Momentum Builds for Rating Agency Reform

Robert G. Dobilas†

Momentum is building within the Administration and Congress to pass new legislation in the credit rating area as part of broader reforms under consideration in the wake of the current financial crisis. While many details remain to be resolved, the public policy debate thus far has focused on the following areas:

• Enhanced disclosure of who pays for credit ratings.
• Additional disclosure of certain issuer information.
• Additional due diligence and additional disclosure of rating methodologies.
• Elimination of some procedural hurdles to securities fraud claims.
• Elimination or reduction of statutory references to NRSRO ratings.

In this article, Realpoint discusses the pros and cons of these various approaches and the progress made to date in accomplishing these goals by federal and state administrative action.

By way of background, Realpoint is the most recent company to be designated a Nationally Recognized Statistical Rating Organization (NRSRO) by the Securities and Exchange Commission (SEC). We were designated for asset-backed securities and our market specialty is rating commercial mortgage-backed securities (CMBS). Realpoint is one of the five companies designated by the Federal Reserve Board as an eligible rating agency for these types of securities issued under the Term Asset-Backed Securities Loan Facility (TALF), and recently we were added to the list of Approved Rating Organizations by the National Association of Insurance Commissioners.

Also by way of background, there are two aspects of this issue which bear initial mention. The first, of course, is the widespread recognition among public officials in the U.S. that the dismal performance of the major rating agencies was a causal factor in the collapse of the credit markets. For example, the Report on Regulatory Reform of the Congressional Oversight Panel stated that the “major credit rating agencies played an important—and perhaps decisive—role in enabling (and validating) much of the behavior and decision making that now appears to have put the broader financial system at risk.[1] The SEC examination of issuer-paid ratings likewise found that the ratings were not merely inaccurate, but that there were serious questions about the “integrity of the ratings process as a whole.” [2]

Key congressional officials likewise subscribe to this view as per the recent congressional hearing at which the Chairman of the Senate Banking Committee, Senator Chris Dodd (D-CT), stated that, other than the subprime originators who knew they were making mortgages that were not going to be repaid, the credit rating industry was the industry most responsible for the nation’s credit and economic problems. [3]

Moreover, it is significant that the disapproval of the dominant rating companies is one of the few items in Washington with bipartisan support, as summarized at the same hearing in the comments of Senator Richard Shelby (R-AL), the senior Republican on the Committee:

“When I was Chairman of this Committee, we acted to address the problem after the SEC failed to take action on its own. I felt that the industry’s heavy concentration and high profits were symptoms of an industry in serious need of reform.” (Emphasis added)

Another congressional leader, then Chairman of the House Committee on Oversight and Government Reform, stated it even more bluntly at a November 2008 hearing on credit rating agencies: “[t]he story of the credit rating agencies is a story of colossal failure.” [4]

Representative Paul Kanjorski (D-PA), who now chairs the House Financial Services Subcommittee with jurisdiction over rating agencies, is also on record noting that: "[w]e must consider radical reforms aimed at improving accountability, reliability, transparency, and independence." [5] He added: “We therefore should no longer pursue only modest modifications in regulating this problematic industry."

The second background factor is that it was less than three years ago that the Congress enacted specific legislation in this area. The SEC regulations implementing that legislation did not go into effect until mid-2007, and there was some reluctance for a time to jump back into the fray. The realization has taken hold, however, that the legislation passed in 2006 was essentially a “process” bill designed to improve the regulatory procedures whereby rating agencies could be given national designation by the SEC. Under the rules implementing the Credit Rating Agency Reform Act of 2006, specific timelines were established for action on NRSRO applications, and the SEC continued to use that legislation as the basis for proposing and adopting additional rules particularly as they related to the management of conflicts of interest stemming from the dominant industry practice whereby the issuers or arrangers of public offerings pay for the ratings.

As discussed in this article, Realpoint agrees with the emerging consensus that while administrative actions in the U.S. and E.U. have been helpful, it is critical for Congress to step in once again to address the glaring failures by the major credit rating agencies that lead to the credit crisis. Governmental actions have stabilized the situation, but lack of confidence in credit ratings continues to impede the financial markets and full recovery in the private (and unassisted) debt markets remains a long and arduous task.

All it takes to understand the depth of this free-fall is a quick review of the CMBS market. At the height of the market, total securitizations were in the range of $200 billion per annum. However, there have been relatively few issuances for over a year. At the same time, there are over $150 billion of securitized commercial mortgages coming due between now and 2012.

Confidence can only be restored and the market truly reconstituted through meaningful governmental intervention aimed at putting in place the reforms necessary to address what is essentially a shared monopoly among three companies that operate under the issuer-pays business model. Two companies control approximately 80% of the market and a third company controls approximately 15% of the market.[6]

Realpoint’s Business Model

In contrast to the issuer-pays business model, Realpoint operates as an independent, subscriber-paid business. In addition to issuing monthly credit ratings for all CMBS, Realpoint offers a broad range of integrated commercial real estate research, surveillance, risk analytics, and data management services for CMBS. Realpoint’s reports include analytical performance summaries, “watch-list” alerts, and other information about a rated security or the underlying, property-level or loan-level collateral for that security. Realpoint’s monthly reports provide ongoing surveillance of the CMBS securities, real estate, properties, loans, and markets.

Realpoint’s revenues are derived from investors, portfolio managers, analysts, broker/dealers, and other market participants. If Realpoint does not produce accurate ratings, it may lose subscribers.

The Issuer-Paid Rating Agency Bidding and Selection Process

In the issuer-paid model, the rating agency focuses almost exclusively on the pre-sale situation; the bulk of the fees for those services are paid at the time the rated securities are issued. The record shows that the three major rating agencies have not lost market share despite poor performance.

As noted, the SEC report on the results of the performance of major rating agencies noted that today’s problem is that the integrity of the ratings process itself has been undermined. The reason for this is obvious to any serious observer: namely, the pervasive practice of “shopping” for preliminary credit ratings and steering the process in the direction of the agency likely to provide the most favorable rating.

This works as follows: when issuers solicit a bid from a rating agency for new-issue work, the issuer requires the rating agency to provide preliminary ratings as part of that bidding process. Unlike corporate bonds and general obligation municipal bonds, which may be rated using publicly-available financial information, an initial issuance of CMBS and other structured finance bonds is rated by a rating agency using privately-held information disclosed on a selective basis. As a consequence, the issuer or arranger of structured finance bonds has the ability to control the ratings process of a new issue by awarding the rating contracts, and its very substantial fees, to rating agencies that provide favorable preliminary ratings.

More precisely, the issuer generally begins the process of selecting its issuer-paid rating agencies by providing data (property information and existing mortgage loan terms) to three selected rating agencies. These companies then analyze the largest properties, and a sample of the other properties, to provide preliminary feedback regarding proposed tranches (i.e., the subordination level attachment points) for the securities to be backed by the pool. An agency that provides unfavorable preliminary feedback risks not being hired by the issuer.

Most often, the issuer chooses to select the two NRSROs that provide the most favorable preliminary feedback to rate the new issue. The issuer then provides the selected NRSROs with the remainder of the information with which to develop the final tranches. In short, the current practice of obtaining undisclosed preliminary ratings, coupled with the current reliance on issuer-paid credit ratings, fosters “ratings-shopping,” and a lack of independence, accountability, and transparency with respect to new-issue ratings.

Potential Benefits from the Availability of Pre-Sale Independent Ratings

The primary problem with the process describe above is simple: the parties who control the information control the end result.

The solution to this is equally simple and it only takes one step: let all the NRSROs have the same information and prepare their own ratings whether or not they are ultimately paid by the issuer of the securities.

Toward this end, the SEC acted in September 2009 to amend its NRSRO regulations by adopting new rules requiring any issuer or other sponsor of an asset-backed security seeking a credit rating from an NRSRO to disclose the same financial information given to its solicited NRSRO to all other NRSROs designated to offer ratings for that particular type of security.[7] We deem this to be one of the most important reforms undertaken by the government in response to the credit crisis. By requiring issuers to simultaneously disclose to all NRSROs the same information that the issuer provides to its hired NRSROs, investors will have the opportunity to receive pre-sale ratings and rating reports from other agencies who were not hired by, and who can thus be independent of, the issuer. In our view, there is simply no better and more straightforward way to enhance the transparency of the ratings process.

A newly proposed remedy to combat ratings shopping has been proposed by Senator Charles Schumer (D-NY), a senior member of the Senate Banking Committee. He has suggested that every tenth credit rating issued by an NRSRO carry one of its two ratings from a separate agency independently designated by the SEC. As he further described it, the purpose of these “randomized” ratings is to “receive a second, independent rating from a different credit rating agency than the one initially hired by the issuer.”[8] The effect of this proposal would likewise be to ameliorate ratings shopping and broaden market opportunities for independent companies.

Realpoint suggests taking this proposal further by requiring all new securities issuances to include an independent rating from an NRSRO (selected by the SEC or another independent agency).

Additional Disclosure Requirements

Considerable discussion has also been directed toward disclosure practices regarding ratings methodologies, and, in this regard, some observers have taken the position that requiring credit rating agencies to provide investors with access to their internal procedures and methodologies would constitute effective corrective action.

At Realpoint, we do not believe it makes much sense to shift the burden from the rating agency’s analysis of the debt issue to the public’s analysis of which rating agency has the best debt analysis system. We are not even sure how these complex (not to mention proprietary) systems are to be made readily available and understandable in Chinese, Russian, and 150 other languages in countries where investors would like to purchase dollar-denominated securities. What the investor really wants to know is that AAA means AAA, not whether one methodology produces a real AAA rating whereas another methodology results in a different version of AAA.

The same point applies to the question of whether there should be unique disclosure requirements for structured finance products. Our view, once again, is that the solution is not to confuse the public with different versions of AAA, but to make sure, as NRSROs, we are not improperly ascribing AAA status to securities on the basis of models that are “issuer-driven” rather than “investor-driven.” At the September 2009 meeting, we were pleased to see that the SEC formally withdrew a previous proposed rulemaking which would have effected dual designations, but the concept lives on in other forums.

Lastly, on the disclosure issue, it has also been suggested by some that another “easy” answer is to have all rating agencies make their ratings publicly available in some type of time-sensitive comparability format. This simply does not work with the subscriber-based business model since selling this information is how we produce our revenues. Realpoint and other companies like it are able to produce independent and reliable bond-rating analysis because certain investors are willing to pay for it, and these subscribers rightly believe that the information for which they are paying should not be made freely available to others. Not only would disclosure requirements of this type undermine competition from the subscriber-paid companies, some have argued that the mandate to make proprietary information freely available to the public may constitute a form of government taking.

Again, the point should not be to make investors do their own analysis because rating agencies failed to do the work for which they were paid. Investors should be able to assume that a rating firm will use reasonable efforts and proper due diligence to issue timely, accurate, and honest credit ratings.

Liability for Securities Fraud Claims

Several congressional measures have been introduced with the express purpose of reducing the First Amendment protections traditionally accorded to rating agencies by liberalizing “procedural” thresholds for private-sector litigation. In our view, this focus on First Amendment or “freedom of speech” defenses, which have traditionally been accorded by the courts to credit ratings, is counterproductive. At Realpoint, we offer and provide our research and best opinions regarding the likelihood of payment of a financial obligation, but we cannot be a financial guarantor of trillions of dollars of CMBS. Whether or not the larger companies could manage that risk is for them to determine, but, in our view, the removal of the industry’s liability protections is anti-competitive. Proposals to increase the potential liabilities of NRSROs, or the administrative costs of NRSROs, may in effect legislate smaller, “niche” NRSROs out of business and thereby force investors to rely on only a few, large NRSROs for ratings.

Various courts, State Attorneys General, and other parties including the SEC are revisiting these legal concepts and it is clear that some changes are in the works. In a major development, a federal judge in New York has ruled preliminarily that this longstanding defense was inapplicable in a case being brought against a rating agency by the Abu Dhabi Commercial Bank.[9] Another relevant case was initiated by one of the nation’s preeminent pension funds.[10]

We see no reason that the judicial process should be short circuited by congressional action particularly in light of the fact that many of the pending cases are in the early stages at the trial courts. Moreover, while securities litigation has worked well for the plaintiff’s bar, individual investors receive next to nothing from these cases and there is no conclusive evidence that there has been any significant deterrent effect. In the medical field as well, over half of malpractice expenses go to lawyers and administrative costs, according to a 2006 study in the New England Journal of Medicine. Additional resort to the courts for effective remedy resolution is not more of what we need in the business community.

Elimination or Reduction of Statutory References to NRSRO Ratings

Realpoint is not opposed to the removal of references to NRSROs from SEC rules, provided that an appropriate substitute, or system of controls, is in place before that removal is implemented. Our understanding is that part of the reason for the development of NRSRO ratings for regulatory purposes is that SEC wanted to use NRSRO ratings as a benchmark to avoid the need for the SEC to evaluate the models and procedures of every broker-dealer or money-market fund. The use of NRSRO ratings was to be viewed in the aggregate, with the resulting capital requirements or qualification of investments viewed in the aggregate. The use of NRSRO ratings was never intended to be a substitute for investor due diligence.

References to NRSRO ratings in SEC rules and regulations are not the cause of investors’ over-reliance on NRSRO ratings. The existing oligopoly structure and industry concentration, the lack of meaningful competition among NRSROs, the lack of pre-sale reports by unsolicited NRSROs, and past failures to expose rating-shopping practices contributed to investors’ over-reliance on NRSRO ratings. Investors relied on ratings because investors could only obtain pre-sale rating reports from the issuer-paid NRSROs; two ratings were provided with each new issue at no incremental cost to the investor and investors were not aware of how rating-shopping practices were used by issuers to obtain ratings.

Conclusion

The credit rating industry suffers from two fundamental problems. First, as noted above, it is highly concentrated, with two companies controlling approximately 80% of the market and a third company accounting for approximately the next 15% of the market. Second, market share has traditionally been maintained by the restricted flow of information from the issuers and arrangers of debt offerings through “ratings shopping.”

In addition, the integrity of the ratings process is undermined by an industry fee structure that relies too heavily on the issuers and arrangers of debt offerings to control the process through the direction of fees for new issues. Current industry practices also place too much emphasis on new issue ratings as opposed to ongoing surveillance on what are, of course, debt obligations of ten or twenty years or even longer durations.

Realpoint has been the major proponent in testimony before the Congress and the SEC in ending this practice of confining the flow of both presale and ongoing credit information only to those NRSROs hired to rate the issuance. As we tried to put it in commonly understood language at a recent congressional hearing:

This is not a complex problem and, in fact, it is not that different from when we were all in high school and everyone sought out the teachers who were known as “easy-graders.” This is what drove the massive level of high-grade defaults during the last two years and it still driving the remainder of the pre-sale process today.[11]

As described, considerable progress has been made on this front and more seems to be on the way in terms of effective transition having the issuer’s pre-sale information disclosed only to pre-selected agencies to being made available to all other qualified rating agencies. After that, the flow of independent ratings will provide the much-needed counterbalance to the system that failed investors and the taxpaying public in amounts reaching trillions of dollars.

† President and CEO, Realpoint LLC

[1] U.S. Congressional Oversight Panel, Special Report on Regulatory Reform (January 29, 2009), 40.

[2] Securities and Exchange Commission, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies by the Staff of the SEC (July, 2008).

[3] U.S. Committee on Banking, Housing & Urban Affairs,Examining Proposals to Enhance the Regulation of Credit Rating Agencies: Hearings before the Committee on Banking, Housing & Urban Affairs, opening statement , 111th Cong., 1st sess., Aug. 5, 2009.

[4] U.S. Congress, Hearing on the Credit Rating Agencies and the Financial Crisis: Statement of Chairman Henry Waxman, 110th Cong., 2nd sess., Oct. 22, 2008.

[5] U.S. Congress, Hearing on Approaches to Improving Credit Rating Agency Regulations, 111th Cong., 1st sess., May 19, 2009.

[6] Three NRSROs (Fitch, Moody's, and S&P) issued approximately 97% of all outstanding ratings. The concentration of outstanding ratings for these three NRSROs is high across all of the five NRSRO credit rating categories. Regarding the category of asset-backed securities, which includes CMBS, RMBS and other ABS, of the over 401,960 outstanding ratings in this credit rating class, all but 17,019 are issued by Fitch, Moody's, and S&P. Among the other NRSROs, Realpoint reports having the largest number of outstanding credit ratings for asset-backed securities (9,200 for 2.3% of all ratings in the category). See United States Securities and Exchange Commission, Annual Report on Nationally Recognized Statistical Rating Organizations, September 2009 .

[7] SEC Press Release 2009-200 (September 17, 2009).

[8] Press Release: Schumer Proposes New Backup Rating System to Keep Conflict-Riddled Credit Rating Firms Honest (August 5, 2009).

[9] Abu Dhabi Commercial Bank v. Morgan Stanley, No.CGC-08-7508 (NYSD).

[10] See, e.g., California Public Employees' Retirement System v. Moody's Corp., No. CGC-09-490241 (Cal. Superior Ct., July 9, 2009).

[11] U.S. Congress, Hearing on Approaches to Improving Credit Rating Agency Regulations: Statement of Robert G. Dobilas, 111th Cong., 1st sess., May 19, 2009.