Junk In, Investment Grade Out: FAQs About Credit Rating Agencies
“The credit rating industry is facing sweeping regulatory changes in the wake of the scandals that have beset Wall Street during the past year.”
-- The Guardian
Most of you are probably asking yourselves, “What in the world does that statement have to do with current events?” Well, actually, it doesn’t. It was made six years ago, in 2003, after the Enron and WorldCom frauds prompted the last episode of “Never Again” outrage at Wall Street. At that time, the powers that be decided that instead of “sweeping regulatory changes” to the credit rating industry, the more fair and balanced approach was “no regulatory changes.” And thank Goldman they did. Who knows what kind of financial cesspool we avoided by not implementing any real reforms back then.
Now, as if there were something inherently wrong with a government-endorsed oligopoly that admits to numerous conflicts of interest, the powers that be are contemplating sweeping regulatory changes again. Except this time, fortunately, it’s only the language they’re using to describe the changes that’s sweeping. The Senate Banking Committee, led by Senator Chris Dudd, is proposing a bill that would establish a new Office of Credit Rating Agencies at the SEC to implement new internal controls for credit ratings agencies (CRAs) to follow, improve transparency of the rating process, and impose penalties on agencies for poor performance and regulatory violations. Sounds like they mean business this time, but don’t worry — as the Atlantic points out, the proposed reforms probably only mean business as usual.
The last time the SEC was put in charge of administering regulatory changes that were force-fed to the CRA industry — under the Credit Rating Agency Reform Act of 2006 — Chairman Christopher “Never miss an opportunity to miss an opportunity to do my job” Cox, had the good sense not to go overboard. Or even onboard. Under his direction, the SEC required CRAs to disclose which of 9 possible categories of conflicts of interest were applicable to their businesses. Moody’s and S&P each responded with the absolute truth, and let’s just say it turns out that they have conflicts in less than 10 of the 9 categories.
Wisely, they weren’t required to eliminate any of the conflicts, but merely issue a written policy explaining how they were “addressing and managing” them. At the time — September 2007 — Cox said that the SEC’s newly-granted oversight of CRAs “will protect investors and enhance the reliability of credit ratings by fostering accountability, transparency, and competition in the credit rating industry.” Phew. Just imagine what might have happened in the ensuing two years without that oversight.
Of course, some perfectionists have found a few nits to pick with the CRAs’ performance since then. Sure, some of the CRAs' calls now seem slightly off the mark. Like the July 17, 2007 statement by Glenn Costello, co-head of Fitch's residential mortgage group, who said, referring to triple-A-rated subprime mortgage bonds: "We continue to be confident that ‘AAA’ ratings reflect the high credit quality of those bonds." But the critics conveniently fail to mention that he turned out to be right. None of those bonds defaulted that day.
Nevertheless, the Senate Banking Committee bill claims that “[f]lawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities – adding to the housing bubble and magnifying the financial shock caused when the bubble burst.”
And some disgruntled institutional investors (i.e., losers) who were wiped out by defaults on triple-A rated mortgage-backed securities have sued the CRAs. Little do they know that CRAs have what amounts to legal immunity based on the First Amendment, which states: “Congress shall make no law abridging the right of CRAs to inflate bond ratings in return for cash.” You see, CRAs consider themselves members of the “financial press” and their “opinions” about the creditworthiness of debtors are thus entitled to free speech protection. The freedom they justly claim isn’t limited to publishing their ratings. In their balanced view, it protects them from all legislation, regulation and civil and criminal liability that's in any way related to their business.
So, to take an entirely hypothetical example, suppose one S&P analytical staffer emails another that a structured-finance deal is "ridiculous" and that "we should not be rating it," and the other S&P staffer replies that "we rate every deal . . . it could be structured by cows and we would rate it." Or, purely for the sake of argument, say an S&P analytical manager describes the market for collateralized debt obligations as a "monster" created by rating agencies, and adds: "Let's hope we are all wealthy and retired by the time this house of cards falters. ;O)” Thanks to our courts’ common sense interpretation of the Bill of Rights, those emails wouldn’t even see the light of day in a courtroom. ;O)
Unfortunately, one federal judge must have a different copy of the Constitution, because in a rare legal setback for the CRAs, Judge Shira Scheindlin recently rejected the CRAs’ First Amendment defense in the lawsuit brought by the institutional investors. Allowing the case to proceed, she noted that the CRAs were allegedly involved in structuring and issuing mortgage-backed securities that they then rated triple-A and that their $6 million compensation – a mere three times their usual fee – was “contingent upon the receipt of the desired ratings.”
Eric Kolchinsky, a former Moody's managing director, says that the First Amendment defense enabled some Moody's analysts to adopt a laissez faire attitude toward the quality of ratings. "Some people almost didn't even care because they feel it's just an opinion. It's part of the culture there." What’s more, according to this obviously unstable finger pointer, Moody's knowingly issued inflated credit ratings on complex securities.
Not so fast, Brutus. After conducting a thorough, independent and objective investigation of these accusations, a law firm hired by Moody’s concluded that Kolchinsky was “a lying psycho who likes to diddle little boys.”
Thankfully, when this issue reaches the Supreme Court, we can count on originalists like Antonin Scalia to uphold the First Amendment defense. Although it hardly takes a constitutional scholar to realize that if there’s one thing the Founding Fathers understood as the fundamental right to “free speech” it was keeping commercial entities unaccountable for conflict-tainted bond ratings that lose investors billions and contribute to a financial meltdown.
Fortunately, attempts at legal and regulatory reform aren’t likely to change the CRAs’ M.O. Frank Partnoy, a law professor who used to design investment products while working for Morgan Stanley, says he expects lawmakers to water down most attempts at tightening regulation of the industry. "I've watched the rating agencies be recklessly wrong, over and over again, and I've seen them get nothing more than a slap on the wrist.”
Realizing that “status quo” isn’t just a legal defense but a way of life for the CRAs, some delusional market participants are starting to go about their business as if the CRAs aren’t there. In “Credit Ratings Now Optional,” the Wall Street-hating Wall Street Journal reports that some prominent companies are selling bonds and structuring complex securities without ratings, indicating that ratings “aren't a necessary ingredient for successful bond sales.” Insurance regulators are considering an overhaul of the way they calculate insurers' capital requirements to remove ties to credit ratings for some types of securities. The SEC in September voted to amend some securities laws to remove references to credit ratings. The Federal Reserve will soon start performing formal risk assessments on securities that may be financed by one of its key lending programs, the Term Asset Backed Securities Loan Facility.
And, in what may be an even more dangerous development, the upstart know-it-alls at ZeroHedge have had the impudence to launch DARPA (talk about a brander’s dream acronym), which distributes independent credit research and analysis that’s not bought and paid for by issuers (or anyone else for that matter, since — get this — it’s free).
These rater-haters can pretend all they want that the CRAs don’t matter. The fact remains the CRAs are as relevant and respected today as ever. Just ask S&P itself, whose website shows a stunning awareness of its current reputation: “Our opinions are respected worldwide because we are recognized as an independent and unbiased source of information.”
Denial ain’t just a river in Englewood Cliffs, New Jersey.
FAQs About Credit Rating Agencies
Q: What is a credit rating agency?
A CRA is a company that provides an objective, independent evaluation of the creditworthiness of the debt issuers who employ it. It assigns teams of highly-qualified finance specialists to thoroughly research a debt issuer’s financial condition and analyze the details of the specific debt issuance in order to arrive at an expert assessment of the issuer’s likelihood of default that does not risk losing the issuer’s business.
Q: What purpose do CRAs serve?
They’re the indispensable grease that makes the capital market machine churn efficiently. By issuing a simple, easy-to-understand alphabetical rating, CRAs serve the needs of all market stakeholders. Issuers are satisfied because the rating gives their debt the Good Housekeeping Seal of Approval. Underwriters are satisfied because the rating means that the due diligence in connection with the offerings they underwrite has already been done. Regulators are satisfied because they can use all-in-one ratings as objective indicators of creditworthiness rather than pouring over a slew of pesky subjective metrics like cash and collateral. Institutional money managers are satisfied because the rating provides ample coverage for even the largest ass. And retail investors are satisfied because a triple-A rating is even more effective than an Ambien.
Q: Doesn’t being paid by the debtor affect the CRA’s impartiality?
Only when the debtor is an individual, not a corporation. That’s why when corporations borrow money from investors in the form of bonds, the rating agency is employed by the debtor (i.e., the corporation), but when corporations lend money to individuals in the form of consumer debt, the rating agency is employed by the creditor (i.e., the corporation).
Q: What is “rating shopping”?
That’s where debt issuers approach different CRAs, and even different departments within the same CRA, to find the best rating for their prospective issuance. Based on the preliminary non-public ratings they receive, the issuers decide which CRA to employ to assign a public rating to their debt. It’s in the best tradition of capitalism because it fosters competition among the CRAs and provides issuers with the best deal for their money.
Q: Is it sound policy to allow rating shopping?
Absolutely. A simple, everyday example shows why. Suppose you’re not feeling well. You have symptoms that are consistent with both the common cold and pneumonia. Naturally, you’re going to visit several doctors to get several different opinions. And naturally, if 10 doctors diagnose you with pneumonia and 1 doctor diagnoses you with a cold, you’re going to go with the doctor who tells you it’s just a cold. That’s just plain common sense.
Q: What are “credit rating advisory services”?
That’s where a CRA helps an issuer structure a debt offering and then issues an objective, independent rating on the offering that it has been paid to help structure. It’s like an artist employing an art critic to sketch a painting and then paying him to critique the finished work. Da Vinci did it all the time. How do you think Mona Lisa came to be regarded as a great beauty?
Q: Isn’t there a conflict of interest there?
No. The issuer has no ethical obligation to refrain from indirectly bribing the CRA to assign a favorable rating.
Q: No, I meant a conflict of interest on the part of the CRA.
Absolutely not. The fact that the rating assigned to the CRA-structured offering is always favorable just proves how accurate the CRA’s structuring advice always happens to be.
Q: What is “notching”?
Notching is where a CRA downgrades its rating on an asset that incorporates underlying assets that haven’t been rated by the same CRA for a separate and additional fee. Think of it as a friendly reminder from the CRA that it’s in the issuer’s best interest to employ the CRA to rate all of its assets.
Q: Are CRAs to blame for assigning triple-A ratings to mortgage-backed securities where many of the underlying mortgages were subprime and wouldn’t have qualified for a triple-A rating even by the CRAs’ own standards?
Not at all. The cause of the subprime mortgage crisis was an unpredictable perfect storm of black swans that has never happened before and likely will never happen again: a boom and bust cycle in the real estate market. It wouldn’t be fair to blame the CRAs for an unprecedented event that was unforeseeable.
Q: Are CRAs reliable given that they missed the current credit crisis entirely?
Nobody’s perfect. But just think of all the years without a credit crisis when the CRAs didn’t miss a credit crisis. Suppose, for example, a triple-A-rated issuer makes timely debt payments every day for 999 days, and then defaults on day 1000. That means the CRA was right 99.9% of the time. You can’t get much more reliable than that.
Q: What are chances that the CRAs will downgrade the US’s triple-A sovereign debt rating?
Triple-zero. Debt ratings do one thing and one thing only: assess the risk of default. Through quantitative easing and other creative accounting measures, the US has wisely signaled its intention to print its way out of its bottomless debt-canyon. And the only limit to printing money is the supply of paper. Since paper is a renewable resource, there’s no chance that the US will ever default, and thus no reason for the US ever to lose its triple-A rating.
Q: Should the government continue to give CRA ratings such a prominent position in our capital markets given their recent performance?
Yes, now more than ever. What some refer to as a catastrophic mission failure by the CRAs, I prefer to regard as a learning experience. We didn’t scrap the CIA in 1989 when it was blindsided by the collapse of the Soviet empire, even though keeping tabs on the Soviets was the agency’s raison d’etre. And that decision worked out just fine until 9/11. We ought to give the CRAs the same chance.
Q: Couldn’t we devise a ratings system with more accuracy and integrity and less conflict and bias?
I could explain why that’s a hopelessly naïve goal but it’s too complicated. Just trust me, there’s absolutely no alternative to keeping the current system exactly as it is. As the old adage goes: if it ain’t fixed, don’t break it.