Institutional Investor's Alpha Magazine - May 2008 - (Page 40)

Credit Rating Agencies directed against the big auditors that approved the books at Enron Corp. shortly before the huge energy company went belly-up in 2001, costing investors and employees billions. That scandal led to the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board and led to tough new auditing and governance regulations. A similar backlash may be in store for the rating agencies. There could be additional consequences. The Securities and Exchange Commission is investigating possible wrongdoing, as are a number of congressional committees. At issue is whether the agencies were guilty of something like what Wall Street ﬁrms did during the dot-com boom, when they routinely issued buy ratings on the very companies that paid them for their investment banking services. Collectively, ten ﬁrms agreed in 2002 to pay a $1.4 billion ﬁne and to sever the ties between their research departments and their investment banking operations. There is no question that the rating agencies contributed to the subprime crisis. First, they issued generally overly optimistic ratings on subprime debt. That encouraged a broad swath of investors to buy into such investments. Second, their subsequent downgrades, in which subprime holdings received junk ratings, created a cascading effect as many institutional investors — because of regulatory requirements — were no longer able to hold the securities once they dropped below investment grade. These securities streamed into a glutted market in which prices had already tanked. Losses begot losses, and the credit markets collapsed. The three main agencies enjoy a unique and privileged position as gatekeepers to the ﬁnancial markets. “There is no — JOHN COFFEE, PROFESSOR, competition to speak of, no liCOLUMBIA LAW SCHOOL ability, and even if their reputation is poor, you have to use them,” says John Coffee, a highly regarded expert on securities law at Columbia Law School. This oligopoly exists in part because the SEC for a long time kept the credit rating business a closed shop. The commission introduced the Nationally Recognized Statistical Rating Organization imprimatur in the 1970s for agencies whose credit ratings were recognized by regulators. But the SEC was slow to accept new players — it didn’t precisely deﬁne the criteria for being an NRSRO until 2003, two years after Enron’s demise — and the number of qualifying agencies dwindled through mergers, from seven in the 1980s to the big three as this decade began. Competition among the top players was further dampened by the fact that many bond issuers typically seek at least two ratings on their securities; Moody’s, S&P or Fitch were likely to get a piece of the action on any deal, regardless of whether they deserved it. After Enron, and particularly after the passage of the Credit Rating Agency Reform Act of 2006, the SEC began recognizing new NRSROs, and six small ones have joined the big three: A.M. Best Co.; Dominion Bond Rating Service; Japan Credit Rating Agency; R&I (Rating and Investment Information); Egan-Jones Ratings Co. and LACE Financial. The 2006 act gave the SEC sweeping new powers over the agencies, which the regulator in its own plodding way is just beginning to implement. SEC chairman Christopher Cox has promised that the commission will propose several new rules this summer. Chief among them: a requirement to disclose past performance. The SEC may also prohibit such conﬂicts of interest as an agency’s offering consulting services to companies whose bonds it is rating. And it may require disclosure of details on the underlying assets behind a rating and how the agencies keep their business departments from inﬂuencing ratings analysts, as well as greater transparency on analytical methodologies and procedures used to monitor ratings and keep them up to date (staleness of ratings is a main criticism of the agencies). Lawmakers, for their part, have expressed outrage over the rating agencies’ failure to do due diligence on the underlying assets of the mortgage securities they rate. They leave that to other parties like the mortgage originator or the underwriters. Congress is likely to insist that the rating agencies at least dip into the asset pool and verify some of the documents in question, perhaps through the use of third-party experts on due diligence. EVEN REGULATORS AND CRITICS outside the U.S. are weighing in. The Madrid-based International Organization of Securities Commissions in March proposed several changes to how rating agencies are regulated, including requirements for an independent review of methodologies and a ban on analysts’ proposing structural changes to products they are asked to rate. “The role played by credit rating agencies in the development of the market for structured ﬁnance products has raised serious issues for regulators globally,” says Michel Prada, chairman of the IOSCO committee that produced the recommendations. “These changes are required in order to ensure that investors and the ﬁ nancial markets can have conﬁdence that credit rating agencies are producing clear, well-researched ratings, free from bias, that can be easily understood by their users.” The proposed reforms may portend a larger crackdown. Among the questions being asked is whether the rating agencies are guilty of bad judgment or if something more sinister is afoot. One area the SEC is exploring is whether the rating agencies followed their own protocols on rating mortgage securities or whether they were led astray by conﬂicts of interest. The potential for such conﬂicts is much greater in rating mortgage securities than “There is no competition among the rating agencies to speak of, no liability, and even if their reputation is poor, you have to use them.” 40 • INSTITUTIONAL INVESTOR’S ALPHA • MAY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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