Tag Archives: Fitch

Why Credit Rating Agencies Exist

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Robert Rhee has posted Why Credit Rating Agencies Exist to SSRN. The abstract reads,

Although credit rating agencies exist and are important to the capital markets, there remains a question of why they should exist. Two standard theories are that rating agencies correct a problem of information asymmetry and that they de facto regulate investments. These theories do not fully answer the question. This paper suggests an alternative explanation. While rating agencies produce little new information, they sort information available in the credit market. This sorting function is needed due to the large volume of information in the credit market. Sorting facilitates better credit analysis and investment selection, but bond investors or a cooperative of them cannot easily replicate this function. Outside of their information intermediary and regulatory roles, rating agencies serve a useful market purpose even if credit ratings inherently provide little new information. This alternative explanation has policy implications for the regulation of the industry.

I do not think that there is much new in this short paper, but it does summarize recent research on the function of rating agencies. Rhee’s takeaway is that, “given their dominant public function, rating agencies should be subject to greater regulatory scrutiny and supervision qualitatively on levels similar to the regulation of auditors and securities exchanges.” (15) Amen to that.

SEC Update on Rating Agency Industry

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The staff of the U.S. Securities and Exchange Commission has issued its Annual Report on Nationally Recognized Statistical Rating Organizations. The report documents some significant problems with the rating agency industry as it is currently structured. The report highlights competition, transparency and conflicts of interest as three important areas of concern.

Competition. There are some of the interesting insights to be culled from the report. It notes that “some of the smaller NRSROs [Nationally Recognized Statistical Rating Organizations] had built significant market share in the asset-backed securities rating category.” (16) That being said, the report also finds that despite “the notable progress made by smaller NRSROs in gaining market share in some of the ratings classes . . . , economic and regulatory barriers to entry continue to exist in the credit ratings industry, making it difficult for the smaller NRSROs to compete with the larger NRSROs.” (21)

Transparency. The report also notes that “there is a trend of NRSROs issuing unsolicited commentaries on solicited ratings issued by other NRSROs, which has increased the level of transparency within the credit ratings industry. The commentaries highlight differences in opinions and ratings criteria among rating agencies regarding certain structured finance transactions, concerning matters such as the sufficiency of the credit enhancement for the transactions. Such commentaries can serve to enhance investors’ understanding of the ratings criteria and differences in ratings approaches used by the different NRSROs.” (23) The report acknowledges that this is no cure-all for what ails the rating industry, it is a positive development.

Conflicts of Interest.Conflicts of interest have been central to the problems in the ratings industry, and were one of the factors that led to the subprime bubble and then bust of the 2000s.  The report notes that the “potential for conflicts of interest involving an NRSRO may continue to be particularly acute in structured finance products, where issuers are created and operated by a relatively concentrated group of sponsors, underwriters and managers, and rating fees are particularly lucrative.” (25) There is no easy solution to this problem and it is important to carefully study it on an ongoing basis.

The staff report is valuable because it offers an annual overview of structural changes in the ratings industry. This year’s report continues to highlight that the structure of the industry is far from ideal. As the business cycle heats up, it is important to keep an eye on this critical component of the financial system to ensure that rating agencies are not being driven by short term profits for themselves at the expense of long-term systemic stability for the rest of us.

New and Improved Rating Agencies!

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The SEC issued its 2013 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization. I had noted that the 2012 report was not an impressive document. Much the same can be said for the 2013 version of this statutorily required document (it is required to be produced pursuant the 1934 Securities Exchange Act). It seems, to my mind, to focus on the trees at the expense of the forest.

The report is overall positive, with the staff noting “five general areas of improvement among the NRSROs [rating agencies]” from the previous reporting period:

(i) Enhanced documentation, disclosure, and Board oversight of criteria and methodologies. The Staff has observed that many NRSROs have developed and publicly disclosed ratings criteria and methodologies that better describe ratings inputs and processes. Some NRSROs have also increased Board oversight of rating processes and methodologies.

(ii) Investment in software or computer systems. The Staff found that some NRSROs have made investments in software and information technology infrastructure by, for example, implementing systems for electronic recordkeeping and for monitoring employee securities trading. One NRSRO has implemented systems that enable it to operate in a nearly paperless environment, so as to minimize the inadvertent dissemination of confidential information and to ensure preservation of all records required by Rule 17g-2.

(iii) Increased prominence of the role of the DCO within NRSROs. The Staff has found that the role of the DCO [designated compliance officer] has taken on more prominence within many NRSROs. The Staff has noticed that certain DCOs have increased reporting obligations to, and more interaction with, the NRSRO’s Board. At these NRSROs, the DCO meets with the Board to discuss compliance matters, quarterly or more frequently.

(iv) Implementation or enhancement of internal controls. The Staff has recognized that all NRSROs have added or improved internal controls over the rating process. More NRSROs are using audits and other testing to verify compliance with federal securities law, and NRSROs have generally improved employee training on compliance matters.

(v) Adherence to internal policies and procedures. The Staff has noticed a general improvement in NRSROs’ adherence to internal rating policies and procedures, which improvement appears to be attributable, in part, to improvements in the internal control structure at NRSROs. (8)

Hard to complain about any of these findings, but I have a sinking feeling that improvements such as these won’t add up to enough of a change to the culture that put profits ahead of objective ratings. Hopefully I am wrong about that