Quis Custodiet Ipsos Custodes?: America’s Rating Agencies and the Future of Securitization

Troubled by rising oil and food prices, an uncertain economic future and growing joblessness, Americans are seeking a scapegoat for the widening recession. Easy targets for criticism may seem to exist in the form of flashy investment bankers mincing around financial networks in Ferragamo loafers, but the truer culprits are likely to be found in credit rating shops. Credit rating research analysts, and especially those working within the triumvirate of Moody’s, Fitch and Standard and Poor’s, determine the direction of billions of dollars in cash flows simply through the addition or omission of single letters. Within S&P’s nomenclature, “BBB” makes a security “investment grade” when one “B” less turns a bond into “junk”. In an industry where practitioners rarely have the time to verify every bit of truth behind a research report, a firm credit rating can be peace of mind. Problematically, though, the gleam of these agencies has flickered out as their inability to functionally process structured investment products becomes increasingly apparent.

On April 22, the US Senate Committee on Banking, Housing and Urban Affairs met under the leadership of Senators Dodd and Shelby to discuss the proper role of credit rating agencies and to what extent these groups bear responsibility for the present turmoil in American markets. Many, like Professor John Coffee of Columbia Law School, allege that the relative lack of oversight within the credit rating business space allowed “loose” practices to flourish that artificially wed investors with risky securities. Enticed by ratings that made these securities—among them being the now infamous CDO mortgage packages—more attractive than they would have been otherwise, these investors chomped up tranche upon tranche of the subprime housing anticipating the best. The packages, after all, bore AAA ratings, purportedly equal in stability to the United States government. But as unqualified homeowners continue to default on their payments, as the general economy suffers as a result and as even more unqualified homeowners default as a result of this suffering, nothing in the picture screams “US Treasury 10 Year”. This being the case, the tables have turned and it is now appropriate to rate the value of the rating agencies, themselves.

Surveying the industry, we immediately discover a handful of faulty practices that slip under the noses of regulatory watchdogs. Firstly, the credit rating sector is an oligopolistic market where until very recently only three agencies had “Nationally Recognized Statistical Rating Organization” designation from the SEC permitting the companies to be monitored regularly. Created by the Credit Rating Reform Act of 2006, the NRSRO badge subjects all corresponding rating agencies to SEC auditors and opens bookkeeping to federal analysts. This is certainly a good first step toward holding rating groups more accountable, but it does not address the underlying problem of their being too few players in the ratings area. Without competition, reputational capital is unimportant for rating firms meaning that they need not rely on the persisting accuracy of their research to garner future business. Issuers will come to Moody’s and S&P’s nonetheless because ratings are necessary in modern security markets. Already, then, the ratings problem poses a Catch 22: Undoubtedly higher levels of regulation are needed to hold the firms accountable, but a more stringent regulatory atmosphere may create barriers to entry for prospective competitors, keeping the present actors isolated in their ivory towers.

It is equally disturbing that credit rating companies currently enjoy immunity from liability in events where their research proves inaccurate. Professor Coffee makes the point that other “gatekeepers” of financial instruments—like accountants, lawyers and investment bankers—are regularly sued by investors when things get hairy. Credit rating representatives, though, are able to hide behind First Amendment rights, claiming that they do nothing more than publish information that in no way implies actual responsibility. This only adds to the complacency instilled by the oligopoly structure of the market space.

Further demons are found in the logistical frameworks of the industry. Credit ratings are, for many securities, firm prerequisites to other financing activities. Therefore, even in instances where ratings are regarded as flawed, financial firms and investors must tolerate the “grades” in order to allow business to move forward. Another red flag rises when we find that ~90% of all revenues raised by rating agencies come from issuers requesting ratings. Professor Frank Partnoy of the University of San Diego School of Law says that this effectively makes rating firms into “watchdogs paid by the people they are to watch”. In contrast, since Sarbanes-Oxley reforms went into effect security analysts in investment banks are strictly separated from underwriting functionaries who could otherwise pressure the research teams to “polish up” reports on firm clients. More recently, rating agencies have implemented a “consulting” business model wherein two reports are delivered to any potential issuer. A first report outlines how the credit model was created and hints at a possible rating. The second report is the one that goes public and determines investment. Effectively, this means that issuers who are unhappy with their “first round” results can opt out of the game, thereby reducing market transparency.

Perhaps even closer to the core of the credit rating dilemma, agencies have few incentives that align their interests with those of the investing public. After the initial authorization of security in the form of a rating, the rating agency has no reason to keep up with the unfolding strength or weakness of the instrument. Compensation for the firms generally comes upfront and to monitor ratings down the line costs money and time. Unless broader accountability standards are enacted, few at the rating shops are likely to bother updating the books until crisis strikes. In the present panic, we see this trend clearly with all three members of the triumvirate frantically downgrading CDOs to save face.

When we look for reasons for why the rating shops got things so patently wrong, a possible explanation exists in rating methodologies. For most of their histories, credit rating agencies stuck to “vanilla” corporate bonds where mathematical models do a good job at predicting the future. GE’s cash flows can be reasonably extended into the future and even the contingencies associated with a riskier entity can be acceptably reflected in formulas. With structured finance vehicles, on the other hand, the situation gets a lot murkier a lot quicker. We might regard “derivatives” and “tranches” as code words to be interpreted as uncertainty. Surely someone knows how the actual instrument functions, but in this case that someone is the keen issuer able to turn trash into gold. Market alchemists seem to have conned rating analysts with their craft, and the resulting pill is a bitter one. Factors like “default contagion”—the idea that a certain base level of defaults will spur accelerating default levels—were not implemented into agency models when they developed CDO ratings. A lack of understanding about the nature of the securities they were grading meant that the graders were working blind.

Taking the floor last Tuesday, SEC Chairman Christopher Cox promised that the federal government was taking concrete steps to remedy the dire scenario. The Credit Agency Reform Act took effect less than two years ago and federal resources are still acclimating to the new regulatory setting. Ideally, as government auditors learn what to look for in credit agency reports and they learn specifically what practices are the most damaging, the SEC can weave solutions. Even so, a pessimistic view posits that no endogenous solution is apparent. What measures can the government realistically undertake that will counter the aforementioned flaws? Great levels of enforcement may be good to crack down on conflicts of interest, but broadened regulation will also comprise a barrier to entry for new market competitors. This will preserve the oligopolistic composition of the industry, permitting self-satisfaction to persist among the rating personnel.

For this reason, it will likely take an in-depth study on the part of the federal government to pinpoint very specific areas for improvement and regulation. But as markets continue to tumble into oblivion, only time will tell if the SEC will be able to preserve the discipline and resolve needed for this course of action. With mainstream American investors calling for blood, we might well see some shed—an increasingly activist Congress may try to fence in rating agencies before they can wreak more havoc. Ultimately, this response would be worse than if the status quo were preserved because it would cut back on rating agencies’ access to information. Nationalization of the industry is always a tangential solution, but one that would not sit well with most free market proponents who think that the market, itself, should determine what information is useful and good. However the powers that be “solve” this problem, it seems clear that accompanying problems will continue to crop up unabated.

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