The champagne was still flowing in congressional Democrats' offices when the financial markets encountered the first operational glitch after the massive financial reform bill was signed into law.
Among its many provisions, the Dodd-Frank Act repealed the Securities and Exchange Commission's Rule 436(g), which had allowed public debt issuers to include debt ratings in documents such as a prospectus without the rating agencies' consent. In the wake of the repeal, the raters' consent meant they would be considered experts, like auditors, and could be legally liable if a rating proved inaccurate. The rating agencies quickly announced that they would not let their ratings be quoted in such documents.
That froze issuance in the asset-backed market, where inclusion of a rating is required. Then the SEC blinked and established a six-month moratorium during which asset-backed securities will not be required to include a rating in the prospectus, and the market went back to business almost as usual.
"That got people's attention. They shut down the entire asset-backed market for a day or two," notes Tom Deas, president of the National Association of Corporate Treasurers and treasurer and vice president at $3 billion FMC Corp., a Philadelphia-based chemical company. Issuers can still use ratings in prospectuses to explain things like debt covenants tied to ratings, but they can't use them for pure marketing purposes without the agencies' consent. Issuers are also free to use ratings in documents that are less legally binding, like a marketing presentation or a press release, Deas notes. (The SEC requirement that's now in limbo to include a rating in the official prospectus applied to asset-backed issues but not traditional corporate bonds.)
"Right now the situation is temporarily resolved as the SEC has issued a six-month reprieve from the requirement to include ratings on securities offerings," observes Wei Shi, vice president of treasury and finance at Toyota Financial Services in Torrance, Calif., historically a major issuer of asset-backed securities.
A long-term solution will have to be developed over the next several months because the use of publicly registered securities for capital-raising is obviously a core component of market liquidity, Shi notes. Issuers like Toyota Motor Credit Corp. tap dozens of available markets and programs across multiple investor bases and security types "so that we can quickly and easily shift our focus to alternative markets if some become unavailable," he says.
A few skittish investors may defer investing until a permanent solution emerges, Shi says, but he predicts that most will continue to buy asset-backed securities the way they have, although there's no a rating cited in prospectuses.
Executives at the rating agencies, speaking on background, make it clear that they intend to continue rating all issues they are asked to rate. And ratings will be readily available to investors who take the trouble to look them up, they say. The ratings just won't be in prospectuses, where they could expose the rating agencies to greater legal liability.
If the SEC makes permanent its temporary lifting of the requirement to include ratings in prospectuses for asset-backed issues that securitize things like mortgages, credit-card receivables and student loans, then the rating agencies win. It remains to be seen whether pressure from the SEC or the financial markets will make the raters back down and accept a role as providers of expert opinions that are liable for their misjudgments, as auditors are.
The extent to which rating agencies should be immune to lawsuits related to inaccurate credit ratings remains controversial. "By wrapping themselves in the First Amendment, they ask to be treated like newspapers," notes Larry White, professor of economics at the New York University Stern School of Business. "In fact, a rating has been called the world's shortest editorial. But they are not like newspapers. They're more like auditors, who can be sued."
Pat Milano, executive vice president of operations at Standard & Poor's, takes the opposite view. "Changes in the legal arena that increase our risk would require us to change who we rate and what we rate for," he warns. "We would have to find a new balance between serving the marketplace and protecting the firm against legal risk."
White concedes that if you remove too much of the raters' protection, they will become unduly cautious and less useful. "We have to find the right middle ground, but they need to be more exposed to liability that they have been," he says.
While financial regulatory reform has been enacted, the rules governing rating agencies remain a work in progress, and debate continues over specific issues, such as whether analysts should bond with the companies or industries they rate or be rotated to prevent bonding.
Imposing rotation is "short-sighted," according to Deas. Manufacturing companies with complex processes are not easy to understand, and the "agencies had made real progress in recent years by hiring people with industry experience," he says. "You can't rotate a chemicals analyst to housing without losing a lot of valuable knowledge."
Sacrificing expertise for objectivity entails real risks because analyst expertise is already suspect. The rating agencies hire good analysts and pay them well, but they aren't the most sophisticated or the highest-paid credit analysts on the planet, White says. "The agencies will always be outgunned by the investment banks."
Nevertheless, the agencies are already moving to institute rotation. "Issuers won't like to lose an analyst they have cultivated and who understands their business particularly well, but we have a staff of analysts that is broad and deep and we're confident that another analyst will be prepared to take over," Milano reports. S&P analysts will be moved off a particular account every five years, he notes. "We will rotate, just as accounting firms do."
But S&P analysts won't go from rating chemicals to housing. "We want comparable ratings, but we will analyze different asset classes differently and organize our analyst teams by asset class," Milano says. "The rotation will come within those teams." An analyst of mortgage-backed securities would rotate from one issuer to another but stay in the mortgage-backed securities asset class, he explains.
S&P will also conduct a look-back review if an analyst leaves to work for a company he rated. "We understand the concern about conflicts of interest," Milano reports. "When that happens, we will review the ratings of that issuer."
The financial reform measure's radical proposal to rotate rating assignments among agencies has been deferred but not killed. Should the SEC, in the two-year study mandated by the legislation, not find a better solution, a lottery system would be implemented after another two years, with yet another SEC department created to randomly assign an agency the rating role when a new issue is submitted, explains Cady North, manager of government affairs at Financial Executives International.
FEI worries that a lottery could penalize small rating agencies that might be handed assignments outside their area of expertise. "We want to be sure the assignment goes to a rating agency that has the capability to do what they are asked to do," North says.
Another issue is whether rating agencies should continue to enjoy an exemption from the fair disclosure rules (Reg FD) that allows rating analysts to see all sorts of information that is not shared with the general public. Rick Moss, treasurer at $3.9 billion Hanesbrands in Winston-Salem, N.C., defends the raters' Reg FD exemption. "There is real value in hearing from a voice that speaks from a fuller understanding of a company's business. I'd hate to see that go away. If they lose that exemption, we'd have to get them to sign confidentiality agreements before talking to them, and I'm not sure how effective that would be."
Substituting confidentiality agreements could "add another layer of cost and labor," North suggests.
Not everyone agrees. Exempting the rating agencies from Reg FD has got to go, insists Jerry Flum, CEO of CreditRiskMonitor, a commercial credit analysis firm in Valley Cottage, N.Y. "They have access to huge amounts of information that nobody else sees, so everyone has to pay close attention to what they say, and there is no way to verify that they are right," Flum says. "They can see budgets and profitability by segments. It's a government-mandated monopoly, which is insane." Get rid of the exemption, he says. Better yet, get rid of Reg FD. "By stripping securities analysts of access to information, Congress has removed an important deterrent of fraud," Flum charges.
Yet another controversial issue is whether the government should effectively compel companies to use rating agencies. It's hard to argue for a deregulated, free-market solution when many of the largest players are mandated to use agency ratings, White notes. Since the Depression, financial institutions that serve the public--banks, insurance companies, pension funds, money market mutual funds, broker-dealers--have been held to prudent investing by stipulated credit ratings, he explains. "That made the rating agencies indispensable, put them on a pedestal," White says. "When they messed up, the consequences were monumental.
"This is a sophisticated institutional market," he adds. "Free the players to find a better business model and a better way to evaluate credit risk. There are bond advisory services with a better track record than the Big Three. Let them grow and get stronger."
S&P does not oppose removing legislative and regulatory mandates to use credit ratings. "We think we offer value and are happy to compete based on that value, but it's up to the regulators to address that," Milano says. But the ratings mandates are embedded in a host of laws and regulations; removing them won't be quick or simple.
At the heart of the controversy is whether you can have an honest system when the raters' revenue comes from the companies they rate. Should the issuer-paid model survive?
Only if there is an effective wall between the sales side of the agencies, and its concern with compensation, and the rating analysts, Moss says. "They should not be aware of compensation or influenced by it. That would be a very positive step."
S&P's Milano agrees. "Issuers deal with multiple people to keep analysts protected from business considerations. It an issuer wants to talk about fees or other services, the analyst bows out and sends the client to business managers."
White provides a historical footnote: Investors paid for bond ratings until the late 1960s, when the popularity of photocopying machines cut into the ability of the rating agencies to protect the sale of their printed products. "Before around 1970, investor-paid worked," he says.
These days, issuers are willing to pay for ratings to make investors comfortable. If ratings lose their credibility and that comfort goes away, they will stop paying, White predicts. This should spark a race among rating agencies to provide the greatest credibility. That means that new entrants should be encouraged and mandates that drive business to the Big Three should be relaxed, White urges.