New York—Rating agencies are under the gun again, and
this time they will have difficulty dodging the bullet. After Enron, ratings agencies were low on the
list of culprits, and the ill effects on their operations were negligible. Now, with the sub-prime meltdown, the ratings
firms will be high on the legislative agenda.
And, given the global impact of the crisis, ratings agencies will be
battling regulatory initiatives on three continents.
After the collapse of the tech bubble in 2000, the focus
was on corporate governance (SarBox in 2002) and analyst conflicts (Global
Research Settlement in 2003). Rating
agencies were an afterthought, yielding The Credit Rating Reform Act of 2006 in
September of last year. The legislation
was intended to stimulate competition by lowering regulatory barriers to entry
which the SEC had inadvertently created in its NRSRO regulation. The markets greeted this legislation with a
yawn, figuring that the formidable market barriers to entry—in the form of
market share, global franchises and brand recognition—would make direct competition
difficult. Stock in Moody’s and
McGraw-Hill (parent of Standard & Poor’s) sailed to new highs.
Less
than prime ratings
What a difference a year makes. The ratings agencies are now in the bright
glare of the media for their role in facilitating the wide-spread
securitization of sub-prime debt. One of
the more transparent areas of ratings agencies is the criteria they use to rate
debt, and consequently there is an ‘audit trail’ on the standards they used to
rate CDOs and other structures which incorporate sub-prime debt. The WSJ examined in depth one facet, so
called “piggyback mortgages” which effectively eliminate down payments by allowing
borrowers to take out a second loan for the down payment at the same time they
are getting a mortgage. The ratings
agency track record is not good—initially viewing piggyback mortgages as having
a similar default risk to regular mortgages.
Worse, after finding in 2006 that piggybacks were 43% more likely to
default (surprise!) they tightened their criteria for future CDOs in April 2006
but did not revise their ratings on existing CDOs previously rated under what
was now flawed criteria. Piggybacks are
only part of the subprime story and as scrutiny increases, additional criteria
issues will come out.
Over a year later after the revised criteria on
piggybacks, on July 10, the ratings agencies acted. And they acted in concert—an aspect which
will also invite scrutiny. Moody's cut
ratings on more than 400 securities that were based on subprime loans. S&P
put 612 on review, and downgraded most two days later. Unfortunately these downgrades are only a
small fraction of the outstanding CDO debt, so further downgrades are likely.
Consequences
in the US
The full consequences of the subprime crisis won’t be
clear until the crisis fully plays out but the signs are not good for the
ratings agencies. In the US, both Senate
Banking and House Financial Services have scheduled fall hearings. Senator Chris Dodd (D-CT), chairman of Senate
Banking (and presidential candidate), castigated the agencies in a press
conference on Monday. Barney Frank (D-MA)
has scheduled hearings in October. The
hearings will be no picnic. Even in
June, during SEC Chairman Cox’s visits to the Hill, ratings agencies were the
subject of pointed questions from democrats and republicans (such as Senator
Richard Shelby (R-AL)).
The hearings will result in legislation. There are different approaches under
discussion. One approach which would be
to release the trial lawyer hounds on the ratings agencies by weakening or
removing their liability protections.
This would appeal to Democrats. Another
approach that is being discussed is to roll back to the pre-1970 situation,
when credit rating agencies were lowly independent research companies who sold
subscription services rather than accepting payments from the firms that they
rated. A related reform that is being
proposed is the removal of credit rating agencies from the regulatory treatment
of institutional investors. Neither of
these latter approaches would be easy to implement, but they reflect depth of
feelings within Congress. Congressional
staff on both sides of the aisle feel that previous legislation didn’t work
(even though it is less than a year old) and something more serious is
required.
And
it’s no better outside the US…
The EU, which
after the tech bubble allowed the ratings agencies to implement a voluntary
code of conduct, is also likely to legislate. The EU’s leading regulator, Internal Market
Commissioner Charlie McCreevy, has swung into action. McCreevy has reportedly invited securities
regulators from across Europe to a meeting next month to discuss rating
agencies and the recent problems. He had
said he wanted to give the voluntary code time to prove itself but the U.S.
subprime meltdown has highlighted some weaknesses. He's expected to decide on whether to propose
new legislation sometime in 2008.
European sentiment is also running strong. The FT quotes an unnamed EU Commission
official as saying, “If the rating agencies believe this is going to be business
as usual, they are very wrong."
Even India is in the act.
A recent article in the New Delhi Business Standard calls for
legislation of ratings agencies: “[Rating agency] reforms
are particularly pertinent in India, where it is now practically impossible to
do a primary issue of a bond without the involvement of a credit rating agency.
Fees to credit rating agencies have become akin to a tax. Infosys has zero
debt, and its first Rs 1,000 crore bond issue should surely face a good market
in a rational world without any credit rating. It is better to trust the
processes of the competitive and speculative market, rather than trying to
install a set of government-supported profit-making gatekeepers.”
The rating agencies have been regulatory Houdinis—managing
to remain largely unregulated despite numerous attempts to impose
regulation. The subprime market may be
the blow that brings them down, but, as with Houdini, the effect of the impact
will have to play out a bit further.
Posted at 11:28 am by Sanford (Sandy) Bragg
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