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Jun 30, 2010

Regulating ratings agencies

New regulation sees the ratings industry become a regulated business

In a 2002 settlement with Eliot Spitzer, Merrill Lynch paid $100 million in fines because the firm’s research analysts allegedly gave more favorable stock ratings to companies that used the brokerage to raise money by selling their stock and bonds to the public.

The investment bank, now part of Bank of America, was the first of ten Wall Street firms to pay a combined total of $1.4 billion to sever the links between research and investment banking, including analyst compensation for equity research and the practice of analysts accompanying investment banking personnel on pitches and roadshows. As a result, analyst compensation is now usually based on the performance of stocks in relation to the analysts’ recommendations, and the spinning of IPOs is banned.

‘Without admitting or denying, the industry recognized that the issue at hand was conflicts of interest between analysts and investment bankers,’ says Keith Darcy, executive director of the Ethics & Compliance Officer Association. ‘Analysts were getting paid by investment bankers to promote stocks they were underwriting securities for.’

Although the ‘big three’ ratings firms – Moody’s, Standard & Poor’s (S&P) and Fitch – were not included in Spitzer’s investigation, they are criticized for misjudging the risk of debt instruments, which were at the core of the 2008/09 financial meltdown.

‘At that time, debt markets were seen as involving only sophisticated investors who could protect themselves,’ says Columbia University professor John Coffee. ‘No one had any idea that ratings were being inflated. The 2002 research settlement was based on the need to protect retail investors, and institutional investors did not appear to need similar paternalism.’

Counting the costs
The price of that assumption has been very high. The carnage from the credit crisis included record personal bankruptcies, home foreclosures, General Motors and Chrysler entering bankruptcy, AIG, Fannie Mae and Freddie Mac becoming wards of the state, upwards of 15 million unemployed workers, a federal deficit of $1.3 trillion, federal debt of $13 trillion and investment banks Bear Stearns, Lehman Brothers and Merrill Lynch disappearing from the Wall Street landscape.

‘The financial crisis of 2008 can be traced back to lack of regulation around credit agencies and investment banks,’ says Baker Donelson board governance and securities attorney Gary Brown.

Under existing federal securities law, including the 2002 Sarbanes-Oxley Act, ratings agencies were not subject to any risk of liability and faced almost no competition and no oversight by any regulatory body.

‘Pressure from underwriters and deal sponsors who accounted for much of their business and profits caused ratings agencies to adjust their valuation models, overriding them much of the time, to produce the inflated AAA ratings that clients wanted,’ says Coffee.

The Franken amendment, authored by Democratic senator Al Franken, is set to completely overhaul the oversight of ratings agencies. Approved by the Senate on May 14, 2010, the amendment imposes tighter regulations on ratings agencies by creating a self-regulatory organization called the Credit Rating Agency Board, which would be overseen by the SEC.

‘The Franken amendment will do the same for the ratings agencies as Sarbanes-Oxley did for accountants and auditors, subjecting them to close regulatory oversight,’ says Coffee.

The Credit Rating Agency Board will be populated with a majority of investors, a representative from the issuer industry and ratings agency industry and an independent member. ‘Instead of letting issuers choose who will rate their products, the board would have discretion to implement a system that assigns credit rating agencies to provide initial ratings to reduce conflicts of interest,’ says Senator Franken’s press secretary, Jess McIntosh.

‘The system chosen by the board could be, but does not have to be, a randomized system, but it would have to take into account the performance of ratings agencies and their institutional and technical capacity. The board would be prohibited from receiving information about an issuer’s preferred agency.’

A little competition is a good thing
Critics think board oversight would, among other things, increase borrowing costs by delaying the securitization process. ‘Having the ratings agency assigned by a third party, whether the government or its designee, could lead investors to believe the resulting ratings were endorsed by the government, thereby encouraging over-reliance on the ratings,’ says Ed Sweeney, spokesperson for S&P.

McIntosh says ratings will be made without the endorsement of the government and will be labeled as independent. ‘The Franken amendment will increase competition by opening the process up to smaller ratings agencies that are currently shut out by the big three,’ she says. ‘Since accuracy will be rewarded under this system, every agency will have a greater incentive to pursue innovation and improve its research models.’

Doing your own diligence
A related amendment from Republican senator George LeMieux, also approved by the Senate, would require regulators like the Federal Deposit Insurance Corporation to develop their own standards of credit-worthiness rather than rely solely on ratings agencies’ assessments. ‘The Franken amendment’s semi-random assignment of ratings agencies will help, but LeMieux’s amendment is even more important because it gets rid of the veritable oligopoly that ratings agencies have enjoyed,’ says Open Compliance & Ethics Group CEO Scott Mitchell.

Franken’s office contends that the two amendments are compatible. ‘The LeMieux amendment doesn’t undercut the Franken amendment; rather, it ends government mandates that require banks to get credit ratings for some of their products,’ says McIntosh. ‘It does not end the use of credit ratings – it’s clear the private sector will continue to use them. The Franken amendment simply requires anyone who chooses to get a credit rating going forward to be assigned an initial ratings agency by the independent board so as to eliminate any conflicts of interest.’

Under the board, ratings agencies would get incentives and assignments based on the accuracy of their ratings, opening competition to smaller agencies such as Morningstar. ‘There’s greater probability that smaller agencies will receive an assignment now than they otherwise would without the board,’ says Catherine Odelbo, president of equity and credit research at Morningstar. ‘In the past Wall Street firms chose their own ratings agencies, and many favored the bigger agencies over the smaller ones.’

If nothing else, the Franken amendment breaks up the cartel currently enjoyed by Moody’s, S&P and Fitch.

Juliette Fairley

Juliette Fairley is a financial journalist and TV presenter who has worked for Forbes, the New York Times and Discovery Channel