This content is from: Portfolio

Weighing the Proposals On Overhauling Rating Agencies

Several proposals on how to overhaul the rating agency model are floating around. Here’s a quick summary of some of the proposals being bandied about at the moment.

One of the early story lines in the financial reform debate was that stepped up oversight of rating agencies, called low hanging regulatory fruit by the New York Times , was a can being kicked down the road. However, with heightened attention on ratings agencies of late (in the Senate as well as in the New York State Attorney General’s office), it’s back on the front burner — several proposals on how to overhaul the agency model are floating around. Some of them, while not all so radical, are fairly pragmatic, and, moreover, easy to implement. Others don’t really make any sense whatsoever.

Here’s a quick summary of some of the proposals being bandied about at the moment.

Call in the S.E.C.

Last fall, House Financial Services Committee member Rep. Paul Kanjorski, D-Pa., who also chairs the subcommittee on capital markets, insurance and government-sponsored enterprises, introduced HR 3890, the Accountability and Transparency in Rating Agencies Act, which among other things would empower the S.E.C. to discipline executives at Nationally Recognized Statistical Ratings Organizations (NRSRO) for failures to supervise. Until the S.E.C. radically changes its image (toothless, not really effective), there's no sense going there.

— Rating: B

Sue the Bastards

Kanjorski’s legislative proposal also includes a provision that would make it easier for chagrined investors to successfully sue rating agencies, raising the standard of liability. A Senate version of financial reform legislation written by Sen. Chris Dodd, D-Conn., also attempts to intensify liability standards, so that plaintiff’s lawyers, instead of having to prove fraud, need merely show that agencies failed to act reasonably when researching and assigning a rating. Hitting the NRSROs where they most hurt is an understandable approach but the unintended consequences, such as possibly scaring away a new crop of potential entrants into the ratings field thus sparking more competition, could outweigh the original intentions.

— Rating: BBB

Issuer Still Pays, Just Doesn’t Select

Sen. Al Franken, D-Minn., in early May introduced an amendment to financial reform that would put an end to ratings shopping, an insidious stain on the financial services industry and one of the reasons (along with “credit enhancements” that proved insufficient) so many disastrous deals wound up with the highest possible ratings. The Senate on Friday May 14 passed Franken’s amendment to the Senate bill, paving the way for the creation of an S.E.C.-administered but independent board of mostly investor community members who would be responsible for choosing which NRSRO rated a deal, not the bankers eager to get the highest possible rating. Creating yet another new entity in a regulatory framework awash in alphabet soup seems like overkill and the relevance of ratings becomes further entrenched in a system that needs to be weaned off them, plus there’s no telling what new conflicts creep up under this model. Yet the Franken proposal, modeled after work done by a pair of New York University law professors, in one swift blow cuts directly to the heart of the financial crisis.

— Rating: AAA

Reference Removal

An amendment proposed by Sen. George LeMieux, D-Fla., also passed earlier this month and will be included in the Senate version of financial reform. LeMieux’s solution is to do away with a host of statutory references to credit ratings, an attempt to undercut the relevance of ratings by eliminating instances where by law government agencies or securities firms need to own things that are rated investment grade by an NRSO. The S.E.C. is already setting about pruning some references to ratings requirements from the Investment Company Act of 1940 and the Securities Exchange Act of 1934, and in doing so prompted some blowback from money market fund industry members who insist they rely on ratings to set a firm threshold for what these vehicles can hold. Ratings are too intertwined in the financial system and in a myriad of contractual instances to think we can write them out of history, although the agencies themselves welcome the notion that they can be taken down from pedestals.

— Rating: AA

Constant Surveillance

Sen. Bill Nelson, D-Fla., has been pushing for an amendment that would force rating agencies to continuously survey issuances even if they are not paid to do so. Most deals involve ongoing surveillance, and the agencies are always doing unsolicited opinion pieces so this seems not very useful, but it’s not the worst idea we have ever heard of.

— Rating: BB

Investor, Eat Thine Own Cooking

Stanford Law professor Joe Grundfest’s white paper on a new breed of investor owned, and governed ratings agencies makes sense – on paper. But with no end to the issuer-pay model in sight, new conflicts would arise eventually at these new agencies so long as they are run for profit. Still, such a paradigm shift could create more ratings, better ratings and more competition. At press time no lawmaker had taken this idea up, but the market could do so on its own any time it wants. Sometimes not always, but sometimes the market really does know what’s best.

— Rating: AA

Richard Blake Rich Blake is a New York City-based freelance financial journalist. He currently contributes to Institutional Investor magazine, Reuters HedgeWorld and, among others.

Related Content