Last week the Securities and Exchange Commission held a roundtable on the credit agencies to consider a range of ideas to get tougher on them. Securities and Exchange Commission Chairman Mary Schapiro lead the discussion and pointed out that “rating agency performance in the area of mortgage-backed securities backed by residential subprime loans, and the collateralized debt obligations linked to such securities has shaken investor confidence to its core.” The SEC has exclusive authority over rating agency registration and qualifications as a result of the Credit Rating Agency Reform Act of 2006.
There seems to be a conflict of interest when the fee for the rating agency is paid by the issuer of the debt instead of the investor who is relying on the rating. This issued-paid model accounts for 98% of the ratings.
The rating agencies are are faced with lots of litigation over their ratings of mortgage-back securities. One of their defense tactics is that their ratings are “opinions” and are protected by the First Amendment. That would probably mean having to prove actual malice and not just making a false statement. If the ratings are found to be more of a private commercial transaction then it is less likely that the First Amendment would apply.
One thing that has struck me as odd about the ratings is that they give the same designation to company debt as they do to structured products. It seems to me that there is a big difference between (1) the bonds issued by GE, payable from GE’s revenues and (2) the bonds issued out of a fixed pool of assets like Mortgage-Back Securities.
There are only a few dozen companies that have AAA ratings on their debt. These companies are actively managed looking for the long term success of the company. There are many variables, making the rating process more complicated.
On the other hand, the structured finance products are not actively managed. You have a bunch of income coming in and you structure that income flow into tranches. The default rate is governed by the quality of the assets and the larger economy’s effect on the cash flow from those assets. The rating process is complicated in a different way because you need to look at the variables that may affect the performance and how they may be correlated. I wrote before on how the rating agencies got this wrong: The Risk Management Formula That Killed Wall Street.
Maybe its time to break the ratings into separate categories so that investors will not be mistaken into thinking that a AAA rated mortgaged back security has less chance of a default than ExxonMobil.
What do you think?
- Text of Speech by Chairman Mary L. Schapiro
- Video of the Rountable (.wmv)
- SEC’s Schapiro: “Intense Review” of Rating Agencies Needed by Bruce Carton of Enforcement Action (Requires Compliance Week Subscription)
- SEC Puts Ratings Firms on Notice by Kara Scanell for WSJ.com
- Credit Agency Reform Act of 2006 (.pdf)
- The Risk Management Formula That Killed Wall Street
- Credit Raters Plead the First. Will it Fly? by Nathan Koppel for the Wall Street Journal
- A First Amendment Defense for the Rating Agencies from the WSJ Law Blog