How will Mary Schapiro fix the ratings-agency mess?

July 22, 2010
seems to be closed, with Ford pulling a deal which was going to be more than $1 billion.

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The biggest unintended consequences of Dodd-Frank to date is the fact that the market in asset-backed securities seems to be closed, with Ford pulling a deal which was going to be more than $1 billion.

There are two related issues here. The first is the repeal of SEC Rule 436(g), which had prevented investors from being able to sue ratings agencies if the ratings turned out to be wrong. There has been lots of talk of the ratings agencies “going on strike” — but technically the ratings agencies have never given their permission for their ratings to be used in bond prospectuses. Instead, the banks got the ratings in there anyway by dint of Rule 436(g), which basically allowed the ratings to be included even without permission from the ratings agencies themselves. Now that the rule has effectively been repealed, they can’t do that any more.

The second issue is a different SEC rule: Regulation AB Item 1120. That’s what people are talking about when they say that credit ratings are required to be included in bond prospectuses for asset-backed securities.

But Dodd-Frank gives the SEC the power to effectively rescind AB1120. If that happened, then credit ratings wouldn’t be included in bond prospectuses, but the bonds could still be sold.

Repealing AB1120, if only temporarily while the SEC works out some kind of sensible permanent solution, seems to be the obvious way to go, especially since it’s a move in the direction of removing credit ratings from official rules and regulations.

At the same time, however, it’s something of an end-run around the whole point of repealing 436(g), which is to make ratings agencies accountable for their actions. No one actually reads bond prospectuses in any case; all the buyers of structured notes are going to know what the ratings are even if they’re not in the prospectus. So repealing AB1120, while it might solve the gridlock problem, would be a bit of a stick in the eye of the legislators who repealed 436(g).

There’s one other possibility here, which would have a similar effect: the SEC could decree that credit ratings count as forward-looking statements, and therefore can’t be subject to “expert liability.”

But for the time being, we’re at an impasse which only the SEC can really do anything about: so long as the ratings agencies are liable for their ratings, they won’t allow them to be used, and yet at the same time the SEC is insisting that credit ratings are included in bond prospectuses. Clearly Congress hoped that the ratings agencies would reluctantly accept their increased liability, but equally clearly that ain’t gonna happen any time soon.

So this is a big test for Mary Schapiro: whether and how she fixes this problem will be a good indication of her philosophy as head of the SEC. What’s certain is that the ball’s now in her court.


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