How to Reform the Credit Rating Agencies

This week Congress is holding hearings on various new proposals to reform the credit rating agencies. In their sights are Moody’s (MCO), Standard & Poor’s (MHP) and Fitch Ratings, Inc. which all played a large role in the housing bubble by assigning AAA ratings - their highest marks - to securities that included subprime loans. The ratings were paid for by Wall Street and allowed traders to buy and sell these securities as well as value them at highly inflated prices, thus earning huge cash bonuses. In actuality, banks were taking incredible amounts of risk and inevitably were forced to write down losses, eventually causing banks to fail and federal bailouts to ensue.

Several whistleblowers testified and told Congress that behind the closed doors at the ratings agencies, analysts thought either the sub-prime laden securities were worthless or too complex to assign ratings, but were told to assign AAA ratings nonetheless in order to keep Wall Street’s money pouring in.

The ratings agency scandal is not unlike the conflicted stock analyst scandal of the dot com era. Again, Wall Street investment banking interest influenced research so that it was impractically positive in order to move securities. Back then it was IPO shares. Congress took up that issue as well and high-flying technology analyst Jack Grubman testified.

To be sure, conflicted equity research is still a major problem on Wall Street, but reform did manage to shut down the overt conflicts of interest. The lesson we can learn from that scandal is that in order to institute real reform, you have to follow the money trail: Once investment banking and IPO underwriting revenue was removed as part of an analyst’s performance measurement, the practice of inflating research was eliminated (or at least hidden behind closed doors).

Moreover, the introduction of smaller independent research firms to the market which could compete with bulge bracket research was supposed to further level the playing field. The concept was correct, however, regulators didn’t effectively implement it, which is why Wall Street research continues to misinform retail investors.

I bring up old history for this reason: In typical Washington fashion all sorts of “creative” and confusing solutions have been introduced to reform the ratings agencies. Some in Congress are suggesting a joint liability scheme where if one ratings agency is sued and cannot pay investor restitution, then other ratings agencies will be forced to pick up the tab. This would presumably force all three to improve performance. But experts suggest this will have the opposite affect. Creating a situation where one rating agency would be insured for its bad performance by the others.

Another idea is to have “rotating raters.” Marketwatch.com describes this as having

every tenth debt security produced by a corporation be subject to a second produced by a random rater…

or

seek to surprise raters and issuers by having every tenth security produced by all the ratings shops be subject to a back-up rating.

Say what?

If I understand these proposals correctly (and who could blame me if I don’t) these are simply tweaks to the current system and add unnecessary complexity. A much more broad reform package is necessary and, once again, Congress need only to follow the money.

Regulators should explore halting the practice of allowing the corporation or issuer to pay for the rating. It’s a classic conflict of interest. Typically a corporation can get a “preliminary” rating from one ratings agency and if they don’t like it, they can simply shop it to other ratings agency until they get the rating that is most beneficial.

The Washington Post’s Steven Pearlstein suggests we go back to the investor-pays model. He writes earlier this month:

Call me simple-minded, but it seems to me that people who use a good service should also be the ones who pay for it. That’s how it works in most markets. And when it doesn’t — health care is a good example — things tend to go awry. It used to work that way in the credit-rating business as well, with investors paying directly for ratings and analysis through some sort of subscription arrangement, or indirectly through their brokers.

Mr. Pearlstein’s proposal is theoretically spot-on, but practically most feel that implementing it would be difficult…not impossible…but difficult. Mr. Pearlstein also suggests applying a fiduciary standard to the ratings agencies. Specifically,

new legislation that makes clear that the ratings agencies owe the fiduciary duty of care and loyalty to their investor clients. That doesn’t mean they can be sued any time an investment goes sour. What it does mean is that they would be liable if they put out a rating they knew, or should have known, was misleading after taking reasonable steps to ascertain that the information provided to them was accurate.

There’s little doubt in my mind that ratings agency risk managers and corporate lawyers would have rethought all those AAA ratings for toxic securitized loans if they thought they could be held responsible for investor losses.

Last but not least, three ratings agencies should not have a monopoly. Smaller firms ought to be allowed and encouraged to participate in this market. Currently federal rules prohibit anyone but Moody’s, S&P, and Fitch from providing this important function. By lifting the barriers to entry, new entrants could compete in the securities rating market and collective performance would improve, or at least the pretenders would be squeezed out.

If the dot com research reform package taught us anything, it’s that money corrupts and new rules are only as good as those who implement and enforce them. Here’s hoping they are up to the challenge.

Comments

[frdm45:]

After what has happened how can these ratings agencies possibly still exist? If it hadn't been for the ratings agencies I don't believe we would have had the crisis in the first place or it wouldn't have been of the same magnitude. How can it be that people in other professions such as doctors, lawyers, contractors can be sued for issuing negligent, misleading, or outright fraudulent advice and these guys walk scot free? I know there is the threshold of whether they knew the advice was misleading; they can't be held resposible for just wildly inaccurate ratings - please, there are only two choices, these ratings agencies execs either don't have enough smarts to run a lemonade stand or they're lying.

Oct 04 06:46 AM

[Bill Herbert:]

Great article - but I would suggest going even further in pursuit of reform.

I would create a Federal Oversight Board that collects money from the users - the investing community - and assigns the task of analysis and issuance of ratings on a random basis to a handful of rating agencies. I would keep the present three, but immediately fire any top execs who were responsible for the past egregious blunders, and bring in new, outside management that is very closely tied to investors' interests.

I would also encourage the formation of several new rating entities (hey, there are a LOT of good, unemployed analysts floating around the job pool right now - although some may be too rigidly honest to hold a job on WS under the present system that rewards the cheaters) to promote competition. And I would institute a "rate the raters" independent review system wherein the ones that did a good job were rewarded with extra business and better fees, thereby starving the slackers and the "business as usual" crowd that is presently so corrupt. Maybe people like you and a few other high-minded individuals could do voluntary two-year rotations on such a review board.

And I would go so far as to outlaw any type of influence exerted by the companies-being-rated on the analysts who are doing the DD and deciding on the creditworthiness of the issuers' paper. I wouldn't even let them buy a guy lunch, or invite her/him to a Christmas party or golf outing. Nada, zero, no bribing or arm-twisting allowed - and swift jail sentences for anybody who steps over the line.

By the way, I would strongly advocate a similar system for corporate audits, so that we can clean up that profession as well. The average audit is more of a whitewash than a thorough review of the real situation, at many companies. It doesn't help that the FASB is a joke, and that corrupt Congressmen have battled reforms for years, and have shielded the SEC from tough scrutiny until things imploded in a morass of corruption, worthless securities, Alan Stanford and Bernie Madoff, and hundreds of truly-busted hedge funds - many of which, incredibly, are still operating today as they try to "unwind" millions of dollars worth of bogus trading profits they have booked on CDS's and other flaky trades.

We haven't come near the final tally of all the bad numbers on the books of the banks, hedge funds, and WS firms. It's going to be an interesting year-end audit season, that's for sure.

Oct 04 09:37 AM

[Mad Hedge F...:]

vhu The case against the Big Three rating agencies took another step forward when a New York judge threw out the freedom of speech defense for one of the complaints. Terry McGraw, CEO of McGraw Hill, and owner of defendant Standard & Poor’s, says that at the peak in 2006, the industry was prepared for a worst case scenario of a 15% draw down in real estate prices over 18 months on the local level. Instead, it got a 50% national plunge that is now two years old and aging. It didn’t help that a Moody’s analyst wrote an e-mail saying he would rate paper issues by “cows.” In the race for market share, Moody’s, S & P, and Fitches’ competitively devalued the meaning of “AAA” so that even the most toxic subprime sludge came out highly rated. With their seals of approvals, the agencies became the facilitators-in-chief of the over lending and over borrowing that made the crash a mathematical certainty. The hedge funds that made billions wisely ran their own in-house ratings departments which thought otherwise. They fell down on their knees, thanking God that inflated “independent” ratings led to wild over valuation of debt securities and set up some of the greatest shorts of the century. There is no Hell hot enough to make ratings agencies adequately pay for their deliberate misdirection of trusting investors. As for the hedge funds, their new short play is the one rating agency that is still publicly traded, Moody’s (MCO).

Oct 04 10:01 AM

[john s. gordon:]

yes remove barriers to entry, the three participants we now have are incorrigible,
> jack

Oct 04 10:54 AM

[RiskAverseA...:]

Before any rating agency reform might hope to succeed it seems an economic environment conducive to a widening list of corporations whose bonds are AAA rated -- precisely the opposite trend of the past half century -- is prerequisite. In other words, a return to simpler forms of financial claims against physical assets, as well as a focus on the fundamental physical realities that support the value of all financial claims in circulation (thereby resulting in their trading in more stable, predictable ranges) is a far more pressing priority. That accomplished, then rating agency regulation might naturally fall into place.

Oct 06 01:03 AM