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A provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act is the liability of bond rating agencies (e.g., Moody’s and Standard & Poor’s) whenever their ratings are included in formal SEC registration materials. The result: The bond rating agencies now are disallowing their ratings from being used. Without them, securitized bond offerings (e.g., mortgage and auto loan packages) are having trouble being done, and other issuers (e.g., Ford) are delaying bond sales.

These actions are a sign that the bill’s provision, put in to protect investors, is working.

A problem is removed

Remember that the securitized bond market froze because of a serious problem caused by the ratings. The agencies grossly overrated subprime mortgage and other bonds, eventually leading to drastic cuts – many went from highest quality to junk. Because investors had depended on the ratings when choosing their investments, the markets came to a standstill and valuations plummeted.

The new finance bill is saying that what’s wrong is that the ratings, by being included in SEC filings, produce a false sense of quality and safety. From now on, the inclusion of the ratings in an SEC registration filing puts the rating agency at risk if something goes wrong.

An undesirable incentive is diminished

Bond rating agencies have tried to serve two masters (clients): investors and issuers. This created an incentive disliked by investors whereby the agency with the better rating got an issuer’s business. Now that the ratings carry a liability, ratings agencies are saying that issuers cannot use them, so that undesirable incentive is significantly diminished.

The focus is back to where it belongs: The issuer and the investor

That means the ratings crutch disappears. The issuer is left having to provide the necessary assurances and proof to the investor that its security is of sound quality and properly constructed. In addition, the investor can no longer delegate the quality analytical work to a bond rating agency, but must make his/her own evaluation.

Don’t expect mis-rated bonds for some time. However…

The saying about closing the barn door after the horses are gone is apt for Wall Street products run amok. Investigations happen, wrists are slapped, fines are paid, regulations are written and a vow to “never let that happen again” is emphasized. In this case, the “that” is low quality bond offerings that were made to look like high quality.

However, periodic problematic events will continue to happen in Wall Street. Wall Street’s creative minds work hard to come up with saleable products, and occasionally they hit on something that seems to offer a special combination of high return and low risk. The result is that investor demand blooms and a fad is born. Then the inevitable happens – the return fails to materialize or unrecognized risks are exposed.

So… This investor generation likely will not see bond overrating recur. But it will see other product fads/flops. How can we spot them and avoid getting burned? Watch investors (individuals and/or institutions) flocking to something because the benefits look compelling and risk appears low.

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Disclosure: No positions

Source: Bond Rating Agencies Now Held Liable, Which Is a Good Thing