Credit Ratings Agencies and Investors: Lessons Learned

Kurt N. Schacht, JD, CFA†

Among the many casualties of the global financial crisis is the traditional practice of using Nationally Recognized Statistical Ratings Organizations (NRSRO, or Credit Ratings Agencies) to analyze the likelihood of default of issuers of corporate securities. The implosion of structured products that carried the highest ratings of quality from the Credit Ratings Agencies have awakened the financial community to conflicts of interest, deficiencies in analysis, and dangerous investor shortcuts.

By way of background, the CFA Institute Centre for Financial Market Integrity represents the views of investment professionals, including portfolio managers, investment analysts, and advisors located in more than 130 countries worldwide. Central tenets of the CFA Institute Centre mission are to promote fair and transparent global capital markets, and to advocate for investor protections. An integral part of our efforts toward meeting those goals is ensuring that the quality of corporate financial reporting and disclosures provided to investors and other end-users remains of high quality. The CFA Institute Centre also develops, promulgates, and maintains guidelines encouraging the highest ethical standards for our members and the global investment community at large through standards such as the CFA Institute Code of Ethics and Standards of Professional Conduct and Asset Manager Code of Professional Conduct.

Over the past two years, the CFA Institute Centre has responded to six domestic and international regulatory consultations, and conducted two surveys of our 100,000 members on various aspects of the Credit Ratings Agency debate. Our responses to these consultations have discussed, among other things, the role and responsibilities of the credit rating firms, the NRSRO process, and conflicts of interest inherent in the issuer-paid model.

Regarding the credit-rating process, users are most concerned about the conflicted nature of ratings. The CRAs did a poor job of handling the crisis and their role was significant in convincing many investors, who would not have otherwise invested, to buy into a mix of exotic and complex instruments that were rated triple-A. While much of this CRA activity is still under investigation, there is convincing information that firms did an inadequate job of performing their due diligence. This includes little investigation of underlying mortgage portfolios, weak testing of default risks in a booming housing market, and failure to objectively and knowledgably rate many of these brand new structured products. Apparently the lure of a high and sustained flow of fee income related to the manufacture, rating, and sale of mortgage paper impaired good judgment and process. In case after case, ratings were issued on collateralized and other structured instruments—ratings that were based on very limited performance data for the underlying collateral. Often there was little or no prior record of default experience or track record of performance for such instruments. All of these factors led to an extremely conflicted, low-quality product and service in the view of many. In an environment in which the government has required these ratings and/or certified the raters, this is unacceptable and should never be permitted to happen again.

Earlier this year, we, in cooperation with the Council of Institutional Investors, created the Investors Working Group, which brought together an august panel of investors, investor advocates, and former regulators to consider these and other matters relating to financial market regulatory reform from the investors’ perspective. Co-chaired by former SEC chairmen Arthur Levitt and William Donaldson, this group considered the substantial role credit rating agencies played in the U.S. market turmoil and recommended changes for a more comprehensive and rigorous government regulatory model complete with conflict protections and consequences for improper process and behavior. These include the following:

1. Congress and the Administration should consider ways to encourage alternatives to the predominant issuer-pays NRSRO business model.

The IWG suggested that the fees earned by the NRSROs should vest over a period of time equal to the average duration of the bonds. Fees should vest based on the performance of the original ratings and changes to those ratings over time relative to the credit performance of the bonds. Credit rating agencies that continue to operate under the issuer-paid model should be subject to the strictest regulation.

2. Congress and the Administration should bolster the SEC’s position as a strong, independent overseer of NRSROs.

The SEC’s authority to regulate rating agency practices, disclosures, and conflicts of interest should be expanded and strengthened. The SEC should also be empowered to coordinate the reduction of reliance on ratings.

3. NRSROs should be required to manage and disclose conflicts of interest.

As an immediate step, the IWG recommended that NRSROs should be required to create an executive level compliance officer position. More complete, prominent, and consistent disclosures of conflicts of interest are also needed. And credit raters should disclose the name of any client that generates more than 10% of the firm’s revenues.

4. NRSROs should be held to a higher standard of accountability.

The IWG recommended that Congress eliminate the effective exemption from liability provided to credit rating agencies under Section 11 of the Securities Act of 1933 for ratings paid for by the issuer or offering participants. This change would make rating agencies more diligent about the ratings process and, ultimately, more accountable for sloppy performance.

The IWG also believes that NRSROs should not rate products for which they lack sufficient information and expertise to assess. Credit rating agencies should only rate instruments for which they have adequate information and should be legally vulnerable if they do otherwise. This would effectively limit their ability to offer ratings for certain products. For example, rating agencies should be restricted from rating any product that has a structure dependent on market pricing.

Finally, the IWG said NRSROs should not be permitted to rate any product where they cannot disclose the specifics of the underlying assets. The IWG also recommended that credit rating agencies be restricted from taking the metrics and methodology for one class of investment to rate another class without compelling evidence of comparability.

5. Reliance on NRSRO ratings should be greatly reduced by statutory and regulatory amendments. Market participants should reduce their dependence on ratings in making investment decisions.

Many statutes and rules that require certain investors to hold only securities with specific ratings encouraged some investors to rely too heavily on credit ratings. Eliminating these requirements over time, or clarifying that reliance on the rating does not satisfy due diligence obligations, would force investors to seek additional and alternative assessments of credit risk.

The IWG report also calls for more and better oversight from the SEC, increased and substantive disclosures about conflicts of interest, a higher standard of accountability, and finally a reduced reliance on credit ratings in statutes and regulations.

As a global organization, we also have been called upon to consider credit rating reform from a number of other perspectives over the past year. To help inform our positions, we have surveyed our global membership on two occasions, most recently in April 2009. In response to the questions asked in that survey, our members conveyed a lack of trust in these firms. More than 60% of the 1,182 respondents concluded that the ratings issued by credit rating agencies are not valid. A nearly identical 60% stated that they don’t find that such opinions are useful in their investment decision-making processes. When asked about government regulation of CRAs, more than 70% said that additional oversight was needed. On the other hand, 51% disagreed with steps by the U.S. government to deemphasize reliance on credit ratings for investors and issuers, alike.

These results point to a number of cross-currents in this CRA debate. We are currently caught in a world that is hovering between full government regulation of ratings and a laissez faire model of these firms as independent service providers to issuers. Our survey results and the seeming contradictions in their responses reflect this confused picture. As it currently stands, there is a very high distrust of the credit rating process. At the same time, a significant majority say more government oversight is needed, while a slim majority disagrees with steps to remove reference to CRAs and to deemphasize their role in providing rating services regulation.

We do not intend to defend members of the CRA industry, realizing that they are clearly not the only ones to blame, but rather are only the easiest to focus on. The CRAs were in the unfortunate spot of being an early and visible target in this credit mess. The complexity and interconnectedness of this crisis are still being sorted out, but most stakeholders were fairly clear on the role played by the CRAs and how various “credits” and instruments, held out to be the triple-A gold standard rating, were now imploding.

There are a few things to consider in this regard. While the government on the one hand was criticizing CRAs and the accuracy of their ratings, the ratings on firms associated with credit rescue programs (such as the mono-line insurers and others) remained unchanged despite well-known problems. It was, and continues to be, a very mixed message and one that needs to be clarified. We must not have a situation in which two sets of ratings apply—one for private companies and another for when government bailout funding is involved.

† Managing Director, CFA Institute Centre for Financial Market Integrity