Investor Liberation
One of the least-controversial parts of Dodd-Frank was its call for a new Office of Credit Ratings at the SEC. Among other things, this new office would implement D-F’s provisions for oversight of credit rating agencies — known as Nationally Recognized Statistical Rating Organizations, or NRSROs in government parlance — and impose increased transparency of their methods and performance. While these parts may have benefits, the provision in D-F most likely to help the new office achieve its goal of promoting “accuracy in credit ratings” is the one that eliminates many, if not all, statutory and regulatory references to credit ratings.
This provision has become newsworthy recently because the SEC unanimously approved the first in what it says will be a series of rule proposals which will end the Commission’s reliance on credit ratings. In particular, the proposal would remove the “investment-grade” requirement that has determined whether an issuer can use the SEC’s Forms S-3 and F-3 for non-convertible debt securities. At least one other item likely set for removal are regulations stipulating what investment funds can buy and hold.
The SEC is just one of 10 governmental and regulatory agencies that has come to place significant confidence and reliance on the ratings of NRSROs. All the main banking, derivatives, and insurance regulators, including the Fed and the FDIC, not to mention a couple of federal housing agencies, also have outsourced their risk assessments to credit rating agencies. An indication of how prevalent their use has become came in 2009 when the TARP special investigator reported that at least 52 different laws and regulations require their use.
The problem is that all these laws and regulations requiring the use of credit ratings to determine everything from bank capital and securities that investment managers could buy and hold, to whether an issuer could bypass certain registration requirements, had given the NRSROs a captive market. They didn’t have to produce a good product to get business — it was flooding in the door at the peak in the mid-2000s almost faster than they could process it. Virtually no institution or issuer had a choice but to use them, so their sole competitive concern was whether an issuer would take a deal to another of the big three rating firms, and even that risk was fleeting. There was certainly enough business to go around.
Elimination of this captive market through rules like the SEC is proposing should eventually enable investors and other institutions to seek other options for determining what previously has been mandated by law or regulation. While some may continue to favor use of an NRSRO for such matters, others may decide to try an independent research firm whose assessments they deem better.
Of course, making NRSROs compete for their business will not eliminate the conflicts of interest inherent in the industry. By removing their captive market, however, the SEC’s proposal is a first step toward making rating agencies’ success a function of the quality of their product for the first time in many decades.
One of the lesser known aspects of this debate is the belief among many that the rating agencies act as underwriters in the sale of asset backed securities especially.The sec has chosen not to pursue this rationale but ther is considerable support for it.As Jim notes this is good first step in addressing the problem..
Thanks, Peter, excellent point. The courts at least seem to have swatted down the notion of CRAs being “underwriters” at least from the perspective of underwriter liability; the interpretations I’ve seen seem to suggest that having a significant role in structuring the pools wasn’t enough to earn status as an underwriter, and thus they were shielded from liability (I was looking specifically at a case against S&P and Moodys with regard to Lehman paper in 2010). The SEC’s approach, as Jim details, seems to be focused more on diminishing the natural market for ratings: if there is no regulatory imperative to hold only AAA rated issues, then perhaps the perverse incentives to create AAA issues get throttled back.
So I understand the intention is to undo about 0.001% of what was done when legislation on NRSROs was introduced in the seventies. Back then, it seems that the government decided to ruin a pretty good system in which the issuer did not pay the agency for a rating, thus agencies did not have to compete for business by rating AAA junk (the conflict of interest you refer to). And they did not have statutory privileges like they do now. Caveat: I haven’t ready any of this legislation, this knowledge is second-hand at best; just wondering why it’s not on the agenda of public discussion (it seems) to completely repeal NRSRO laws. Would it become too difficult to regulate banks if ratings weren’t entrenched in public law? Let’s not kid ourselves; those ratings aren’t much good anyway.
I meant to say, of course, that the agencies did not have to compete by “rating junk AAA” – not the other way round 🙂
Krzysztof, In fact, one of the bright points of Dodd-Frank was its call to remove all references that require the use of credit ratings in statute and regulation. Section 939, to be precise, calls for removal of these references and, therefore, removal of the captive market. There is no guarantee that the quality of ratings will improve, of course. At least entities that offer such services will no longer get paid regardless of whether they do it well or not.