU regulators, and won’t be allowed to provide consulting services to issuers who also pay them to provide ratings. Agencies would also have to appoint outside experts, who wouldn’t be paid based on the company profitability, and couldn’t be fired.

Best of all, the agencies would no longer be allowed to claim their ratings are mere “opinions,” so that they might be held liable for their own misconduct or incompetence. 

Good—as far as it goes. But I’d go farther. For one thing, I’d ban the inclusion of “ratings triggers” in credit agreements, and would declare existing triggers unenforceable. That way, ratings downgrades (which, as we’ve seen lately, can be highly arbitrary and capricious) wouldn’t have the potential to send a company into a sudden financial tailspin for no reason.

But there’s an even simpler way to fix the rating-agency problem, I believe: get rid of credit ratings altogether. Let fixed-income investors do their own research, just the way equity investors do. If fixed-income types hadn’t relied on the ratings crutch in the first place, this whole credit crackup wouldn’t have gotten so out of hand.   

Anyway, good for the EU. The SEC needs to do something similar.

Comments

[PerkyPixieJMU:]

So many thoughts racing around in my head right now I don’t know where to start.

But…
1. Awesome idea about banning “ratings triggers” from credit agreements. Extend that to all federal, state and local laws and any other legal document?

2. As far as I know, I'm a big fan of unsolicited credit ratings. Scary to me: McCreevy makes unsolicited ratings sound like the devil. Not only does he suggest that unsolicited ratings are based off of less comprehensive, or essentially unreliable, unchecked, unverifiable or possibly false, information (umm…S&P and Moody’s sure did issue a lot of terribly inaccurate solicited ratings over the past few years), but his proposal would discount the validity of unsolicited ratings by requiring that they “have a different rating category.” On one hand, I do understand the perceived value of making sure that (unsophisticated) investors are aware that a particular rating was published without the permission of the issuer. On the other hand, can we say barrier to entry (and I don’t even need to bring up Egan-Jones, shiver, which is so very vocal about how it, without receiving any information from Enron, spotted problems with the company months before the it went down the toilet)?! I really think the better way to deal with the “problem” of unsolicited ratings is to follow the SEC’s proposal to require the public availability of all information an NRSRO uses to develop a rating. Yes, there are pitfalls to that, too, but come on! :) It would totally foster competition, just like Congress mandated in 2006. Information is power!

3. And finally, it would be a bitter pill to swallow for nearly everyone, and it would probably create a far more inefficient market, but it would be great if there were no such thing as a credit rating agency. The fact is, though, we need them for some reason or another.

My (simplistic and idealistic) solution:

I. Identify and fine guilty individuals from all parts of the industry: those who lied on their mortgage applications, underwriters, issuers, credit rating agencies and institutional investors (who didn’t do their due diligence).

II. Abolish the term “NRSRO” and begin removing all references of credit ratings, “NRSRO” and “investment grade” (and any other similar term) from all legal documents (or at least government rules and regs).

III. Establish an independent, private organization (like the PCAOB?) to develop accuracy standards (relating to historical default rates or rating migration statistics, etc.) that any rating agency would have to measure up to in order to be “in the club,” granted that this would be an entirely voluntary “club.” If a rating agency doesn’t agree with the organization’s policies, the agency doesn’t have to join, simple as that. And perhaps one of the organization’s policies could be that when one of its rating agency members issues a rating, the agency has to publicly disclose all of the information it used in determining the rating.

IV. If pension funds and investment management companies wanted to pool their resources to pay for their own private “rating agency,” that would be super awesome, too.

I know, I know. A majority of people says credit rating agencies are financial gatekeepers and should therefore be heavily regulated. Yes, they have come to be gatekeepers. I really feel like we’re sending investors mixed messages: “credit rating agencies must be held liable because the public counts on them!….but you (the public, and more specifically any institutional investor) are forbidden from relying on their ratings.”

It’s just a tricky situation (shrugs shoulders).

2008 Nov 14 10:26 PM

[Rick Dugan:]

I have to agree that the current rating system in the U.S. has virtually no predictive power and that the EU is taking a great approach, but the further recommended steps in this article are impractical and misdirected, for the following reasons:

1. The rating agencies were not the ones who caused companies to become over-levered, make bad investment decisions, sell uncompetitive products or services, etc. Most of the companies in question were in financial peril long before they were downgraded (and in fact, that is the biggest problem with the current system).

2. The companies that accepted ratings triggers were big boys who knew the consequences of downgrades and nonetheless managed their businesses poorly enough to receive them (see 1. above). Creditors have a right to build reasonable protections into lending agreements. While imperfect at best, credit ratings provide an independent means of ascertaining likely repayment risk and relative financial health.

Nobody would argue with the fact that rating agencies are very late messengers, but shooting the messenger is not going to fix the real underlying problem, which is poorly managed companies.

2008 Dec 31 09:39 AM

[oldlures1:]

I sure wish this notion could get legs; be more visible. However, at this juncture, I'm afraid the rating agencies are going to get off scott free. They've torched the stage, and extited stage left without anyone realizing it!

Jan 20 06:37 PM