Should free markets govern bond rating agencies?


There’s a lot not to like about the Financial Choice Act, the deregulatory construct put forward by House Republicans on April 28. engage in risky transactions for their own account. He also seeks to gut the Consumer Financial Protection Bureau, one of Washington’s most effective agencies.

What hasn’t received much attention is how the bill would change the rules governing credit rating agencies – but it should. What the Choice Act would require is wrong, both in how it would roll back the law and what it would retain. But the bill also misses a big opportunity to change the rating industry for the better.

First, a bit of history. Rating agencies – Moody’s Investors Service, Standard & Poor’s Financial Services and Fitch Ratings are the main ones – played a central role in the financial crisis. They gave high ratings to mortgage-backed securities which quickly collapsed, leaving investors with billions in losses. Rating agencies failed miserably to assess the credit risk of these securities, which were full of poisoned loans. It was their job.

After the crisis, rating agencies paid large fines to settle government investigations. However, the rating agencies have not had to change their economic models, in which the issuer of the debt instrument analyzed pays for the rating it receives.

This is an obvious conflict of interest. But rather than change the compensation model, regulators responded to the crisis by stepping up their scrutiny of rating agencies registered with the Securities and Exchange Commission. Agencies must disclose certain information, for example, about their performance measurement statistics and the procedures they use to determine debt ratings. Rating agencies must also establish an “effective internal control structure governing the implementation of and adherence to policies, procedures and methodologies for determining credit ratings” according to the SEC.

The Choice Act fails in two ways when it comes to credit rating agencies. First, it proposes to roll back Dodd-Frank’s accountability measures on such companies, no longer requiring the chief executive of a rating agency to attest to the company’s internal controls over the processes it uses to determine credit scores. The bill would also repeal Dodd-Frank’s requirement that a rating agency confirm in its statements that a rating was not influenced by its business activities.

There is more. What’s particularly odd about the Choice Act, given that it was written by lawmakers with a penchant for deregulation and the free market, is that it would keep existing agencies entrenched and shielded from competition. . It does this by maintaining the government’s imprimatur for rating agencies known as a nationally recognized statistical rating organization – an NRSRO, in industry parlance. Budding rating agencies must apply to the SEC to receive this imprimatur, which is very difficult to obtain.

Bill Harrington is a former senior credit officer and senior vice president at Moody’s and an expert in asset-backed securities and derivatives ratings. In an open letter on LinkedIn, he called the bill a giveaway to ratings agencies and said it would eliminate any liability that exists between those companies.

In an interview, Mr Harrington was particularly critical of the way the bill allows chief executives of agencies to get away with attesting to the integrity of the ratings process. He called the Choice Act “a complete disaster.”

Jeff Emerson, a spokesman for the House Financial Services Committee – from which the Choice Act originated – argued that because appraisers can already offer services without seeking government approval, the free market works.

“We do not believe there is any government accreditation or imprimatur in maintaining the regulatory regime on credit rating agencies that choose to register with the SEC,” he said in an e-mail. mail. “That’s why the Choice Act repeals the Dodd-Frank section that allows the SEC to establish a board to assign ratings to structured finance products. We don’t need to put the government back in the business of approving ratings.

Mr Harrington said he believed the committee spokesman’s comment evidenced a deep misunderstanding about how rating agencies work, particularly the benefits of government designation for companies that use it. have. He is troubled that the Choice Act keeps the rating agencies in place and the SEC as a gatekeeper that inhibits competition in the arena.

There’s a better idea, said Lawrence J. White, a professor at New York University’s Stern School of Business: eliminate government certification once and for all. Let anyone post opinions on the creditworthiness of a debt security and allow the market for these services to reward excellence and punish failure.

He took this position in an article on the subject in 2013.

“It’s important to remember that when we’re talking about investors in the bond market, we’re not talking about mom and dad sitting around the dining room table figuring out what to do with their 401(k),” he said. said Professor White in an interview. . “The overwhelming majority of bond holdings are held by institutions that one would expect to have enough expertise to determine who is a good advisory firm.”

Since institutional investors are the bond market, he added, “the case for government certification of the identity of these advisory firms becomes much weaker.”

Mr. Harrington and five former rating agency executives fully agree with Mr. White. And they posted a letter on LinkedIn on May 1 recommending the idea.

The requirement to accredit rating agencies, they wrote, puts “government imprimatur on credit ratings that are too often the result of sloppy procedures and/or commercial biases.” Stripping them of government approval would allow the market to work by opening up the company to competition.

Removing the lock that big agencies have on ratings could also prevent another financial mess, the group argued. “A return to something akin to the pre-2008 status quo, in which a government-sanctioned conflicting corporate oligopoly assesses credit quality, risks a repeat of the financial crisis,” they wrote.

Over the years, lawmakers have tried to open up the world of rating agencies to encourage more participants and, eventually, better performance. The 2006 legislation encouraged the SEC to admit new companies to the rating club. The commission created the Office of Credit Ratings to register new entrants. But the number of credit rating agencies — now 10 — has not increased. It has been almost five years since a newcomer was admitted to the club.

“Why do we need credit rating agencies to be given a federal license that the SEC approves what they do?” asked Marc Joffe, a former Moody’s executive who is one of six former executives calling for an end to licensing requirements. “Take that away, and anyone who provides a credit score can compete on equal footing with rating agencies.”

The six people who signed the letter have been discussing rating agency regulatory policy for several years, Joffe said. One of them is Ann Rutledge, founder of R&R Consulting in New York and CreditSpectrum, a provider of credit analytics.

“The drive to make our capital markets more efficient is not there,” Ms Rutledge said in an email. “The only people who will suffer are ordinary Americans struggling with a dysfunctional, dysfunctional economy because capital markets are rigged to pay for themselves.”


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