SEC Chairman Mary Schapiro recently said the rating agency industry needs to be subjected to a stronger regulatory framework because investors frequently consider those ratings in making investment decisions. Schapiro needs to follow up her soft words with a “big stick.”
The fixed-income solutions should be as draconian as the splitting of stock research from investment banking in the wake of irresponsible stock recommendations during the tech boom.
The three nationally recognized credit rating agencies (Moody’s Investors Services, Standard & Poor’s and Fitch Ratings) contributed significantly to the 2008 financial meltdown. A recent court decision opened up the possibility of massive liability claims against them.
The agencies assigned AAA ratings to mortgage-backed securities and collateralized bond obligations that subsequently defaulted. The AAA rating gave legitimacy to products backed by dubious mortgages and below investment grade bonds. The losses around the globe to investors were several trillion dollars. Critics charge that the abuses stemmed from the remuneration process.
The real problem, critics believe, is that issuers pay for ratings. In essence, the students grade the teacher.
In the past there was no one looking over the rating agencies’ shoulders to make sure that they were making reasonable assumptions or even that they possessed a basic understanding of the risks they were assessing. The SEC hopes to make changes that will increase the number of nationally recognized agencies and require the rating agencies to provide more transparency. Specifically, the SEC wants the agencies to provide greater disclosure on their deliberations and disseminate pertinent information.
Eric Kolchinsky, a former senior officer of Moody’s, has publicly accused the company of committing fraud. He charged that Moody’s was amply compensated for providing inflated ratings. Moody’s received $3 billion for providing structured finance ratings from 2002 to 2006.
Kolchinsky cited a flagrant inconsistency. Moody’s supplied a Wall Street financial product with a “high rating” even though it had already decided to downgrade the assets which “backed this security.” Moody’s contradictory actions raise meaningful ethical issues. He stressed that Moody’s failed to hire enough analysts to thoroughly investigate complex securities. This led to shoddy investigations.
Credit ratings are pivotal to the fixed-income markets. Investors, issuers, investment banks, broker-dealers and governments rely upon these ratings. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk. Accurate credit ratings increase the efficiency of the fixed income market, and lower costs for borrowers. This in turn increases the total supply of risk capital in the economy. It even opens the capital markets to borrowers who might otherwise be shut out altogether: small governments, startup companies, and special purpose borrowing facilities.
Professors from NYU offered a solution to the conflict of interest problem that arises from issuers paying for ratings. They recommended that the SEC should create a department that houses a centralized clearing platform for ratings agencies. They would select several rating agencies based on their experience at rating this type of debt, some historical perspective on how well the agency rates this type of debt relative to other ratings agencies, and past audits of the rating agency’s quality.
Warren Buffett could provide a meaningful role in helping the SEC fix the credit rating agency problem. His investment vehicle, Berkshire Hathaway, owns about 20 percent of Moody’s.
Thus, he could combine his financial clout and personal integrity to institute meaningful changes that could be emulated throughout the industry.
When the “Oracle from Omaha” speaks, people listen. He does not need to carry a “big stick.”
Originally published in the Sarasota Herald-Tribune
