Both the House and Senate bills propose to strip away federal rules requiring financial-services firms and institutional investors to factor credit ratings into their investment decisions, paring back the government’s implied endorsement of the agencies and theoretically paving the way for greater competition that could foster improved performance. Unfortunately, the bills may not go far enough. The Credit Rating Reform Act of 2006 also sought to foster competition by abolishing the SEC’s authority to designate NRSROs. Instead, it said, any firm that has three years of experience and meets certain other standards can register with the SEC as a “statistical ratings organization.”
“In reality, the Reform Act of 2006 created a tremendous barrier to entry,” Cifuentes says, noting that no one is likely to pay for ratings from a fledgling firm that isn’t recognized by the SEC. “As long as that legislation is not changed,” he argues, “it will be very difficult for new interests to come into this market.”
Meanwhile, there are other hurdles to effective reform, beginning with the fact that critics simply have not been able to reach a consensus on why rating agencies have performed so poorly over the past decade.
Some point to the lack of a standard ratings system that would make it easier to compare ratings and agency performance, and call for an independent body to create and oversee those standards. “Because each rating today means something else and takes different disclosure information into effect, it gives issuers the ability to pick and choose which agency they want to go to for their desired rating,” says Gene Phillips, a director at PF2 Securities Evaluations, a third-party CDO valuations and consulting firm. The proposed legislation merely calls for an SEC study of standardizing ratings terminology.
More vocally, many critics fault the agency system’s issuer-pay model: to win business, their argument goes, rating agencies watered down their standards in response to customer pressure. The Senate Permanent Subcommittee on Investigations presented evidence in support of this thesis for its April hearings on the rating agencies: a raft of seemingly damning e-mails sent by agency executives during the period leading up to the subprime crisis.
What’s the Real Problem?
Rather than modify internal controls, critics say that the agencies’ business model must change. Egan-Jones touts its model of being paid by end users. White and his colleague Matthew Richardson have argued for a system in which issuers pay into a common fund and the SEC then decides which agencies rate which securities. Still others have floated the idea of compensating rating agencies deal-by-deal based on the accuracy of their ratings, or by using as currency the very securities they have rated.
Other critics argue that the biggest problem with the rating agencies’ performance was that their rating methodologies themselves were suspect, especially when applied to structured securities. The agencies sometimes relied on very short default histories to predict the future behavior of mortgage-backed securities, for example. Perhaps most egregiously, they failed to account for the possibility that mortgages across the country could slide into default simultaneously — exactly what happened in 2007 after housing prices started to decline.