If Moody's Investors Service and Standard & Poor's were running nuclear reactors instead of credit ratings, would they still be in business?
Given their record as architects of one ratings failure after another over the past decade — from scoring Enron an investment-grade credit just days before its bankruptcy to issuing platinum ratings on trillions of dollars of doomed mortgage-backed securities — the answer is almost assuredly no.
Yet even as Congress appears poised to pass the most sweeping financial reform legislation since the Great Depression, the proposed regulations may do nothing to change how the agencies operate. Tainted they may be, but beyond a reputational hit they seem poised to carry on as before.
The Wall Street Reform and Consumer Protection Act of 2009, passed by the House in December, does call for rating agencies to beef up their internal controls, register with the Securities and Exchange Commission, bear more government supervision, and disclose more detail about their ratings methodologies. And it gives investors slightly more leeway to sue the agencies for gross negligence in their rating activities. A companion bill in the Senate, the Restoring Financial Stability Act of 2010, calls for many of the same changes, and also gives the SEC authority to deregister any agency for providing bad ratings over time.
But those proposals leave many critics unimpressed. "These kinds of things don't have much meaning," says Arturo Cifuentes, a structured-finance expert and professor at the University of Chile. As a former banker, CDO (collateralized debt obligation) fund manager, and senior vice president at Moody's, Cifuentes knows the rating-agency world well, and has testified extensively on rating-agency reform before Congress. "They are token things done in order to make the public vote for you in the next election," he says of the proposals.
No Shortage of Controls
Consider the call for internal controls, which is aimed at muting the conflict of interest inherent in a business model where agencies are compensated by the issuers of the very securities they are rating. The legislation would seem to suggest that such controls don't already exist when in fact they do — often to little apparent effect.
Moody's, for example, had a credit policy group tasked with ensuring sound rating methodologies and procedures, according to former Moody's managing director Eric Kolchinsky, who testified to a House committee in September. Moody's also had a compliance group entrusted with enforcing laws and internal policies, but Kolchinsky claimed the credit policy group was routinely overridden by line managers in the name of winning business, while the compliance group was understaffed and had little professional compliance experience. Kolchinsky was suspended from his post last year after complaining about the firm's practices.
"Just because you have a fancy board and some guy named 'chief compliance officer' doesn't mean that down on the ground things are going to go right," warns NYU Stern School of Business economics professor Lawrence White. "We've seen lots of examples where fancy boards didn't ensure that."
This isn't the first time Washington has tried to overhaul the raters. The Credit Rating Agency Reform Act of 2006 granted the SEC new authority to inspect credit-rating agencies and required that it report to Congress on credit-rating quality and conflicts of interest or inappropriate sales practices. Like the latest legislative initiative, it, too, required the rating agencies to establish internal controls aimed at managing conflicts of interest.
Yet here we are again.
"Why is it that after a series of failures we haven't had any real reform in this industry?" asks Sean Egan, managing director of Egan-Jones Ratings Co., a small ratings firm that, unlike most of its competitors, gets paid by its institutional-investor clients rather than securities issuers. "We've had a near-meltdown of the whole financial system, and yet we still don't have any real change."
Part of the problem is that Congress is grappling with a ratings system that the government itself embedded in the nation's financial system over the course of seven decades. Seeking to strengthen bank reserves following the Crash of 1929, the U.S. Comptroller of the Currency ruled in 1931 that Federal Reserve member banks could carry at cost any bonds that rating agencies had accorded investment-grade status, but would have to mark to market any that were rated below investment grade.
In 1936, the Comptroller of the Currency further decreed that Federal Reserve member banks could invest only in bonds considered investment grade by the established rating agencies of the day: Moody's Investors Service, Fitch Publishing Co. (now Fitch Ratings), Poor's Publishing Co., and Standard Statistics Co. (the latter two merging in 1941 to become Standard & Poor's, now a unit of McGraw-Hill). All this made financial institutions, by law, dependent on the rating agencies' work.
Over the ensuing decades, this government-ordered dependence on rating agencies deepened as state insurance regulators adopted minimum capital requirements for insurance companies and linked those requirements to bond ratings, too. In the 1970s, federal pension regulators did the same for pension funds. And in 1975, the SEC instituted new capital requirements for banks and broker-dealers that again referenced credit ratings.
To guard against the use of bogus ratings, the SEC further specified that those ratings be furnished by a "nationally recognized statistical rating organization" (NRSRO). Initially it accorded that status to just three firms: Moody's, S&P, and Fitch. It added four more in subsequent years, but thanks to a series of mergers the ranks of the nation's NRSROs had been pared back to three by 2000, effectively cementing their status as an oligarchy.
Today, the number of NRSROs has climbed to 10, but the Big 3 continue to account for the lion's share of the market. And while all 3 played a role in the subprime-mortgage crisis, Moody's and S&P were the bigger players by far, consistently rating 80% or more of the CDOs issued during the second half of the last decade. By contrast, Fitch saw its role in the CDO market dwindle dramatically after 2004, as it began to tighten its rating standards.
Both the House and Senate bills propose to strip away federal rules requiring financial-services firms and institutional investors to factor credit ratings into their investment decisions, paring back the government's implied endorsement of the agencies and theoretically paving the way for greater competition that could foster improved performance. Unfortunately, the bills may not go far enough. The Credit Rating Reform Act of 2006 also sought to foster competition by abolishing the SEC's authority to designate NRSROs. Instead, it said, any firm that has three years of experience and meets certain other standards can register with the SEC as a "statistical ratings organization."
"In reality, the Reform Act of 2006 created a tremendous barrier to entry," Cifuentes says, noting that no one is likely to pay for ratings from a fledgling firm that isn't recognized by the SEC. "As long as that legislation is not changed," he argues, "it will be very difficult for new interests to come into this market."
Meanwhile, there are other hurdles to effective reform, beginning with the fact that critics simply have not been able to reach a consensus on why rating agencies have performed so poorly over the past decade.
Some point to the lack of a standard ratings system that would make it easier to compare ratings and agency performance, and call for an independent body to create and oversee those standards. "Because each rating today means something else and takes different disclosure information into effect, it gives issuers the ability to pick and choose which agency they want to go to for their desired rating," says Gene Phillips, a director at PF2 Securities Evaluations, a third-party CDO valuations and consulting firm. The proposed legislation merely calls for an SEC study of standardizing ratings terminology.
More vocally, many critics fault the agency system's issuer-pay model: to win business, their argument goes, rating agencies watered down their standards in response to customer pressure. The Senate Permanent Subcommittee on Investigations presented evidence in support of this thesis for its April hearings on the rating agencies: a raft of seemingly damning e-mails sent by agency executives during the period leading up to the subprime crisis.
What's the Real Problem?
Rather than modify internal controls, critics say that the agencies' business model must change. Egan-Jones touts its model of being paid by end users. White and his colleague Matthew Richardson have argued for a system in which issuers pay into a common fund and the SEC then decides which agencies rate which securities. Still others have floated the idea of compensating rating agencies deal-by-deal based on the accuracy of their ratings, or by using as currency the very securities they have rated.
Other critics argue that the biggest problem with the rating agencies' performance was that their rating methodologies themselves were suspect, especially when applied to structured securities. The agencies sometimes relied on very short default histories to predict the future behavior of mortgage-backed securities, for example. Perhaps most egregiously, they failed to account for the possibility that mortgages across the country could slide into default simultaneously — exactly what happened in 2007 after housing prices started to decline.
It was that kind of oversight that led the agencies to confidently put AAA ratings on CDOs consisting of BBB-rated mortgage bonds. (More than 90% of AAA-rated subprime residential mortgage-backed securities issued in 2006 and 2007 have since been downgraded to junk status; see the chart above.)
It's difficult to figure out if the rating agencies were merely kowtowing to pressure from Wall Street banks, didn't know what they were doing, or didn't care as long as the money was rolling in. And, in defense of the agencies, news broke at press time that New York attorney general Andrew Cuomo was investigating whether eight large banks provided misleading information to them in an effort to win inflated ratings.
Whatever the case, "the real problem is the inaccuracy of the ratings," says Phillips. "If they were accurate, nobody would care about the peripheral issues. And we have done nothing to encourage the rating agencies to be accurate."
If Congress and federal regulators prove incapable of meaningful reform, it may be left to the marketplace to cast the final vote.
Already, there's evidence that investors are looking elsewhere for information. "It's clear the public debt markets are better indicators of trouble than ratings," says Michael Muldowney, CFO of Houghton Mifflin Harcourt Publishing Co., which has debt rated by both Moody's and S&P. "There have been empirical studies showing credit spreads on debt widening ahead of a ratings downgrade."
It's unlikely, of course, that the rating agencies will disappear completely. As Egan points out, it would be horribly inefficient if, say, 500 buyers of a bond offering had to assemble 500 teams of credit analysts to do the same due diligence.
But Cifuentes doesn't think it would be bad if "Moody's and S&P [were] prevented from giving ratings, at least in structured finance. They have been proven ineffective. How much worse could you be?" He suggests that "we all would be better off if a new group of five or six rating agencies came along."
Eventually, investors may simply tire of waiting, especially if they are freed from rules requiring them to consider credit ratings when making investment decisions. In short, if Congress doesn't get credit-rating-agency reform right — and soon — it may not have to bother at all.
Randy Myers is a contributing editor of CFO.