Rating Agency Reforms Overview: Rating agencies are drawing increasing criticism both for conflicts of interest and for a lack of foresight:
- Rating agencies are paid by the companies and governments whose securities they evaluate, rather than by the investors who rely on their opinions.
- They have a long history of flagging problems much too late, once they are apparent to other observers.
Rating Agency Inconsistencies: For example, Moody's forecasted a general decline in home prices for 2006, but did not follow that with credit downgrades for mortgage-backed securities.
Source of Rating Agencies’ Conflicts of Interest: The rating agencies changed their business model in the 1970s, switching the source of their revenues to the issuers of debt and equity (both private companies and government bodies) from the actual users of their ratings reports, such as:
- Investment Companies
- Insurance Companies
- Financial Advisors
- Individual Investors
The reason for this change was that, as photocopiers became more commonplace in the 1970s, the rating agencies saw revenues plummet as unauthorized copies of their reports began to circulate. Their situation was analogous to that of the music industry today, which is under seige by file-sharing technologies. The rating agencies started charging the issuers of debt and equity securities on the premise that they could not raise money if they were unrated.
Meanwhile, the leading rating agencies (Standard & Poor's, Moody's and Fitch) have been entrenched as a quasi-cartel ever since the SEC designated them "nationally recognized statistical rating organizations" (NRSROs) in 1975. A variety of federal and state regulatory bodies require banks, insurance companies and certain other financial institutions to hold only "investment grade" securities. The safe harbor for proving compliance is to show that one or more of the NRSROs gave such ratings to the securities in question. The quality of the ratings aside, this keeps up the demand for them.
Some observers suggest that financial institutions must do much more of their own research and investment monitoring, rather than trusting the rating agencies' judgment. The latter approach is having increasingly disastrous consequences, and using it as way to cut corners and shift blame is becoming increasingly unacceptable.
Proposed Rating Agency Reforms: Rating agencies face new 2008 SEC regulations. However, a bold program of reform proposed by the SEC back in June, and subsequently endorsed by an influential international organization of academics called the Financial Economists Roundtable (FER), got severely watered down by time the final regulations were issued on December 3. The initial set of proposals had four main parts.
First, there was a provision for improved public disclosures. The rating agencies would have to reveal their track records in predicting defaults. They also would have to disclose the data used in their models, and reveal their procedures for verifying data and for reviewing and modifying ratings. Publishing statistical analyses of their upgrades and downgrades by asset type also would be required.
Second, there was a proposal to require the rating agencies to overhaul their procedures for rating complex securities, such as MBS. Far too many mortgage-backed securities were granted unjustifiably high ratings, giving investors a false sense of confidence in them and thus contributing mightily to the current market meltdown. When the rating agencies proved completely unreliable in assessing the risk associated with MBS, this damaged the credibility of all their ratings, thereby increasing the severity of the credit crisis.
Third, the SEC had suggested reducing the use of ratings in its regulations. Veteran Wharton finance professor Marshall Blume feels that this was the most important proposal of all. It would force investors to do more of their own research, and not rely too much on the rating agencies, with all their conflicts of interest and analytical failures.
The only June SEC proposal that actually got adopted in December 2008 was one dealing with conflicts of interest. A rating agency must recuse itself from rating a security that it helped to design. Also, employees of rating agencies must refuse gifts from clients worth more than $25.
"It's a quarter of a loaf at best," says another Wharton finance professor, Richard Herring. However, he is encouraged that the Obama transition team asked the FER for its views on reforming the rating agencies. The last may not have been heard on these issues.
Rating Agencies and Securities Research: Rating agencies are good places to learn the craft of securities research and analysis, but potential hires should be alert to possible regulatory initiatives that may place these firms under even closer scrutiny. Even without increased regulation, rating agencies are likely to increase pressure on their employees as they get placed even more squarely under the microscope by the investing public in general.
Sell side securities analysis has its own problems with conflicts of interest. Specifically, giving bad opinions to securities or issuers can cost their employers underwriting business. Not coincidentally, unambiguously negative opinions are rarely given by sell side analysts.
Securities analysts of all stripes have spotty track records as forecasters. Be aware of this challenge if you consider entering the field.
