Regulatory Use of Credit Ratings: How it Impacts the Behavior of Market Constituents

In July 2008, the United States Securities and Exchange Commission (SEC) published three proposals relating to the use of credit ratings in its rules and forms. The proposals were designed to address concerns that the misuse of credit ratings may have contributed to the current crisis. Learning from the recent experience and developing a solution to prevent future credit bubbles, the SEC is focusing, among other tasks, on credit rating agencies (CRA) oversight and regulation. The SEC Commissioner Kathleen Casey, in her speech to the SEC Open Meeting on December 3, 2008, stated that CRAs were not the only cause of the current crisis, but they played a role that was not insignificant. Last year the SEC staff conducted an extensive 10-month examination of the three largest CRAs and used the findings of the examination to inform the proposed amendments. The majority of them were related to the weaknesses of the rating process applied to rating residential mortgage-backed securities and collateralized debt obligations, lack of transparency, and conflicts of interests. As a result, the SEC called into question the appropriateness of using credit ratings as part of the regulatory process.

In Europe, the Joint Forum of the Basel Committee on Bank Supervision conducted its own survey of the use of credit ratings by its member authorities in the banking, securities, and insurance sectors. The survey answered the call of the G7’s “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience” to review whether the current regulations and/or supervisory policies unintentionally give credit ratings an official seal of approval that discourages investors from performing their own due diligence. The survey’s questionnaire was designed to elicit information regarding member authorities’ use of credit ratings in legislation, regulations, and supervisory policies. The goal of the survey was not only to collect information on internal references to “credit ratings,” “credit rating agencies,” or any references to specific credit rating agencies, but also to assess whether the use of credit ratings has had an effect of implying an endorsement of such ratings and rating agencies or discouraging investors from performing their own due diligence. The Joint Forum collected 17 surveys from member authorities, representing 26 separate agencies from 12 different countries, as well as five responses describing international frameworks.

Use of Credit Ratings by Fiduciaries and Regulators

Both in the U.S. and in Europe, credit ratings are generally used for five key purposes: (1) determining capital requirements; (2) identifying or classifying assets, usually in the context of eligible investments or permissible asset concentrations; (3) providing a credible evaluation of the credit risk associated with assets purchased as part of a securitization offering or a covered bond offering; (4) determining disclosure requirements; and (5) determining prospectus eligibility. Rating agencies themselves ascribe widespread use of credit ratings by the market participants to the following attributes:

• Independent: Investors may or may not agree with a specific rating opinion, but in general, it is believed to be unbiased towards any particular set of interests.
• Forward-looking: Through their historical default studies, rating agencies demonstrated that the ratings serve as reliable indicators of relative ability of bond issuers to honor their payment obligations upon maturity of the bonds.
• Stable: Ratings are meant to be driven by fundamentals of the issuing entity and not much affected by economic cycles.
• Simple, easy to understand: Letter symbols arranged in an alphabetical order are intuitively understood.
• Broad coverage: Credit rating agencies with global outreach assign ratings to hundreds and thousands of issuers in different countries. In addition, multiple asset classes and types of instruments are covered by rating services, which, in theory, allows for direct comparison of relative creditworthiness of different types of financial instruments.

The first regulatory reference to the ratings in the U.S. is found in 1931 in the Office of the Comptroller of the Currency (OCC) and Federal Reserve examination rules, and was mainly based on distinction between investment grade securities, generally rated BBB/Baa and above, and securities of below-investment grade quality. Over time, regulators in the U.S. and globally have incorporated credit ratings into laws and regulations to set capital requirements for regulated entities, provide a disclosure framework, and restrict investments. In 1975, the SEC adopted amendments to rule 15c3-1 of the Securities Exchange Act of 1934 requiring broker-dealers, when computing net capital, to “haircut" their proprietary securities positions. Rule 15c3-1 allows broker-dealers to take reduced haircuts for certain securities provided such securities are rated in a specified rating category by one or two credit rating agencies. Another example of rating use in regulatory documents is Rule 2a-7, which governs certain investment and operational policies of the U.S.-domiciled money market funds. It prohibits money market funds from investing in asset-backed securities unless rated by a credit rating agency. We also note that the SEC’s rules reference credit ratings assigned by different agencies interchangeably for the purposes of regulatory compliance and satisfying investment guidelines, thus contributing to commoditizing the rating opinions. Recognizing possible unintended consequences of the regulatory use of ratings, in the summer of 2008 the SEC in three separate releases proposed and sought public comments to amendments to most of the SEC’s rules that rely on security ratings with alternative requirements.

Market Participants Comment on the SEC Proposals to Remove References to Credit Ratings in its Rules

By the end of the comment period in September 2008, the SEC had collected and posted on its website 63 comments from retail and institutional investors, issuers, finance professional trade associations, and service providers such as law firms and CRAs themselves. The majority of respondents (79%) opposed the proposal of removing references from various SEC rules and other regulatory documents. Among those who opposed the SEC proposals were institutional investors mainly represented by the boards of independent directors of money market mutual funds and investment advisors managing those funds. The amendments, if accepted, were expected to make a significant impact on the scope of fund directors/trustees’ responsibilities short of placing the fund’s boards in the position of assessment or approval of individual securities’ creditworthiness. The boards found the proposed changes inconsistent with the broader SEC intent to reduce the operational burdens of fund directors. Responding funds’ directors pointed out other challenges that investors may face should the proposed changes be adopted:

• Boards of different fund complexes are likely to have diverse views on creditworthiness of money market securities thus complicating comparative analysis for fund investors;
• Smaller funds lacking research staff may pursue more aggressive strategy by pushing for yield rather than limiting credit risk.

Moreover, the boards’ members admitted lack of relevant credit analysis background or experience. Thus, the boards were likely to seek the advice of qualified consultants such as CRAs. Accordingly, the fund directors found the proposed changes neither advancing the core oversight role of the fund boards nor beneficial for fund investors, and urged the SEC to leave Rule 2a-7 in its current form.

Finance professional trade associations also expressed a high level of acceptance of references to credit ratings. One of the objectives of the professional trade associations is to liaise with regulators and facilitate lobbying activities of institutional investors such as mutual funds, public fund managers, or corporate treasurers. Thus professional trade associations do not provide their own opinion, but rather express the view of their members. Consistent with the view of institutional investors, 91% of participating professional trade associations were opposed to the relevant proposals. In its comment, The Investment Company Institute, the national association of the U.S. mutual funds and investment companies, noted that “…ratings – even if occasionally flawed – protect investors by establishing an important floor below which investments may not be made. By eliminating this floor, the Commission would remove an important investor protection…, abandon a regulatory framework that has proven highly successful, introduce new uncertainties and risks, and put in jeopardy a form of mutual fund that has served investors highly successfully for a generation.” Institutional investors and their professional trade associations use credit ratings as a benchmark that can be applied against a variety of conclusions regarding creditworthiness of a particular security by different fund boards. In their view, a removal of such a benchmark would likely create confusion for fund shareholders facing such multiple opinions and decrease comparability of fund portfolios managed by different investment advisors. In this case, the SEC is facing a dilemma of promoting market efficiency and transparency for the benefit of investors while limiting blind reliance on CRAs’ ratings.

On the other side of the spectrum is academia, which was represented by two respondents: Professor Lawrence J. White of the Stern School of Business, NYU, and Professor Frank Partnoy of the University of San Diego Law School. Both professors supported the proposed changes. Comments from academia were mainly focused on addressing an elimination of perceived monopoly of credit rating agencies created by the regulatory use of credit ratings. Prof. Lawrence J. White of the Stern School of Business, NYU noted, “the consequences of these existing requirements…have been to protect a handful of rating firms, who thereby have had a guaranteed market for their ratings.” Prof. Partnoy echoed Prof. White’s comment by reiterating his view that the success of the credit rating business is largely based on fee income from regulatory-dependent structured finance rating. Prof. Partnoy recommended including language indicating reliance on market-based information and market prices to gauge riskiness of a particular asset instead of credit ratings.

Critiquing Prof. Partnoy’s recommendation, we draw on the lessons of the market dislocation of 2007–2008: deterioration of relationship between market price of the security and its value. At the time of acute liquidity constraint, secondary market price does not necessarily reflect the security’s intrinsic value, but rather the balance sheet capacity of its market makers. Faced with the absence of market quotations, financial institutions were forced to take massive write downs on performing securities. High dependence of market indicators exacerbated the speed with which the market downfall unfolded. The SEC proposals were supported by academia mainly because of the stated goal to move away from the “regulatory license” and protected oligopoly of CRAs. The weakest part of the proposals is an absence of any suitable alternative for a credit risk indicator.

Comments were also submitted by organizations that provide services to the financial market participants such as data consolidators and distributors, law firms, and CRAs themselves. Six law firms’ comments on proposed changes were largely consistent with those comments provided by investors and trade associations representing broker/dealers and securitization market participants such as Securities Industry and Financial Markets Association (SIFMA) and American Securitization Forum (ASF). None of commenting law firms supported the proposed changes to Rule 3a-7, but rather expressed concerns that the removal of references to credits ratings and/or changes in eligibility requirements are likely to lead to less transparency in the asset-backed and mortgage-backed securities (ABS/MBS) markets and may further impair ability of ABS/MBS holders to sell or otherwise transfer affected securities.

The final and, perhaps, counterintuitive group of responses came from CRAs themselves. In the U.S. there are currently ten organizations officially recognized by the SEC as Nationally Recognized Statistical Rating Organizations (NRSRO). They are Realpoint LLC, LACE Financial Corp., A.M. Best Company, Inc., DBRS Ltd., Egan-Jones Rating Company, Fitch, Inc., Japan Credit Rating Agency, Ltd., Moody’s Investors Service, Inc., Rating and Investment Information, Inc., and Standard & Poor’s Ratings Services. Only five NRSROs participated in the comment process. The three of the five commenting rating organizations (Moody’s Investors Service, Standard & Poor’s Rating Services and Egan-Jones Ratings Company) supported the SEC proposals. Two NRSROs (DBRS, Ltd. and Realpoint, LLC) objected to the proposals.

Those NRSROs supporting the proposals recognized that the widespread regulatory use of ratings may present certain dangers for the rating business as it was initially envisioned. Fourteen years ago, Moody’s senior-level official Thomas McGuire discussed appropriateness of the use of the private product produced for a fee for regulatory purposes. He argued that the financial market would be able to keep a natural check on rating agencies to produce accurate ratings so long as no other objectives except serving investors’ interests weighed on the rating agencies. Use of ratings for regulatory purposes disturbs the natural balance. These CRAs’ main concern was related to the perception of greater need for the SEC to become involved in the substance of rating methodologies. Vicki A. Tillman, Executive Vice President Standard & Poor’s Ratings Services, commented that “the investing public may perceive that [the SEC] is involved in NRSROs’ processes or methodologies, or that [the SEC] has influence over the meaning or substance of NRSROs’ ratings.” In their comments, the participating global CRAs reiterated their view on credit ratings as merely one of the tools available to market participants including regulators. Moody’s Investors Service “[does] not believe, and never [has] recommended, that [ratings] should be used as anything but an opinion about credit risk. [Moody’s] expect[s] that [the SEC’s] reassessment of the use of ratings in its rules and forms will help reinforce this concept.”

Opposing the SEC proposal were two smaller rating agencies for which NRSRO status was granted relatively recently: DBRS received NRSRO status in September 2007, and Realpoint received NRSRO status in June 2008. DBRS highlighted a conflict of interest that a reliance on the use of broker/dealers internal models for calculating net capital requirements may pose if not checked against some other common measures of risk such as ratings assigned by NRSROs. DBRS also proposed measures to reduce and manage such a conflict. Commenting to Rule 2a-7 proposed amendments, DBRS also voiced concerns about whether boards of directors of money market funds have necessary expertise and resources to be solely responsible for credit quality control of portfolio holdings. Realpoint, being the most recent credit rating agency granted an NRSRO status, not only opposed the SEC proposals, but advocated enhancing and clarifying the role of NRSROs in the SEC’s documents. Responding to the SEC’s question of what the advantages and disadvantages are of eliminating the requirement to use NRSRO ratings from Rule 2a-7 governing activities of money market funds, Realpoint noted no advantages in relying solely on money market fund boards of directors to make minimum credit risk determinations, but proposed “[the SEC] to require the board to separately consider credit rating(s) of Requisite NRSROs and document or publish when the board's determinations deviate therefrom. Such a requirement would support [the SEC] stated goals without authorizing a complete disregard for readily-available NRSRO credit ratings.” Realpoint urged the SEC to consider amendments to the definition of “Requisite NRSROs” in Rule 2a-7 to include at least one unsolicited NRSRO credit rating.

Analysis of CRAs’ responses highlights an interesting phenomenon of a division in opinions of mature CRAs versus those recently granted NRSRO status. Both Moody’s and S&P advocated NRSRO ratings being removed from the SEC’s rules, thus eliminating the public perception of regulatory support of their businesses and encouraging independent credit research and analysis by the market participants. Contrary to this view, the new entrants DBRS and Realpoint supported the existing regulatory regime and suggested measures to enhance and encourage the use of ratings in the SEC rules. The division of CRA opinions suggests that the use of credit ratings in the SEC rules perhaps helps to enhance the existing ratings business model. If so, the new entrants may be challenged to gain a market share absent mandatory rating requirements and related “rating shopping.”

Change in Behavior of Market Constituents

There is an impression among some market participants, broad investment public, financial, and mainstream media that regulatory use of ratings caused the success of the credit rating business. Such an impression misconstrues the history of the use of the ratings. Indeed, the ratings agencies themselves have cautioned that CRAs’ ratings should not be used as a substitute for actual financial market regulation and market discipline. By using credit rating as a regulatory tool, a regulator can alter behavior of the market participants, including investors, issuers, regulated entities, and credit rating agencies themselves. Credit ratings are meant to be used by investors as an independent second opinion regarding securities’ creditworthiness, thus being an additional source of information in an investment decision-making process.

Issuers mainly use ratings to increase marketability of their debt, thus facilitating access to capital markets. By establishing a level of credit risk, published rating opinions play a major role in building an effective and liquid market. However, an official recognition of credit ratings in certain regulatory documents such as Net Capital Rule and an interchangeable use of available ratings encouraged “rating shopping” among issuers. Rating shopping occurs when an issuer chooses the rating agency that will assign the highest rating or that has the most lax criteria for achieving a desired rating. The phenomenon is especially noticeable in rating structured credit issues, where the rating is based on the use of quantitative models sensitive to various assumptions. In its report titled “Rating Shopping – Now the Consequences” published in April 2006, Nomura Securities pointed out an assumption of zero correlation between two companies in different industries in S&P modeling of default probabilities in CDO ratings. The assumption was more lenient than correlation statistics used by other rating agencies and led to more favorable rating conclusions. Naturally, S&P’s market share in CDO business was higher than that of Moody’s and Fitch. It was noted in the same report that investors may serve as a watchdog against rating shopping and demand deals having multiple ratings. In the environment where ratings are commoditized and used interchangeably, an issuer tends to request a rating from an agency with more lax standards than its competitors. Due to extra advantages derived from getting the highest possible rating, issuers are discouraged from considering a lower rating despite of its apparent benefit of accuracy and stability. From the issuer’s perspective, the rating credibility is supported by the official status of NRSROs.

Finally, rating agencies have viewed diversity of rating opinions derived on the basis of proprietary methodologies as one of the major benefits to the marketplace. However, the use of a ratings-based regulatory system for identifying, measuring, and managing investment risks may encourage regulators to attempt homogenizing credit rating methodologies. This comes in contradiction to the core purpose of the rating business: to provide independent and competing opinions about relative creditworthiness.

To conclude, we would like to note a growing dependency of all market constituents on the CRA ratings as a common measure of creditworthiness, especially in the world of less transparent structured credit securities. The behavior of market constituents, including investors, issuers, and regulated entities has been affected by such dependence. The SEC proposal came about to address the perceived failure of the CRA to accurately indicate riskiness of structured credit securities. Still, the feedback to the SEC proposals to eliminate references to NRSROs’ ratings in its rule indicates that the market participants are not ready to accept responsibilities for an independent credit risk assessment. We infer that investors, fiduciaries, and regulated entities are looking to regulators to offer a common measure of risk, accurate and free of conflict of interests. At the very minimum, the market participants expect the SEC to assume a more important role in controlling the integrity of the credit rating process.

Viktoria Baklanova, CFA, is senior director at the Fund and Asset Manager Rating Group of Fitch Ratings in New York. Viktoria is responsible for rating money market funds, bond funds, and other public investment vehicles. She is a PhD candidate at the University of Westminster Law School.

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The views and opinions expressed in this article are those of Ms. Baklanova and are not intended to, and do not represent, the opinions, views or policies of Fitch Ratings or the Fitch Group. The full text of the paper is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1378627