Thursday, September 24, 2009

Rating Agencies: The More the Moroser

It turns out I couldn't find a better antonym for "merrier" than "moroser."

But it is a grave and serious (both suggested antonyms) issue we're approaching today: the regulators' and market participants' aim to foster competition in the credit rating agency market. Just yesterday, various market participants and reporters expressed great delight at the NAIC's ruling to allow Realpoint LLC to rate portfolios of commercial mortgage-backed securities. (Separately, the NAIC is purportedly considering the viability of creating their own, not-for-profit rating agency.)

While we don't have anything whatsoever against Realpoint -- and while we certainly support the need for reform -- we would want regulators to tread this path carefully to avoid the creation of too many new credit rating agencies (CRAs or "NRSROs"). Remember, it was ratings competition that encouraged the decline in ratings quality in the first place, as the CRAs competed to win and maintain market share and revenue by altering their ratings standards.

We are not alone in this opinion. A former rating agency managing director submitted the following in prepared testimony to the House Oversight and Government Reform Committee:
“Senior management [at Moody's] still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten policies.” - Eric Kolchinsky
Competition as a concept is not necessarily a bad thing: for one it serves to bring down prices. We are not saying the "Big Three" CRA oligopoly should remain status quo. Nor are we saying that there should be a Big Three nor that it need remain Moody's, S&P and Fitch who comprise the Big Three. But we are saying that CRAs are not like hedge funds. Having three or five or ten accurate CRAs is worth a whole lot more than having 30 CRAs, irrespective of whether those 30 are accurate.


First, the recent years since Enron's failure have shown that regulating the CRAs is no mean feat. (Indeed the reforms proposed then were ineffective in buffering against this financial crisis.) It's going to be much more difficult to regulate an army of CRAs with different methodologies than to regulate only the currently existing ones. The SEC's website indicates that at least ten CRAs have already been granted NRSRO status.

Second, the creation of additional NRSROs places additional burden on the investor, who now has to familiarize herself with the slew of new methodologies.

Third, the CRAs were never competing on ratings cost anyway - they're competing on ratings standards (and historical performance to a limited degree). In other words, the less conservative approach might achieve a higher rating and win business. Now there will be more approaches to choose from. Thus, the availability of several alternatives only increases the problem of "ratings shopping," as issuers and structurers cast a wider net to achieve their ideal mix of (i) ratings quality/timeliness/service, (ii) ratings cost and (iii) minimal subordination level required to reach their target rating, in the case of structured finance securities. In the worst case scenario, thus, the rating chosen by the issuer, which typically seeks the highest rating, will be the most lenient measure available from the numerous CRAs. But this does nothing for the investor, who is usually best served by the most accurate rating. And the rating agencies are, after all, an investors service.

Fourth, the CRAs better fit the mould of regulator than that of market participant (buyer/seller). This financial crisis has brought upon us the realization that often having too many regulators can cause a problem: in the U.K. there is talk of the absorption of the FSA; in the U.S. the independent functionings of the OCC, OTS, and FDIC has resulted in various discussions -- especially with regional and community banks being able to swiftly switch between regulators -- which may result in one or more of them being folded into the SEC or the Fed, bodies proposing to take on further responsibilities going forward. Perhaps, then, we should be keeping tighter reins on the CRAs too and rather working towards creating fewer, manageable NRSROs with more meaningful responsibilities.

- PF2

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