Examining Reform Proposals for the Credit Rating Industry

Raymond W. McDaniel†

The recent market crisis exposed numerous vulnerabilities in the infrastructure of the global financial system that had severe and reverberating consequences.[1] Important lessons for credit rating agencies and other market participants have emerged from the rapid and dramatic market changes.

During the past 18 months, Moody’s has reached out to market participants and policymakers globally for feedback regarding the utility of our ratings and ratings system. We have used that feedback, lessons learned from the recent market crisis, and our own deliberations to adopt a wide range of measures to enhance the quality, independence, and transparency of our credit ratings and the rating process. [2] These enhancements build on Moody’s existing practices and processes through which we continually seek to ensure the integrity and credibility of our ratings.

We believe, however, that beyond our own internal efforts, thoughtful action by legislators, regulators and other market participants can play a critical role in reinforcing high quality ratings and improving market transparency without intruding on the independence of rating opinion content .

Numerous reform proposals are now the subject of vigorous public debate. We believe that some – such as increasing transparency in the ratings process or reducing the use of credit ratings in regulation – likely will have a positive impact. We are concerned, however, that other proposed measures do not address the more fundamental vulnerabilities in the credit market and ultimately could, if implemented, end up reducing transparency and the availability of diverse, independent opinions in the market.

Fragmentation of financial regulation is also increasingly a threat to achieving globally agreed upon goals for reform in the credit rating industry. [3] Inconsistencies and contradictions in regulation are beginning to appear at the national and/or regional level. These divergences may result in negative consequences not only for rating agencies, but more importantly for the broader capital markets.

Finally, for credit rating agencies to most effectively fulfill their important but limited role in the structured finance market, key weaknesses in the structured market must be addressed. In particular, we see a strong need for greater transparency and disclosure by issuers to the investing public of information about transaction structures and asset pools. Only with such transparency and disclosure can investors make informed and considered judgments about these assets and properly assess the opinions offered by credit rating agencies.

Proposals to Improve Credit Ratings

There are numerous proposals in the U.S. and other countries at various stages of consideration and adoption aimed at improving the accountability and transparency of the credit rating industry. We believe that many of these proposals could be constructive, if properly crafted and implemented. Others, however, while well intentioned, could actually undermine the very attributes of credit ratings that market participants and authorities most value.

Below I have summarized Moody’s views on proposals in eight key areas in which changes are being debated, including: 1) enhanced transparency, 2) regulatory oversight, 3) the use of credit ratings in regulation, 4) governance, 5) liability, 6) credit rating agency business models, 7) the independence of ratings content, and 8) combating rating shopping.

1. Enhanced Transparency

Moody’s supports efforts to increase the transparency of ratings performance and ratings methodologies and believes that such disclosures can benefit the credit markets.

In our view, the market would benefit from a single regime governing disclosure of ratings performance and track-records for all rating agencies in the market. In particular, we expect that authorities and market participants are interested in comparing the aggregate performance of issuer-paid ratings to the performance of non-issuer-paid ratings (including subscriber-paid ratings). An absence of uniformity in regulatory approach and a corresponding lack of transparency regarding the performance of non-issuer paid ratings is likely to impede, rather than promote, quality-based competition.

Moody’s already has increased the transparency of our methodologies and their risk characteristics, and we support legislative efforts to continue such initiatives by requiring increased disclosures in the industry relating to information such as the assumptions used in ratings, the potential limitations of ratings, the information reviewed in the rating process, and the potential volatility of the rating.

It also may be appropriate to disclose some additional data, such as fees received from each rated entity, to regulators. In pursuing this path, however, care must be taken to avoid undermining analyst objectivity. Moody’s, for example, currently prohibits analysts and managers from engaging in discussions regarding fees with issuers. Mandatory public disclosure of fees received from each rated entity could undermine our efforts to prevent analysts’ judgment from being influenced by knowledge of how much revenue particular issuers contribute to Moody’s aggregate revenues. Mandatory disclosure of rating fees also could inadvertently raise antitrust issues.

2. Regulatory Oversight

Moody’s generally supports provisions in the U.S. House of Representatives’ recently published Discussion Draft, “Accountability and Transparency in Rating Agencies Act” (Discussion Draft), to enhance the oversight of all Nationally Recognized Statistical Rating Organizations (NRSROs), including the proposal to establish an office within the Securities and Exchange Commission (SEC) to oversee the credit rating industry. Such a dedicated office, staffed by individuals with expertise in the credit rating industry, would increase the focus of regulatory oversight and ensure that the interests of all market participants are well protected. Moody’s also supports legislative language that would clarify the SEC’s ability to apply fines or sanctions to NRSROs that fail to meet regulatory requirements, as this would help to promote accountability for credit rating agencies. Finally, we welcome requirements for all NRSROs to establish governance procedures that appropriately manage conflicts of interest. Moody’s already has such procedures in place, but enacting such a requirement would help restore confidence in our industry by ensuring that all NRSROs have appropriate governance mechanisms.

3. Credit Ratings in Regulation

Moody’s has long been concerned about the regulatory use of ratings,[4] and the rapid and dramatic market changes over the last two years have only reinforced our belief that it can produce adverse consequences. Specifically, we believe that the use of ratings as a regulatory tool for oversight of regulated entities can adversely affect the behavior of market participants, encourage both over-reliance on ratings and rating shopping, and reduce incentives for rating agencies to compete based on the quality of ratings. We therefore strongly support efforts to remove references to credit ratings in regulation. We recognize, however, that in light of current market conditions, eliminating or reducing ratings-based criteria should be pursued judiciously as financial markets continue to show signs of weakness.

4. Governance

Moody’s supports the concept of oversight by an independent board of directors. Eight of the nine directors on the Moody’s Corporation Board are independent directors, as defined by the New York Stock Exchange (NYSE). We also support having the board provide oversight with respect to procedures and policies. From a governance point of view, we believe it can be healthy for boards to have such input and that our board members have the appropriate skill set to succeed at this type of oversight. We also believe that a separate committee of independent directors within the board may be the best way to accomplish this goal. Audit Committees may serve as a good model for forming a committee charged with the oversight of rating policies and procedures.

However, it could undermine ratings quality to require the Board, as some have proposed, to provide oversight with respect to the content of methodologies – a role that is currently filled at Moody’s Investors Service by our independent Credit Policy Group. Implementing a proposal like this would replace the judgment of a large body of full-time experts in credit analysis with, at best, a small body of part-time experts in credit analysis and, therefore, we question how it would strengthen the quality of ratings.

5. Liability

Liability for credit ratings has been the subject of much discussion in recent months, seemingly based on the misguided belief that credit rating agencies are somehow “immune” from lawsuits. This, of course, is not the case.

No less than any other market participants, credit rating agencies have potential liability, for example, if they knowingly make false statements, engage in fraudulent conduct, or issue opinions that they do not genuinely hold. Moody’s and other credit rating agencies are in fact being sued at this moment in numerous cases in federal and state courts around the United States. So, under the existing law, there is already substantial accountability. Courts agree, however, that, given the specter of unlimited liability, and the public interest in having independent rating opinions, credit rating agencies should not be subject to potential liability simply because some disagree with an assigned rating, or because of honest errors of judgment.

Measures that would create new standards of liability could have a significant negative impact on markets. It is a rating agency’s task to make unbiased and often unpopular observations, and it is in the nature of the business that our opinions about the future (which are not statements of fact) often are not welcomed – either by the issuers, the underwriters, or the current holders of the issuer’s securities. At any time, therefore, some market participants are likely to be unhappy with, and eager to contest, what they perceive as the “rightness” of a particular rating.

Any change in the legal regime that exposes rating agencies to greater liability is likely to result in a significant increase in threatened and actual litigation, much of it driven by mere disagreement with rating opinions. Indeed, litigation pursued against rating agencies historically has come from issuers seeking to use the courts to coerce agencies into issuing higher ratings or refraining from taking negative rating actions. This could lead credit rating agencies to avoid publishing controversial opinions and instead to issue ratings that tend to conform to market sentiment. This would clearly be an unintended and undesirable consequence of any reform recommendations as it would quash diversity of opinions and, in turn, negatively impact transparency in the markets. In addition, to the extent that rating agencies would increasingly move in lock-step with the market, rating opinions would be more volatile and pro-cyclical. If ratings continue to be used in the regulatory frameworks, such pro-cyclical behavior could have an adverse impact on global capital markets.

Finally, measures that would attempt to create new standards of liability for credit rating agencies could lead to a greater risk of over-reliance on ratings by investors. This is because investors may be tempted to believe that, if a rating agency is subject to heightened standards of liability and publishes an opinion in such an environment, the CRA would be expected to have considered all elements of risk for an investor. This could leave the investor with the misguided comfort that a rating agency’s opinion on credit risk addresses all the risk elements (e.g., foreign exchange risk) relevant to the investor, not just the credit risk that our opinions are actually intended to address.

6. Rating Agency Business Models

Some market observers remain skeptical that meaningful rating quality improvements can be achieved within the context of the issuer-pays model, maintaining that the potential conflict of interest inherent in the issuer-pays model is fundamentally unmanageable. In fact, all credit rating agency business models (investor-pays, government-pays, and issuer-pays) have embedded conflicts that need to be properly managed. Furthermore, the greater analytical resources and the free public availability of ratings under the issuer-pays model have demonstrable benefits in terms of rating quality.

During its history, Moody’s has operated at various times both under an issuer-pays and an investor-pays model. Historical performance recorded under both does not support the assertion that the potential conflict of interest in the issuer-pays model is unmanageable. In fact our research shows that with respect to ratings on companies, the issuer-pays model that Moody’s has used since the early 1970s is actually associated with higher accuracy ratios,[5] lower investment-grade loss rates, and higher downgrade rates [6] than the investor-pays model Moody’s used prior to that time.

All together, the data suggest that our ratings on companies have become more accurate and less “issuer-friendly” over time. Moreover, these findings are consistent with academic studies and our own research, which have observed that our corporate rating criteria, as measured by standard credit-related accounting ratios, appear to have become more “conservative” over time.[7]

Those who argue that an investor-pays business model has fewer potential conflicts than an issuer-pays model ignore the sources and drivers of potential conflicts of interest in the ratings business. Investors – whether they are short sellers, long-investors, or governments – can be just as motivated as issuers to influence ratings. Also, distinctions between investors and issuers are not easily drawn; both corporate and government entities may, at various times, be both an issuer of, and investor in, rated securities. Moreover, because investor-financed ratings are by definition only available to those who can afford the subscription fees, there is the risk with this investor-pays model that wealthier parties have an advantage over smaller rivals.

Another alternative model that is currently the focus of some debate is the “deal-pays” or “bond surcharge” model. This model seeks to avoid the conflicts between issuers, investors, and ratings agencies entirely by automating the fee payment process through some sort of surcharge on debt issuance that is thereafter allocated among credit rating agencies.

Whatever the mechanism for selecting the rating agencies, the nature of competition is changed. Rather than competing for investors and issuers on a one-by-one basis, each rating agency will seek to convince a single agent (whether a board of investors, the government, or a board of issuers) to pick it for the next transaction or set of transactions. This power leads to similar conflicts as exist in other models, and may result in “lobbying” activities and greater risk of error, as it substitutes the decision of one entity (the sole decision-maker) for the decisions of the many (the market).

Moody’s has always believed that healthy competition in the credit rating agency industry is crucial. It is the mechanism through which each participating rating agency is motivated to improve. The answer is not as simple as “more competition is good and less competition is bad.” The critical question is, “What kind of competition is being encouraged?” Are the rules and regulations (or the market) structurally encouraging competition for the most flattering ratings? Are they encouraging competition based on the most predictive ratings? Or are they encouraging something else entirely? We believe that the public interest is served by trying to answer the question “How can the system encourage high quality ratings?” not simply “Who should pay for these ratings?”

7. The Independence of Ratings Content

Most, if not all, policymakers recognize the need to preserve the independence of credit rating agencies. However, some policymakers have proposed “quality control” measures that intrude into ratings content and methodologies. Such measures can steer rating agencies toward government-approved opinions. We believe that regulatory change should clearly and unequivocally protect rating agency independence so that different credit rating agencies can have different views on the same security and compete against one another based on the quality and usefulness of their opinions.

8. Deterring Rating Shopping

Rating shopping is a harmful practice that exists regardless of whether issuers or subscribers pay for ratings. It stems from issuers’ control of the information needed to analyze an obligation and assign a rating. It occurs in situations where those paying for credit ratings do not feel constrained to seek the best quality rating. It is facilitated by opaque markets that limit the ability of credit rating agencies, analysts, and investors to independently make their own informed judgments and provide them to the marketplace.

Some policymakers have proposed requiring the disclosure of preliminary ratings to combat this problem. We do not believe that this will in any meaningful manner deter rating shopping. As issuers become aware that preliminary ratings will be required to be disclosed, they will simply “shop” one stage earlier in the process. For example, issuers could: (i) present “what if” scenarios to rating agencies, thereby avoiding any trigger for disclosure; or (ii) completely bypass rating agencies that are perceived to have a more conservative methodological approach. This will result in an environment where the more conservative rating agencies are not provided with an opportunity to offer their credit opinion to the market, thus leaving the market worse off in that only favorable preliminary and final credit ratings will be available for consideration.

As discussed in more detail below, we believe the answer to ratings shopping is to be found by encouraging issuers to make more detailed information as well as ongoing performance data available to the general public at issuance.

Improving Disclosure in the Structured Finance Market

As it is with corporate securities, analyzing and monitoring structured finance products is a data-intensive process. Consequently, Moody’s believes that one of the most significant steps that can be taken to restore confidence in the structured finance market and promote the appropriate use of credit ratings is to improve the availability and quantity of underlying information for structured securities in the market. We hope that regulators and policymakers will adopt a more forceful, legislative approach in encouraging issuers to address the information quality problems in the structured finance market.

Unlike in the corporate market, where investors and other market participants can reasonably develop their own informed opinions based on publicly available information, in the structured finance market there is insufficient public information to do so. Disclosure requirements for publicly offered securities do not require the public dissemination of sufficient information about the structure or underlying assets of a securitization to make reliable analysis possible. Indeed, under this limited information disclosure model, credit rating agencies must ask for additional information to analyze and rate securities.

In the absence of sufficient data, investors are unable to conduct their own analysis and develop their own independent views about potential or existing investments. Furthermore, credit rating agencies are practically unable to offer unsolicited ratings and research, which has the effect of restricting information available to investors and increasing the potential for rating shopping by issuers. Finally, since they are not subject to a similar degree of public scrutiny as corporate issuers, structured finance issuers may feel less responsibility for the quality of information related to their securitized products.

To address these problems in the structured finance market, Moody’s suggests policymakers require issuers of asset-backed securities to disclose the necessary information for investors to conduct a thorough analysis of the principal risks of the securities.

In our view, updating the disclosure regime will yield three principal benefits:

• Giving investors access to more information would reduce the risk of over-reliance on credit ratings. Such access also would have the effect of enhancing investors’ ability to meaningfully assess the work of credit rating agencies.
• Embedding enhanced information requirements in offering documents and ongoing performance documents intended for investors likely will improve the information about structures and assets. This approach, which is analogous to that taken in corporate debt markets, aligns responsibility for information quality with the party that: (i) has the greatest control over the information in the first place; and (ii) will gain the benefit from access to the securities markets.
• Making more information available to investors will broaden the range of opinions and analysis available, including from all credit rating agencies. If sufficient information is made available to investors, then it necessarily is available to those rating agencies not selected to rate a securitization. As a result, all rating agencies (as well as a host of other market commentators) would be in a position to offer ratings and research, which would broaden the range of information available to investors.

Risk of Diverging Rules: Regionalization of the Rating Agency Industry

Regulation is first and foremost the responsibility of national regulators who constitute the first line of defense against market instability. However, our financial markets are global in scope, therefore, intensified international cooperation among regulators and strengthening of international standards, where necessary, and their consistent implementation is necessary to protect against adverse cross-border, regional and global developments affecting international financial stability .[8]

In its April 2009 Declaration, the G-20 members committed to adopting registration systems for credit rating agencies by the end of 2009. Importantly, the G-20 agreed that countries should base their systems on the International Organization of Securities Commissions (IOSCO) Code of Conduct Fundamentals for Credit Rating Agencies (IOSCO Code). We fully support this approach because we believe that the IOSCO Code has created a common language used by regulators, rating agencies, and market participants around the world.

As national authorities work diligently to adhere to the G-20’s timeline, however, regulatory variations are emerging. Some of these variations strike at the core of rating agencies’ role in the financial system, including:

• Global ratings comparability . Some jurisdictions are imposing internal governance requirements that may result in each large office having to act as a separate rating agency, while others are requiring rating agencies to apply the same policies and procedures on a globally consistent basis;
• Use of ratings in regulation . Some jurisdictions seek to limit reliance on rating agencies, while others seem to be increasing reliance by using rating agencies to address wider disclosure issues, or as a means of prohibiting or restraining issuance of complex or new securities.

Moody’s supports the G-20’s position on “enhancing sound regulation,”[9] and we believe it is appropriate to align regulatory oversight with market activity. However, to the extent that rules diverge in significant ways from country to country, they will affect the consistency both of CRA operations and the use of credit ratings. Such outcomes, in turn, may negatively impact the broader markets by reducing the availability of comparable information across national borders, creating opportunities for regulatory arbitrage, and, ultimately, undermining investor confidence.

Conclusion

Moody’s has always believed that critical examination of the credit rating agency industry and its role in the broader market is a healthy process that can encourage best practices, support the integrity of our products and services, and allow our industry to adapt to the evolving expectations of market participants. Many necessary actions can and have been taken by Moody’s and others in the industry, and policymakers at the national and international levels have proposed a host of constructive reform measures for our industry and credit markets generally.