Share SEC Report on Credit Ratings Highlights Conflict of Interest Inherent in Issuer-Pays Model with your friends.

E-mail

E-mail It

Social Web

December 19, 2012

SEC Report on Credit Ratings Highlights Conflict of Interest Inherent in Issuer-Pays Model

Posted in: Uncategorized

SECThe Securities and Exchange Commission released a report on the method for how credit rating agencies get their business, something mandated by the Dodd-Frank financial reform law. And just as expected, it showed a serious conflict of interest in the current business model, where rating agencies are paid by the issuer of securities, and have to compete for their business, adding all sorts of distortions into the kinds of ratings they give. A better model, envisioned by Dodd-Frank at first but then put into this study, would allow an oversight board to dole out to qualified ratings agencies the securities that would get rated, removing the conflict of interest entirely.

Sen. Al Franken championed this issue during the financial reform debate, and he seemed pleased with the results of the study. This is from an emailed statement:

“People all over the country, including thousands of Minnesotans, lost their homes or their life savings because of the greedy practices of Wall Street, and the credit rating agencies were a big part of the problem,” said Sen. Franken. ”I’m pleased that the SEC confirmed what I’ve always believed – that dangerous conflicts of interest continue to put investors at risk – and I’m going to work with the SEC to implement a solution to this problem.”

First of all, we have a oligopoly in the ratings agency business. 91% of all structured finance products in 2011 were rated by three agencies: Moody’s, Fitch, and Standard and Poor’s. Believe it or not, the system has seen INCREASED competition in recent years; this is down fro 97% in 2007. But regardless, this oligopoly increases the potential for corruption, while limiting the competition that could place a premium on quality ratings.

The SEC report highlights the potential for conflict of interest at work:

For example, an arranger may have multiple NRSROs (Nationally Recognized Statistical Rating Organizations) analyze a proposed structured finance product and select the one or two NRSROs that provide the desired credit ratings (i.e., engage in “rating shopping”) [...] This creates an incentive for the NRSRO or NRSROs to provide preliminary estimations desired by the arranger in order to be hired to produce a final credit rating for the transaction.

In addition to the “rating shopping” dynamic, the issuer-pay conflict may be more acute for structured finance products (as compared to other types of debt instruments) because certain arrangers of these products bring substantial ratings business to the NRSROs. As sources of repeat business, arrangers of structured finance products may exert greater undue influence on an NRSRO than personnel involved in obtaining credit ratings for other types of issuers. Furthermore, in the case of certain structured finance products, there are only a few major investment banks that assemble and sell these products. Losing the business of one of these banks could have a substantial impact on an NRSRO’s revenues. Conversely, an arranger potentially could bring repeat rating business to a credit rating agency because the arranger’s own credit rating was determined by the credit rating agency and, therefore, wants to curry favor with that credit rating agency.

This is all just common sense. If you have a small number of security issuers, and the rating agencies have to compete for their business, you’re going to get rating agencies who are incredibly compliant as far as their product goes.

The SEC offers a couple comments as to the potential for conflict of interest in a “subscriber-pay” model, if the subscriber has an interest in particular ratings. The solution is to get an independent agency to assign the ratings and then increase or decrease the amount that rating agencies get based on the QUALITY of the rating. If Fitch does a good job assessing risk over time, they get more business. If Moody’s does not, they lose business.

That this is completely simple probably means that it will never get enacted, but Franken has been pretty dogged on this front, and hopefully he will continue his efforts.

101 Park Avenue by Adam_T4 under Creative Commons license


Return to: SEC Report on Credit Ratings Highlights Conflict of Interest Inherent in Issuer-Pays Model