SEC Update on Rating Agency Industry

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.

Does Morningstar Speak with Forked Tongue?

Morningstar Credit Ratings, a small Nationally Recognized Statistical Rating Organization (albeit a subsidiary of Morningstar, the large investment research firm), has issued a Structured Credit Ratings Commentary on Rating Shopping in Asset Securitization Markets. It finds that

Rating shopping is alive and well in the U.S. securitization markets notwithstanding the implementation of regulatory and legislative actions intended to curb the practice and promote competition among credit rating agencies, or CRAs. It is important to note, however, that the rating shopping following the financial crisis has not led to a “race to the bottom” scenario with respect to rating standards that some congressional lawmakers and other critics of the issuer-paid model believe was prevalent during the years leading up to the crisis. (1)

I have to say that I find Morningstar’s analysis perplexing. The commentary highlights a number of structural problems in the ratings agency industry. It then goes on to say that everything is fine and that there is no race to the bottom to worry about, to lead us into another financial crisis.

The commentary goes on to state that while

it is rational for issuers and arrangers to choose the CRA with the least onerous terms, CRAs generally have held their ground by adhering to their analytical methodologies notwithstanding the constant threat of losing business. . . . The CRAs’ unwillingness to lower their standards in the midst of reviewing a transaction is attributable in part to strong regulatory oversight from the SEC, which has focused heavily on holding nationally recognized statistical rating organizations, or NRSROs, accountable for following their published methodologies. (1-2)

I find it odd that the commentary does not consider where we are in the business cycle as part of the explanation. Once the market becomes sufficiently frothy, rating agencies will be more tempted to compromise their standards in order to win market share. I wouldn’t accuse Morningstar of speaking with a forked tongue, but its explanation of the current state of affairs seems self-serving: move on folks, we rating agencies have everything under control for we have tamed the profit motive once and for all!

The Road to Securitization

Miguel Segoviano et al. of the IMF released a helpful Working Paper, Securitization:  Lessons Learned and the Road Ahead (also on SSRN). It opens,

Like most forms of financial innovation, there are cost and benefits associated with the securitization of cash flows. From a conceptual perspective, a sound and efficient market for securitization can be supportive of the financial system and broader economy in various ways such as lowering funding costs and improving the capital utilization of financial institutions—benefits which may be passed onto borrowers; helping issuers and investors diversify risk; and transforming pools of illiquid assets into tradable securities, thus stimulating the flow of credit—an issue of particular relevance for some European countries. However, these features need to be weighed against the potential costs, including the risk that securitization contributes to excessive credit growth in and outside of the formal banking system; principal-agent problems that amplify perverse incentives; the complexity and opaqueness of certain products which make efficient pricing problematic; and the heavy reliance of the industry on credit ratings. (3)

The authors identify lessons learned from the financial crisis as well as impediments to a renewed securitization market. They conclude with a set of policy recommendations.

I recommend this paper as a good overview. I particularly like that it looks beyond the United States market, although it does spend plenty of time looking at the history and structure of the U.S. market. The recommendations tend to be pretty reasonable, but not particularly innovative — implement Dodd-Frank-like requirements in non-U.S. jurisdictions; de-emphasize the role of NRSRO credit ratings; increase transparency and decrease needless complexity throughout the industry; modernize land record regimes, etc.

It is surely hard to get your hands around the global securitization industry, but it is important that we try to. Securitization is here to stay. We should manage its risks the best that we can.

New and Improved Rating Agencies!

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

These Are A Few of My Favorite Things

Along with raindrops on roses and whiskers on kittens, reforming Government-Sponsored Enterprises and rationalizing rating agency regulation are two of my favorite things. The Federal Housing Finance Agency noticed a proposed rulemaking to remove some of the references to credit ratings from Federal Home Loan Bank regulations. This is part of a broader mandate contained in Dodd Frank (specifically, section 939A) to reduce the regulatory privilege that the rating agencies had accumulated over the years. This regulatory privilege resulted from the rampant reliance of ratings from Nationally Recognized Statistical Rating Organizations (mostly S&P, Moody’s and Fitch) in regulations concerning financial institutions and financial products.

The proposed new definition of “investment quality” reads as follows:

Investment quality means a determination made by the Bank with respect to a security or obligation that based on documented analysis,including consideration of the sources for repayment on the security or obligation:

(1) There is adequate financial backing so that full and timely payment of principal and interest on such security or obligation is expected; and

(2) There is minimal risk that that timely payment of principal or interest would not occur because of adverse changes in economic and financial conditions during the projected life of the security or obligation. (30790)

The FHFA expects that such a definition will preclude the FHLBs from relying “principally” on an NRSRO “rating or third party analysis.” (30787)

This definition does not blaze a new path for the purposes of Dodd Frank section 939A as it is in line with similar rulemakings by the NCUA, FDIC and OCC. But it does the trick of reducing the unthinking reliance on ratings by NRSROs for FHLBs. Forcing financial institutions to “apply internal analytic standards and criteria to determine the credit quality of a security or obligation” has to be a good thing as it should push them to look at more than just a credit rating to  make their iinvestment decisions. (30784) This is not to say that we will avoid bubbles as a result of this proposed rule, but it will force FHLBs to take more responsibility for their decisions and be able to document their decision-making process, which should be at least a bit helpful when markets become frothy once again.

When the cycle turns, when greed sings
When I’m feeling sad,
I simply remember
my favorite things
and then I don’t feel so bad!

S&P’s Coy-ful Analysis of Basel Securitization Framework

S&P has long taken the public position that ratings from an NRSRO (like S&P or Moodys) should not be required.  This position would seem to be against its own interest and thus be quite public spirited.

Its recent Response to Consultation on Basel Securitization Framework may make one question whether it really stands by that public position after all.

The response raises a “number of significant concerns” about proposed revisions to the Basel securitization framework:

  • In seeking to reduce the framework’s reliance on external ratings, the proposals increase its reliance on various formula-based approaches. These generally do not take into account the full range of factors that can affect the creditworthiness of a securitization exposure, potentially undermining the framework’s risk sensitivity.
  • Because the proposed framework includes at least five different approaches to calculating securitization capital charges, there is significant scope for inconsistencies in treatment between different banks and/or jurisdictions.  . . .
  • Notwithstanding the Committee’s aim of ensuring more prudent capital charges for some securitization exposures, we question whether the losses experienced by securitizations globally since the 2007-2008 financial crisis warrant the scale of increase in capital charges that the proposals would result in, especially for investment-grade tranches.
  • Our analysis suggests that in many situations the Revised Ratings-Based Approach (RRBA) leads to significantly higher capital charges than the other proposed approaches, which suggests the RRBA may be incorrectly calibrated.
  • Although the proposals envisage various capping mechanisms to mitigate the risk of excessively high capital charges, our analysis suggests that these caps could determine capital charges in many situations, rather than being an exception. . . . (2)
The first two concerns appear to argue that NRSROs are necessary to the rating process.  The second two appear self-interested (consistent with their behavior for years) in that they argue against higher capital charges.  Higher capital charges would slow the growth of the securitization market and thus their own rating business income. Given that S&P had gotten its models for RMBS so wrong, it is disconcerting to see it oppose capital requirements that might err the other way for once.  And the last concern — that the exception may swallow the rule — is deliciously ironic, given that that was a major problem with S&P’s ratings of RMBS during the boom. As always, S&P’s input on this topic must be viewed through the lens of its self-interest to ensure that its positions are in the public interest.

Rating Agency Reform

Emily McClintlock Ekins and Mark A. Calabria have recently posted a policy analysis to SSRN, Regulation, Market Structure, and Role of the Credit Rating Agencies.  They argue, as others have before them, that the major rating agencies are an oligopoly.  And like others, they argue that references to ratings should be weeded out from financial regulations.  The main value of their analysis, at least as far as I am concerned, lies with their analysis of other options.  They review three alternative regimes:

  • Open Access
  • Licensing
  • Licensing with captive demand

They define an open access regime as “an industry specific regulatory framework not stipulated by the state.” (24) With a licensing regime, “the state would stipulate that credit risk analysis be used to either require or incentivize investors to purchase high quality financial instruments.” (25) And with a licensing regime with captive demand, the state would, in addition to licensing,  also “stipulate, or ‘designate,’ whose credit risk analyses would be eligible to be used to meet requirements or incentives when purchasing financial instruments.” (26) They reject other reforms, such as (i) having the government take on the role of the rating agencies, (ii) holding the rating agencies liable for their ratings and (iii) banning ratings of overly complex financial instruments.

While I do not take a position on their reform agenda (other than finding the analysis of the open access option to be overly optimistic), it is important that people are thinking about what life would be like without the NRSRO designation for rating agencies that grants them the power to act as gatekeepers to the capital markets.  While many have criticized, few have come up with real alternatives to the system we now have.  Much more thought needs to go into creating a real alternative, and this analysis is part of effort to come up with one.

(As a side note, they have some interesting charts and tables, including Figure 5 which shows the increase in rated RMBS by Moody’s and S&P from 2002 to 2006.  Bottom line:  they more than doubled.).