The fallout from the 2008 financial crisis continues in the form of greater regulation.
On May 18, the Securities and Exchange Commission proposed new rules for credit-rating agencies designed to increase transparency and improve the quality and integrity of the ratings they issue.
The proposed rules are designed to implement some provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year.
While the proposed rules will likely improve the ratings process and the resulting ratings of securities, particularly structured financial products, the danger is that, given those improvements, institutional buyers will once again let down their guard and fail to do sufficient due diligence of their own before investing in such products.
By all accounts, including from the Financial Crisis Inquiry Commission, shoddy rating practices — heavily tainted by conflicts of interest, particularly with regard to structured products such as mortgage-backed securities and collateralized debt obligations — contributed significantly to the crisis and the market meltdown.
There is evidence that the credit ratings agencies gave AAA ratings to structured securities that should have been rated far below that, and even below-investment grade. There are reports that rating agency employees even suggested to investment bankers how to tailor the mix of securities in structured products to gain the desired AAA ratings.
Whether this was because the agencies' analysts were simply outsmarted by the highly paid Wall Street investment bank quants, or the analysts were influenced by the fact that the ratings were being paid for by the investment banks and the analysts did not want to be responsible for losing future business by being tough, or both, is unclear. But in either case, the new regulations should reduce the problems in the future.
The proposed regulations, which will apply to Nationally Recognized Statistical Rating Organizations, would require them to report to the SEC on their internal controls, protect against conflicts of interest, establish professional standards for credit analysts, and disclose, along with any ratings, the methodology used to determine that rating. They would also be required to report on the performance of their ratings. Over time this should help investors determine how much weight to put on NRSRO ratings of securities.
Among the steps to be taken to prevent conflicts of interest, an NRSRO would be prohibited from issuing or maintaining a credit rating where an employee of the NRSRO who participated in the sale or marketing of a product or service of the NRSRO also participated in developing or approving procedures used in determining a credit rating.
Further, where a former employee of an NRSRO who participated in determining a credit rating is employed within a year by the issuer, underwriter or sponsor of the security, the NRSRO must determine whether any conflict of interest influenced the rating, and if so, it must revise the rating.
Some market observers have suggested the rating agencies should be abolished, as they have given investors a false sense of security and made them complacent about doing their own due diligence. That is unlikely to happen as there obviously is demand for informed opinion on the likely safety of a fixed-income security. Portfolio managers and analysts don't have the time, or often the depth of knowledge, to do their own analysis of every security brought to market by Wall Street, especially on the more exotic structured products.
Others argue the issuer-pay model is fraught with potential conflicts of interest as the rating agency has a natural tendency to please the customer paying for the rating, and that investors should pay for the ratings on the securities they are interested in buying.
Unfortunately, ratings are expensive, and no one investor would want to pay for a rating that other investors might take advantage of for free. That is in part why the current issuer-pay model evolved.
The tweaking of the system as prescribed by Dodd-Frank, and now being implemented by the SEC, is probably the best that can be accomplished at this time, but it won't solve all the problems with credit ratings.
Therefore, the message to institutional investors is: Don't become complacent. Do your own due diligence as far as possible to double check on the work of the credit rating agencies. Ask for more disclosure from them, and where possible, get second opinions. And if you don't understand something, or it seems too good to be true, don't buy it.