Analysis: Regulation of credit rating agencies poses conundrums for lawmakers

The government should not regulate the methodologies or ratings of credit rating agencies because it would reinforce an over-reliance on them, a top Treasury official told lawmakers this week.

Standard & Poor’s, Moody’s and other agencies have come under fire for misleading investors by assigning top ratings to mortgage-backed securities and other structured finance products that imploded when the housing market took a dive.

The administration’s regulatory reform proposals call for more transparency about ratings and strict supervision of how the agencies manage conflicts of interest, but do not include any regulation of the methodologies or ratings themselves.

It’s a counter-intuitive approach when lawmakers are looking for some response to the dramatic failure of ratings to alert investors to the potential risks of the investments.

It is like the approach the city of Paris took some years ago when it combated the problem of parking in the city by reducing the number of parking garages in order to discourage people from driving in the central city.

The central conundrum of the credit ratings came to the fore in testimony this week by the assistant Treasury secretary for Financial Institutions, Michael Barr. He acknowledged that “there were clear failures in credit rating agency methodologies” in the run-up to the crisis.

But, he said, the administration wanted to follow the lead set by Congress itself when it passed a law on credit agency reform in 2006 to distinguish between regulating the ratings and regulating the way in which they are communicated to the investing public.

“The government should not be in the business of regulating or evaluating the methodologies themselves, or the performance of ratings,” Barr said in testimony Wednesday before the Senate Banking Committee. “To do so would put the government in the position of validating private sector actors and would likely exacerbate over-reliance on ratings.”

 While this may sound reasonable, it ignores the fact that people rely on these ratings so much now because the SEC has designated a limited number of rating agencies as Nationally Recognized Statistical Ratings Organizations since 1975. A number of laws and SEC rules restrict investments of regulated entities like mutual funds and pension funds to those with a certain rating from these NRSROs.

Even before that, prudential bank regulators set ratings from the established agencies as thresholds for securities that banks were allowed to invest in.

Using the traffic analogy, making the rating agencies more accountable is not like solving a parking problem, but more like installing a traffic light at an intersection where there have been a number of fatal crashes.

This was the point made in testimony this week by John Coffee, a Columbia University law professor who testifies often on the subject of credit rating agencies.

He criticized both the administration and legislative proposals in Congress for falling short on two points – not requiring credit rating agencies to exercise a certain amount of due diligence in checking the creditworthiness of the risks they rate and not holding them accountable in the same way that auditors and underwriters are through the threat of legal liability.

“Unless the users of credit ratings believe that ratings are based on the real facts and not just a hypothetical set of facts, the credibility of ratings, particularly in the field of structured finance, will remain tarnished,” Coffee said in urging a requirement to perform due diligence.

 The threat of liability is necessary, he said, because the “issuer pays” model – the company receiving the rating pays the agency, creating a bias to please the customer – will continue to dominate the industry and requires the threat of lawsuits as a “countervailing pressure.”

Coffee suggested that the due diligence issue could be addressed by requiring mutual funds and other institutional investors to get certification of third-party due diligence as part of their own fiduciary duty. This would obviate the need to impose a requirement on the agencies themselves, who argue that they are only expressing opinions and are protected under the First Amendment.

As for the threat of litigation against the agencies, that could be limited to instances where there is a strong inference that the rating agency “knowingly or recklessly” failed to verify factual elements relevant to risk according to its own methodologies, Coffee said.

The Columbia expert noted another conundrum about credit rating agencies – that increased competition among agencies leads to an inflation of ratings as the agencies try to keep or lure customers with a more favorable rating.

It was only in 2006 under pressure from Congress that the SEC disclosed the criteria for becoming an NRSRO, opening the door for would-be competitors to S&P, Moody’s, and Fitch’s to gain the same status.

But, following Coffee’s view, the established agencies were more able to resist client pressure for better ratings when they were the only game in town.

One of the measures under consideration to curb this rate-shopping is to require issuers to disclose any and all ratings they receive on the issue, even preliminary ratings given as they are shopping around.

A more radical approach was advanced by Lawrence White, a New York University professor, who urged the committee to dismantle the entire NRSRO structure and rob the ratings of their force of law by removing all legal and regulatory requirements based on them.

Investors would still have to be prudent, White said. “But the burden should be placed directly on the regulated institutions to demonstrate and justify to their regulators that their bond portfolios are safe and appropriate – either by doing the research themselves, or by relying on third-party advisors,” he said.

This approach would allow investors to call upon a wider array of innovative and technologically advanced sources of advice for assessing the safety of their bond portfolios, White said. “The bond information market would be opened to innovation and entry in ways that have not been possible since the 1930s,” he said.

Any new legislative measures to delve deeper into regulating the methodologies of the rating agencies would only serve to rigidify the status quo and create a protective barrier around existing agencies, White argued.

The administration’s proposals do mention in passing that something should be done to lessen the market’s reliance on ratings. “But this seems to be largely lip service,” White said, “embodied in promises that the administration will examine the possibilities.”