Noise from Washington on Ratings Agency Reform
This week Congress is holding hearings on various new proposals to reform the credit rating agencies. In their sights are Moody’s, Standard & Poor’s 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. ”Call me simple-minded,” he writes earlier this month, “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.