Of Credit Rating Agencies and Charlie Sheen
We have written previously on the sorry state of play regarding the role and practices of credit rating agencies (CRAs). Indeed, few players in the financial crisis caused more rancour than CRAs for their enabling role in the proliferation and distribution of structured products such as asset-backed securities (ABS). But in a giant game of chicken, the SEC blinked first, allowing ABS securities to be registered without requiring reference to expert credit ratings, sidestepping the apparent intent of legislators to make CRAs legally accountable for the quality of their work.
It is no exaggeration CRAs were central to the spread of these toxic instruments to nearly all corners of the institutional investor world, which to this day, must deal with the continued financial and legal fallout. Everyone hoped that Dodd-Frank would usher in a new era of oversight for CRAs. Indeed, regulators around the globe sprang into action post crisis to assess gaps in CRA regulation and process, moving forward with a plan to ensure two things. Step one was to change laws and require investors to do their own credit analysis instead of relying on ratings alone. [See proposed SEC rules (PDF).] While it was acknowledged that CRAs provide a valuable and important service when properly regulated — in particular, a shorthand means of assessing credit quality and risk of default in the fixed-income world — the problem was that even sophisticated investors were failing to do any of their own credit analysis as a check and balance on the ratings issued. If the credit was good enough for S&P it was good enough for the investor, it seemed.
Step two was to put CRAs on notice that if they do rate securitized products, they too will be held accountable for fraud and negligence in issuing sham ratings associated with the marketing and sale of the securities. That got their attention. Even though the ABS market was as lucrative as any in history for the CRA industry, the prospect of such firms being held liable to investors for bogus ratings was like a splash of ice water. Rather than accept liability, they refused to allow their ratings to be a part of registration statements for new ABS securities — knowing that without the required ratings, issuance of new registered securities would stop dead. Quite a card to have in your hand in a time of economic stress, when securitization offers much-needed financing capacity to the economy.
Backed into a corner, the SEC chose to keep the new ABS market viable, offering assurances that it would not enforce the requirement for a rating to be part of registration statements, as detailed in a recent article by New York Times writer Gretchen Morgenson. So for now, the issuance and related credit ratings of these securities is to be encouraged, not impaired by higher liability — just like flimsy ratings still being offered on sovereign debt, all in the name of financial stability and recovery. Could the cure be worse than the disease? In the immortal words of actor Charlie Sheen, I can hear the CRAs now: “Duh, winning!”